Dec 6 Barclays call on TX - Buy TX into the bounce: 1-OW
TX is the most leveraged steel maker in our coverage universe to the recovery in global steel prices, with an EBITDA exposure to North America of approximately 55-60% (mainly spot based contracts). As a result of the unfavorable domestic inventory trends (I/S ratio at 4-months), Brazilian steel pricing dynamics should remain fairly insulated from global movements. We expect TX to continue outperforming its Brazilian peers, and believe its valuation gap should narrow further. TX trades on a 2011E EV/EBITDA of 4.9x, at an excessive 30% discount to Brazilian mills, in our view. Global steel prices rebounding – Just another mini-cycle? The recent news flow is definitely positive for global steel stocks, especially amidst low expectations and months of underperformance. Nucor has been reportedly attempting to implement sequential price increases amounting to US$80/s.ton (mostly cost-push driven), which we consider positive, if fully implemented. We retain our fundamental longer-term caution on the steel industry as a result of chronic excess capacity in ex-China steel markets of about 150Mt, weak construction market demand trends, liquid export markets and lower-than-expected supplier discipline (one of the reasons for minicycles). While we agree with the near-term bounce trade, it is likely that history repeats itself, and steel prices correct shortly due to loose supply/demand conditions, which we believe are irreversible in the short/mid-term. We maintain our call that the Brazilian steel sector should bottom in 1Q11 (not in the 4Q10) and that the destocking cycle should only end by 2Q11. We reiterate our preference for non-Brazil steel exposure and would be buyers of Ternium into the bounce in steel prices.
Short-term momentum – Prices in the US moving higher, mainly cost driven: Some bright spots are emerging, and we view TX as the main beneficiary of recent industry developments (with c.60% of revenue exposure to US/Mexico). While there are still reasons to justify fundamental caution (end-user demand 28% below pre-crisis levels and an industry running on 70% of its capability), price increase announcements have been higher than expected. Nevertheless, it is important to note that previous attempts to increase prices by US steelmakers have not been successfully implemented. We credit the spike in prices mainly to rising cost pressures and improving sentiment. Moving into company specific issues, it is important to note that the bulk of TX’s shipments in North America are spot price based (annual contracts usually carry quarterly re-setting pricing mechanisms), which should allow the company to gain from an environment of rising steel prices.
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.
Concerns on its capex plans are exaggerated – We welcome the leverage. Ternium’s current net cash position amounts to US$300mn, and we believe market participants may be excessively discounting the company’s sub-optimal capital structure. In our view, the resumption of its capex plans may provide a positive catalyst to shares and some of the alternatives under study include: (i) a greenfield slab project in Brazil (most likely); (ii) brownfield crude steel expansions in Argentina; (iii) further downstream rolling capacity additions in Mexico/Argentina; and (iv) upstream investments to enhance its iron ore mining operations in Mexico. Some investors are concerned with the possibility of the company engaging in a large greenfield slab project in Brazil due to high execution risks, the significant capex burden and weak fundamentals of the slab market. Nevertheless, in our view, there are a few aspects which are being overlooked, including: (i) this project would face lower volumes risk, as the output would be directed to tap Ternium’s current slab deficit (feeding rolling facilities in Mexico); (ii) the project’s lead-time would be greater than three years, and we expect global markets to be more balanced by then; (iii) this project might enable the company to participate in the significant long-term growth potential of the Brazilian steel market; and (iv) a higher proportion of results derived from Brazil may demand a lower country-risk for the company.