This Steel Giant Is Expecting an Improved Business Environment

Sarfaraz is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The world’s leading steel producer, ArcelorMittal (NYSE: MT), recently released its quarterly results that disappointed investors, but the sequential improvements led to some optimism. Meanwhile, its American rival, United States Steel (NYSE: X), also released its results that weren't any better, but the company is in a good position to capitalize on the changing market conditions. Steel stocks have largely struggled in the past, with the exception of Nucor (NYSE: NUE), due to problems associated with overcapacity. 

ArcelorMittal's earnings

Amid the cost cutting initiatives, the Europe-based steel behemoth posted a net loss of $345 million, down from a profit of $92 million in the same quarter last year as sales dropped 16% from $22.7 billion in Q1, 2012 to $19.75 billion in Q1, 2013. EBITDA has also dropped to $1.57 billion from $2.12 billion a year ago as shipments fell 5.7% to 20.95 million metric tons. The latest EBITDA figure included $500 million from the sale of carbon credits and gains made on asset disposal.

The company has been focusing its investments towards mining. The unit’s operating income dropped 19% YoY to $286 million due to lower prices, despite the 7% rise in quarterly external sales to 7.3 million tons.

Improvements

However, compared to the previous quarter’s net loss of $3.8 billion, the results show a considerable improvement. Shipments were also up 5% from the previous quarter. Earnings of the mining division were also up 54% sequentially. Moreover, the current EBITDA is above analysts’ estimates of $1.32 billion.

I believe that the sequential improvement is an indication that slowly but surely, the economic environment is improving. The company’s CEO, Lakshmi Mittal, said that the business environment will remain “challenging” and is expecting further sequential improvements in earnings as full year EBITDA is predicted to be more than $7.1 billion – as long as iron ore prices and steel margins do not fall below the 2012 levels. Moreover, to achieve the targets, the current cost cutting plans -- to reduce $3 billion by 2015 -- coupled with a 2% rise in steel shipments and a 20% rise in iron-ore shipments should also help.  

U.S. Steel

ArcelorMittal’s results were a little better, if not worse, than that of its smaller rival U.S. Steel that missed both top and bottom line estimates. U.S. Steel's first-quarter revenue dropped 11.2% year-over-year to $4.59 billion, missing analysts’ estimates by $70 million, while its adjusted loss per share of $0.35 was worse than the anticipated loss of $0.20 per share. However, I believe that U.S. Steel is better positioned than ArcelorMittal.

Nonetheless, the performance of steel companies in general has been far from impressive and the steel stocks have plummeted this year. Both ArcelorMittal and U.S. Steel's shares have fallen nearly 18% since the beginning of the year. But Nucor has gained 10.8%. Incredibly, over the course of one year, Nucor, a major player in the struggling steel industry, has matched the performance of S&P 500 ETF (SPY). Nucor is one of the few steelmakers actually posting a profit and is fundamentally sound. I believe that Nucor's investments in DRI will give it a cost advantage in the future and would reduce its reliance on using scrap metal in its mini-mills.  

Europe and China

Despite some of the positive rhetoric surrounding ArcelorMittal, the fact remains that the company has significant exposure to Europe. The steelmaker is practically a European company. The whole region is witnessing soft demand and prices are expected to remain under pressure in the near future as, according to Eurofer, the continent’s steel industry’s lobby group, the capacity exceeds the supply by 50-60 million metric tons. Furthermore, rising energy prices and labor costs are hurting Europe’s heavy industries, which I believe is one of the main reasons behind the soft steel demand from the continent.

ArcelorMittal is expecting a low to mid-single digit growth in demand in each of its markets except Europe, where it expects a decline. This year, global steel demand could grow by 3% to 3.5% while Europe will contract by 1%. Investors should note that Europe's anticipated contraction is considerably better from last year's decline of 9%. 

However, things are much better in the U.S and China. Both these regions could witness an increase in demand of 3% to 4.5%. Despite the current slowdown in the U.S., the automotive sector in both these countries has been showing improvements. According to Lakshmi Mittal, ArcelorMittal’s CEO, American auto sales could cross 15 million units this year. But the downside is that problems associated with overcapacity coming from China will persist in the near term.

China alone accounts for 46% of the total global production, and overcapacity from here puts pressure on steel prices around the world in general and Europe in particular. This year’s overcapacity is expected to be around 200 million tons. Therefore, China will continue to exert downward pressure on steel prices. 

What this means for ArcelorMittal’s investors is that they have little option but to ride out this tough environment as the company continues with its cost cutting initiatives and focuses more toward more lucrative operations – such as the new high-margin steel products for the energy and automotive sectors.

Conclusion

I believe that things will significantly change for the better for steel stocks in general and ArcelorMittal in particular once Europe stops contracting and China starts growing. However, that is not going to happen in the short-term which is evident from China’s anticipated overcapacity.

For now, U.S. Steel looks better simply because it is not heavily exposed to Europe and is better positioned to gain from the improving market conditions at home. Although U.S. Steel is considered one of the most expensive stocks with a lofty price-to-earnings ratio of 122.30 but what makes it relatively more valuable is its lower enterprise value, or EV, to sales ratio.

The EV to sales ratio gives better valuation as compared to P/E ratio when an industry, like steel, is cyclical in nature. Moreover, unlike the market cap, EV incorporates the effects of debt and cash reserves. In this case, ArcelorMittal’s EV to sales ratio is 0.49 while U.S. Steel’s is 0.31, which makes it more valuable. 

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Sarfaraz Khan has no position in any stocks mentioned. The Motley Fool recommends Nucor. The Motley Fool owns shares of ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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