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Steel: Which Giant to Choose?
Posted by: Victor Selva (IP Logged)
Date: February 11, 2014 09:45AM
Currency risks in emerging markets, subdued international prices, and structural overcapacity. Though at first sight the outlook for the steel world might seem a bit bleak (maybe more than a bit), I am of the belief that there are still reasons to bet on some producers that are robust enough to thrive in a non-friendly environment and become leaders in an extremely competitive sector.
Despite current turmoil in emerging economies, global volatility and falling prices, the long-run fundamentals for the steel industry are still worth considering. As the world comes out of recession and less developed countries make huge efforts to catch up with major global powers, the steel sector becomes a main player the mammoth investments that need to be realized in emerging markets such as China, India and Brazil.
The truth is that that the global steel industry is very competitive, with even large companies grasping only a small market share and ending up as price-takers. But opportunities reside on being cost-effective and flexible enough to swings in economic cycles. Some of the candidates to prosper in this unstable scenario are ArcelorMittal (MT), the world’s largest steelmaker, and United States Steel Corp. (X), a steel giant with a long-held dominance in the American market. Instead, I would choose to go long on Gerdau SA (GGB), the second-largest producer in the sector.
Why Not No. 1?
Brazil-based Gerdau has three main advantages. Size – though it’s a strong pro – is not necessarily one of them. To start with, Gerdau is a highly integrated company, with annual iron ore production capacity totaling 11.5 million metric tons, enabling it to be over 80% and 40% self-sufficient in Brazil and the U.S., respectively, and thus hedging itself from volatility in raw material prices.
Second, the company has a relatively modern fleet of furnaces, mainly composed of electric arc furnaces (EAFs), which are more energy-efficient than traditional blast furnaces and should result on a more flexible supply.
Last, the location is also a positive factor: with a high geographical diversification, Gerdau has still managed to maintain a strong leadership in the markets where it operates (particularly in Brazil and the U.S.). This allows it, on the one hand, to supply many different markets and therefore reduce risks of local economic underperformances and, on the other hand, to profit from low-cost labor in Brazil. In addition, the upcoming sporting events – 2014 World Cup and 2016 Olympics – are expected to generate a strong inflow of investments in infrastructure in the country, with Gerdau as a potential beneficiary of this.
In spite of being the biggest worldwide, I believe that ArcelorMittal doesn’t count with these characteristics. Further, as players in the industry are so atomized, being the No. 1 producer implies having only 6% of the global market share, which doesn’t give ArcelorMittal a superior bargain power than its peers. And though it’s still a very diversified and vertically integrated group, its costs will tend to be higher than those of Gerdau, since its furnaces are primarily blast furnaces and its labor expenses are higher as the company is based in Europe.
US Steel will also have to deal with an old and inefficient fleet of furnaces, which will inevitably position it behind modern producers. Through its Project Carnegie, management is approaching this problem, but the pace of investments in EAFs will not be enough to meet the market requirements. Moreover, by condensing most of its operations in the U.S., the company has the disadvantage of high operational costs, too. This has resulted in U.S. Steel reporting net losses for the last four years. This makes it for me, the least attractive stock of the three.
Gerdau’s P/E ratio is of 12.24x, trading significantly lower than U.S. Steel (15.62x) and ArcelorMittal (18.57x). In my view, this discount is justified, as mentioned, by its operational efficiency, its vertical integration and its geographical diversification with strong presence in the markets where it holds production units. In addition, Gerdau is the only one of the three that presents a positive operational margin (3.18% vs. -1.18% and -4.16% for U.S. Steel and ArcelorMittal, respectively), evincing its better-suited production techniques and low costs.
World-leading guru Steven Cohen (Trades, Portfolio) recently bought 62,837 shares of Gerdau, while Ken Fisher (Trades, Portfolio) has increased his holding by 13.2%. I trust their moves might be indicating that this may be a good moment to look at Gerdau.
Disclosure: Victor Selva holds no position in any stocks mentioned.
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