ArcelorMittal Still a Steal

Despite a difficult operating environment, the steel giant shows promise.

ArcelorMittal continues to be one of our favorite steelmakers on the basis of valuation and its competitive position, with geographically and operationally diversified assets in both steel and mining. While this is still a weak operating environment, we think market fears are overblown, given the company's emerging-market exposure, asset-optimization plans, and potential for asset sales, as well as our view that steel fundamentals, excluding Europe, will be stronger in 2012 and 2013 than in 2011.

For 2012, management expects global steel consumption growth of 4.5%-5%, including 5% in China, 5.5% in the NAFTA countries, roughly flat in the European Union, and 5.7% for the rest of the world. This is about in line with forecasts made by the World Steel Association and commentary from other steel companies. Our shipment forecast for ArcelorMittal of 3% in 2012 assumes 5% growth in all steel segments other than Flat Carbon Europe, where we expect a 1% reduction. Apparent steel demand weakened in late 2011, but sentiment has improved with many global leading indicators rebounding. In the U.S., energy, equipment, and automotive end markets remain strong with some positive signs for the construction markets, with the Architectural Billings Index breaching 50 and the housing market appearing to have bottomed. Capacity utilization rates for steel producers in the U.S. are at a postrecession peak of nearly 80% despite increased supply. While raw-material prices and steel prices remain volatile, we are encouraged by signs of a widening spread relative to the last several months of 2011.

Bridget Freas, CFA, is a senior analyst with Morningstar covering the steel and aluminum sectors.

Weakness in Europe will cut deep as the recession unfolds, but more than one third of ArcelorMittal's shipments are to emerging markets. The company is already the largest steel producer in Brazil and Africa and the second largest in the Commonwealth of Independent States, and expansion plans are concentrated in Brazil and India. About 40% of EBITDA from the steel segments is generated from assets outside North America and the EU. While China is unlikely to repeat its prior couple of years of double-digit demand growth, we expect a soft landing in 2012, requiring steel demand in line with management's forecast of 5%. Steel consumption is a key component of early-stage economic development, and there is no reason China should be any different. Even while the past couple of years brought acceleration in China, a near-term cooling does not change the long-term growth story. The EU and U.S. are consuming 25%-35% less steel per capita than they did just five years ago, a trend that is not sustainable, while growth in Brazil and India is just starting to accelerate.

We view the company's decision to maintain capital expenditure plans and an annual dividend in 2012 as a sign of confidence. ArcelorMittal has suspended all steel capacity expansion for now, but after $4.8 billion in capital expenditures in 2011, it intends to spend $4 billion-$4.5 billion in 2012. About $3 billion is maintenance spending; the remaining $1 billion-$1.5 billion is focused on mining projects primarily in Canada, Liberia, and Brazil. The majority of these are expected to have an EBITDA payback period of less than 18 months, based on current prices. ArcelorMittal's last-minute cold feet about the Macarthur Coal deal indicates the company will pull back when it lacks confidence.

We do expect iron ore and coking coal prices to fall slowly over the next four years, but we do not view this as a risk to mining EBITDA growth, as any price risk is more than offset by volume growth and further supported by lower output costs per ton as production ramps, particularly for iron ore, which is a much larger component of the mining business.

ArcelorMittal's asset-optimization plan, sustainable cost-cutting efforts, and potential to sell noncore assets provide further protection against weaker-than-expected market conditions, in our view. In September 2011, the company outlined a plan targeting $1 billion of additional EBITDA by the end of 2012 through improvements in core assets--maximizing production at the lowest-cost facilities to increase productivity while scaling back production at less optimal plants to optimize output with no market share losses. It has idled several furnaces across Europe, including in Spain and France, and plans to permanently close 2.6 million tons of previously idled capacity in Belgium, which is expected to produce the bulk of the $1 billion in savings and will be heavily weighted to the back half of 2012. Management has also made strides to take costs out of the producing assets in the past two years, largely related to selling, general, and administrative and fixed costs. The firm had achieved about $4 billion in sustainable cost efficiencies as of the end of 2011, and it intends to achieve an additional $800 million by the end of 2012, largely related to variable costs and operational improvements. Finally, the company currently has $9 billion in investments in associates and joint ventures all over the world. Management believes there are significant noncore assets that do not contribute to the EBITDA line that could be sold at a reasonable valuation in 2012.

More Upside Potential Than Downside Risk for Next Two Years Our fair value estimate is derived from our base-case forecast for ArcelorMittal, which assumes a low-growth scenario overall with a modest recession in Europe, soft landing in China, and continued slow progress in the U.S. Our bear-case scenario assumes a deeper euro debt crisis and a stalling of steel consumption growth rates in 2012-13, which produces a fair value estimate of $29, above where the shares currently trade. While there is a wide range and we are not at the very bottom, our earnings estimates for ArcelorMittal are below consensus for 2012 and 2013. The more bullish consensus forecast further illustrates our view that the market is more spooked than the underlying fundamentals suggest. There could be additional upside potential to our fair value estimate should steel market conditions improve more quickly than we expect.

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ArcelorMittal Still a Steal