Dec 6 Barclays call on TX - Buy TX into the bounce: 1-OW
Defensive cost structure - Captive iron ore + DRI technology = Less exposure to raw material swings: Ternium holds a stake in two mining companies located in Mexico, with a total capacity of 4.2 Mtpa. We estimate that it currently produces ~50-60% of its iron ore requirements, placing it in a comfortable position (on a relative basis) against raw material price increases. Additionally, the company’s crude steel production in Mexican operations is mainly DRI based, which uses natural gas as a reducing agent as opposed to coking coal. This results in a relatively lower exposure to coking coal, which is only used as a steel making input in the Siderar blast furnaces in Argentina. Captive iron ore capacity combined with DRI technology in Mexico should place Ternium in a better position to weather raw material cost pressures than the typical integrated producers.
Venezuela - Last tranche still pending, but immaterial impacts in a worst-case scenario: Recently, the company disclosed that it did not receive the final instalment related to the Sidor nationalization process. While negative, similar situations have happened in the past (i.e. US$300mn that were overdue in the beginning of February were only paid in March 3rd), and we expect TX to proactively defend its interests going forward (litigation in international courts may be an option). For perspective, Ternium has already collected cUS$1.7bn since 2009, with this last receivable amounting to only US$256mn (2.8% of our target price). The “Venezuelan overhang” has been a reality of Ternium’s investment case during the past years, and we see no reasons for these concerns to continue weighing on share prices going forward. Valuation gap to continue closing; The short-term outlook still favors Ternium over Brazilian steels: The valuation gap has been one of the main pillars of our relative preference for Ternium vis-a-vis its Brazilian peers. After the significant outperformance of the stock over the past three months (in US$ terms, TX +11% vs. -6% for Brazilian steels) the discount play is no longer as compelling as before, currently at 30% vs. 40-45% some months ago. We acknowledge that Ternium should trade at a discount to its Brazilian peers mainly on: (i) lower growth prospects; (ii) higher country risk from its Argentinean operations; and (iii) its reliance on third party slab purchases to feed its rolling mills. On the positive side, we believe Ternium’s DRI technology in Mexico should earn a premium as the company is less exposed to coking coal pressures and we see no major differences in return prospects compared to Brazilians. We still see some room for further compression of the discount (potentially to the 20% levels) and view Ternium as the best vehicle to play the short-term rebound in US steel prices.
The sale of Usiminas’ stake – Overhang potential, but still a function of a window of opportunity: Usiminas holds a 14.25% stake in Ternium (c.US$1bn) and has publicly stated its intention of selling this stake (this was publicly mentioned for the first time during its 1Q10 conference call, in May 2010). According to Usiminas, the sale would be coordinated with Ternium’s controlling shareholder, and the timing of sale is still unclear. Admittedly, there is a short-term overhang potential (Ternium average daily traded volume is of US$8mn); however, the potential for higher liquidity of shares is a long-term positive for a stock we think has low visibility.