NUE - ArcelorMittal Hit Hard On Weakening Spreads And Evidence Of Demand Erosion

Summary

• ArcelorMittal shares have been weak as spreads have come under pressure from plunging steel prices and persistently high energy costs.
• Steel demand in 2023 could be weaker than many companies expect, with non-residential construction and industrial machinery demand weakening.
• ArcelorMittal management has been doing a lot of good things, and India is a meaningful growth opportunity, but that's overshadowed by weak near-term sentiment on steel.
• ArcelorMittal shares look undervalued below the mid-$30s, but investors will have to wait out sentiment until utilization starts moving into the 70%s again.

This has been a rough year for ArcelorMittal ( MT ), as weakening demand and higher production costs have started to squeeze steel spreads more intensely. Macro concerns continue to dominate and overshadow the underlying operating improvements at this global steel giant, sending the shares down about 25% since the start of the year .

It’s hard for me to see significantly more downside in U.S. or EU steel prices from here, but commodity markets have a way of surprising in both the good and bad times, and even if prices stabilize near current levels, spreads are going to remain under pressure. As far as positive drivers go, I like ArcelorMittal’s opportunities in India and its focus on returns in mature markets, but those drivers likely won’t do much to offset the difficult macro environment.

ArcelorMittal shares look undervalued by all of the approaches I use, but sentiment on most segments of the steel sector is pretty poor now, and I don’t expect a particularly strong macro backdrop for 2023. This may be a name for more contrarian investors to consider as a longer-term rebound play, but it’ll take patience to work out.

Estimates Have Dropped Significantly Heading Into The Q3 Report

ArcelorMittal is due to report earnings later this week (Nov 10), and it seems increasingly likely that the report is going to be a weak one.

ArcelorMittal has shuttered significant capacity in Europe (around 11Mtpa) and has seen prices plunge relative to the second quarter, with recent spot prices in the EU and US down about 50% versus Q2, with Q3 average prices down about a third. Customers have started working down stocks in anticipation of weaker demand heading into 2023, and there have been reports of price cuts from Nucor ( NUE ) and Steel Dynamics ( STLD ) for some products. At the same time, input prices (energy in particular) have offered no respite, squeezing spreads in most of its markets.

In only about a month, the average sell-side EBITDA estimate for ArcelorMittal’s third quarter has fallen from about $3.3B to $2.3B, and expectations have likewise been dropping significantly for Q4’22 and 2023. I’d expect the Europe segment to see the most pronounced weakness, offset by relatively better performance (but still down significantly year over year and quarter over quarter) in NAFTA and Brazil. I would expect higher input prices (energy particularly) to drive higher working capital, and so I expect around $1 billion or so of net debt build from the second quarter – at this point, liquidity isn’t really an issue for ArcelorMittal, but the markets being how they are, it’ll likely be a talking point.

Commentary on the outlook for Q4 and 2023 will obviously be important to sentiment. Steel Dynamics management sounded relatively comfortable with the outlook for demand in the U.S., but I expect to hear about more destocking across the sector.

2023 And 2024 Aren’t Looking Great Right Now

I’m not particularly bullish about the outlook for the global economy or steel demand in 2023 at this point. Commercial construction activity, which accounts for around half of global steel demand (and around 40% to 45% of demand in the U.S. and EU) is slowing, and higher rates and weaker business confidence are not going to improve sentiment in the near term. U.S. demand should get some boost from increased infrastructure activities (including healthy energy market demand), but I’m still nervous on balance about non- residential construction.

Looking at industrial markets, I expect healthy heavy vehicle production in 2023 as companies carry meaningful backlogs into the year, but I do expect a downturn in orders for trucks and similar mobile equipment. Non-mobile machinery demand likewise seems set to fall as industrial orders decline and backlogs start to shrink (both Dover ( DOV ) and Honeywell ( HON ) have posted sequential backlog declines in Q3’22).

Auto production is a meaningful market to a point – it accounts for around 10% of global steel demand – but I’m getting more concerned about demand here as well. Ford ( F ) and General Motors ( GM ) had fairly positive commentary on their calls, and they’re looking to rebuild channel/dealer inventory, but outside of the U.S., I think we could see weaker demand, and particularly so in Europe. With around one-fifth of global auto steel, that’s a relevant market for ArcelorMittal.

Demand in 2024 has a lot to do with just how far the Fed overshoots in its attempts to stamp out inflation. I do expect non- residential construction demand to be better, but heavy vehicle demand could be softer, as could machinery.

With U.S. hot-rolled coil prices approaching $700/ton, I’m tempted to think that pricing won’t get too much worse. The U.S. market is more concentrated and more responsibly run than in past cycles, and the larger share of electric arc furnaces likewise helps. Still, commodity markets have a way of correcting below cost floors and a weaker 2023 economic outlook remains a threat.

Capacity utilization is currently below 70% in ArcelorMittal’s NAFTA, Brazil, and EU markets, and it usually takes capacity utilization heading toward the mid-70%s to get the stocks working again (or, I should say, anticipation of utilization in the mid-70%s). While further capacity cuts could perhaps help boost capacity, they won’t help reported revenue or EBITDA, so a lot is really riding now on better-than-expected demand and stronger-than-expected economies in 2023.

The Outlook

Despite a tough near-term outlook, I do see positives for ArcelorMittal. The company has embraced an operating philosophy built around cash flow and economic returns rather than capacity/scale for its own sake, and it has helped drive better full-cycle spreads and a cleaner balance sheet.

On top of that, I like the growth opportunity from the company’s operations in India – specifically the AMNS joint venture. India’s metal intensity is far below global averages (apparent steel use per capacity is around 70-80 versus a global average in the 240s), and the industry is pretty consolidated (the top four account for over 50% of capacity). Even if India can’t match the industrialization seen in China over the last few decades, closing just some of that gap would mean significant opportunities for AMNS; to that end, the company is planning to roughly triple its capacity (to 30Mtpa over time), and intends to self-fund this expansion.

Relative to my earlier expectations for 2022, ArcelorMittal has done a little better on shipments and realized prices (higher revenue), but worse on input costs (lower EBITDA). While my 2023-2024 EBITDA estimates were already lower than the Street’s, I’ve lowered them further (about 10%-15%) to account for weaker spreads and a weaker macro backdrop.

Over the long term, I’m still expecting very low single-digit revenue growth from the 2021 starting point and long-term FCF margins averaging out in the mid-single-digits, a meaningful improvement from a long-term low single-digit average. Discounted cash flow is definitely an imperfect way to value cyclical stocks like ArcelorMittal, but I believe it can point to periods where the Street is ignoring the likely long-term trend (for good or bad); for now, the Street seems very negative on the long-term outlook.

Likewise with my multiples-based valuation approaches. I’ve found that it's useful to value steel stocks on a hybrid EBITDA approach that combines a multiple to long-term average EBITDA and a multiple to forward twelve-month EBITDA, as well as an ROE-driven price/book approach. By both approaches the shares look undervalued (with a long-term EBITDA multiple of 5.4x, a short-term multiple of 3.75x, and a near-term trough ROE of 6%).

The Bottom Line

Unless the bottom falls out of 2023-2024 estimates, ArcelorMittal shares look too cheap below the mid-$30s, but clearly the market feels differently today. I do see downside risk for steel prices and profits in 2023/24, but even if 2023 EBITDA were to fall to $5B, I would still get a fair value in the low $30’s – assuming, of course, that long-term multiples to “steady-state” earnings aren’t going to be permanently lower.

Chasing value in the face of weak sentiment is nothing new for value-oriented investors, but it’s an approach that requires patience and a willingness to see some losses in the near term. I do think that valuation is quite low here, but with downside risk for 2023 still in play, I’d still advise some caution.

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