After A Lot Of Pain, Can ArcelorMittal Deliver Some Gains?
Summary
•Weak domestic demand has pushed Chinese steel producers to export even more steel, keeping the pressure on steel prices in North America and Brazil amidst lackluster demand (particularly in Brazil).
•ArcelorMittal higher-than-average costs give it more leverage to a strong recovery, but depress margins and returns across the full cycle.
•ArcelorMittal looks like an iffy long-term prospect, but the shares could have double-digit upside if this summer does indeed mark a bottom in Western Hemisphere steel.
Not every steel stock has been a crushing disappointment since my last update on ArcelorMittal (NYSE:MT), but most of them have lived down to that generalization. That 10-month stretch has seen Steel Dynamics (NASDAQ:STLD) fall almost 10%, while Gerdau (NYSE:GGB) has fallen more than 50% and ArcelorMittal itself has fallen another quarter. As I said, there have been a few exceptions as voestalpine (OTCPK:VLPNY) and Salzgitter (OTCPK:SZGPY) have managed positive returns in U.S. dollars.
The simple answer to what's gone wrong is that prices continue to erode in the face of too little supply discipline and weak demand. Iron ore prices have effectively collapsed and hot-rolled steel prices are down by double-digit amounts from the prior year. While conditions have actually been improving in Europe, North America and Brazil are still looking at lackluster demand and meaningful import competition.
Is ArcelorMittal at long last a true bargain or is this just a reloaded value trap? Over the long term, I lean toward the latter as I believe the company's iron ore operations are structurally disadvantaged and the company is unlikely to earn a good return relative to its cost of equity. In the short term, I think it's possible to make a more bullish argument as the shares seem to be pricing current conditions as close to a new normal.
Will Imports Ruin Any Recovery?
One of the chief challenges to North American producers like ArcelorMittal, Steel Dynamics, and Gerdau (which is a Brazilian company but has considerable assets in North America) is that seemingly any price momentum is met by increased exports from Chinese producers. Chinese steel companies are gorging on cheap Australian coal and iron ore, and since their own domestic demand environment isn't good (domestic consumption declined 5% yoy in Jan-Apr 2015), they're sending that steel to North America and Brazil and exports have risen 33% yoy from January to April of this year.
One of the principal issues is the different cost structure. Estimates vary, but most industry analysts seem to agree that cash breakeven on exports for the Chinese steel industry is somewhere in the neighborhood of $375/t for hot-rolled steel. Weak as North American prices have been, they've still managed to stay in the mid-$400's and that's ample incentive for Chinese producers to export - imports climbed to around 28% share of the U.S. market in 2014 and they're still rising.
What happens next is a big question. U.S. producers want tariffs on imported steel and history would suggest they'll probably get them. What doesn't seem to be on the table are significant capacity curtailments by major U.S. producers. ArcelorMittal has talked about restructuring its North American operations, but management comments lead me to think that's most likely going to focus on downstream operations like finishing as opposed to closing meaningful production capacity. Likewise with Nucor (NYSE:NUE), Steel Dynamics, and U.S. Steel (NYSE:X) - nobody seems eager to shrink capacity, even though that seemed to help the European market.
Speaking of the European market, it looks as though some winds of protectionism might be blowing there too. Regulators are looking at tariffs on cold-rolled steel imported from Russia and China and although those aren't a big part of the EU market, it represents a change in attitude relative to recent practice.
Can Iron Ore Be Fixed?
When iron ore was expensive, ArcelorMittal's extensive vertical integration seemed like a great advantage (the company can supply more than half of its own iron ore needs, and close to a quarter of its coal needs). Now that prices have plunged to heretofore unthinkable levels, that asset has started to look more like a mixed blessing if not an albatross.
I think ArcelorMittal would do very well to achieve long-term costs in its iron ore operations in the $60's/ton - much higher than the low-cost Australian operations of Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP), as well as Vale's (NYSE:VALE) Brazilian operations. Management believes they can reduce costs at various points in the supply chain, but they're just not going to compete with sub-$30 cash costs in Western Australia. It's not entirely fair to compare ArcelorMittal to the cost-leaders, and long-term spot market pricing is likely to be quite higher than those low-end cash costs, but a long-term low price environment for iron ore does erode the company's cost advantage over non-integrated producers.
Waiting For Global Growth
Unlike voestalpine, and to a lesser extent Steel Dynamics, I don't believe there's a lot that ArcelorMittal can do to "high-grade" its portfolio. The company's Usibor high-strength steel may fend off competition from aluminum in the auto sector, but the company is simply too big (around 8% to 9% of global capacity) to use mix shifts to higher-value products like auto steel or rail to offset core weakness.
What ArcelorMittal needs more than anything is supply discipline and demand growth. Global capacity utilization was below 73% in April despite a 1% decline in global production. Generally speaking, 80% to 85% is the point where integrated steel companies can do well and where ArcelorMittal can start generating good leverage on its otherwise relatively high fixed cost base.
U.S. auto production has been pretty solid, but there could still be upside from non-residential construction and infrastructure. Brazil is in the midst of a severe downturn that has sapped demand for construction, appliances, and autos, but I expect that this market will turn around (although "when" is a key question). China remains a key swing market; it would do ArcelorMittal and other U.S. producers a lot of good to see the Chinese construction market come back to life in a big way and reabsorb the steel that is being directed to the export market.