Description

Overview: Aperam (APAM), a best-in-breed stainless steel manufacturer in an out-of-favor industry, offers investors over 200% upside with limited downside given its low leverage with no near term maturities, high dividend yield, strong cross-cycle earnings power, credible cost-cutting program, and positioning to benefit from Brazil’s urbanization and very likely European stainless steel consolidation. Everyone is negative on the stainless markets, and seemingly no expectations are baked into APAM's current valuation. Since its spin from ArcelorMittal (MT) at €30/share early this year, APAM has traded below €11, providing a compelling entry point to investors. APAM is undervalued on an absolute and relative basis: it currently trades at ~2x normalized EBITDA and at a 30-50% discount to peers Acerinox SA (ACX) and Outokumpu Oyj (OUT1V), both of which have lower cross-cycle earnings and significantly higher leverage than APAM. When market participants focus on normalized EPS as they did in the beginning of 2009, the stock will have a huge move.

Company Background: APAM has one of the largest stainless and specialty steels distribution networks in the world, with 19 stainless steel service centers, 10 transformation facilities and 30 sales offices located on 3 continents over 30 countries. With a production portfolio of Ferritic, Austenitic, non-grain oriented electrical, grain-oriented electrical, and high nickel alloys, APAM has diverse exposure to the stainless steel space. The company also has high exposure to niche stainless grades whose margins significantly outstrip those of commercial grades on a per-ton basis. Roughly 70% of APAM’s 3,100kt upstream capacity are located in France and sit in the lower half of the European cost curve. APAM’s key asset, its Brazilian mill Timoteo, has upstream capacity of 0.9mt and produces flat stainless steel and electrical steel products. Brazilian stainless steel market is in tight supply, and industry participants consider Brazil’s stainless market one of the most attractive end markets globally. Timoteo is running close to full capacity, with volumes in the most recent quarter growing quarter-over-quarter as a result of strong automotive demand.

APAM’s assets generate margins well in excess of European peers; from 2007 to 2009, EBITDA per ton averaged $314 for APAM (10.4% margin), $165 for Acerinox (5.6% margin), $186 for Outokumpu (4.5% margin), and $93 for ThyssenKrupp (2.5% margin).

Stainless Steel Industry: All stainless players’ earnings and valuation have suffered due to slower than expected economic growth, European end market exposure, nickel price volatility, and slow improvement in production discipline. Industry participants believe they have pricing power when global capacity stainless steel utilization is at or above 80%. Utilization declined from ~85% in 2006 to ~65% in 2009 and has since recovered to ~75%. While many players have taken higher-cost capacity offline, earnings across all peers remain well below cross-cycle earnings potential not only from lower stainless selling prices but also from alloy surcharge volatility.

In the absence of pricing power, volatility in the alloy surcharge has a significant impact on stainless demand and pricing. Costs for alloys used in the production of stainless steel, including nickel, chrome, and molybdenum, comprise the “alloy surcharge” added to the base price of the finished product. Many stainless companies have stated over the past year that nickel pricing volatility has pushed potential buyers to the sidelines in anticipation of lower surcharges and expect demand to return once alloy volatility subsides.

Leadership Journey: In its last two years as an MT subsidiary, APAM achieved $144mm in sustainable cost reductions. At the time of the spin, APAM launched the “Leadership Journey” (LJ), an initiative to target management gains and profit enhancement of $250mm over the next two years ($100mm in variable cost savings, $100mm in fixed cost savings, and $50mm in revenue upside).

The primary goals of the plan are to increase productivity and rationalize downstream operations in order to drive down fixed costs, expand vertical integration, and generate efficiency gains. By Q3 2011, APAM stated LJ had contributed $123mm to EBITDA or a run rate of $200mm of recurring cost savings through 1) switching from LPG to natural gas 2) converting its blast furnace from coke to biomass in Brazil, and 3) suspending higher cost operations of its traditional cold roll mill in Isbergues. In conjunction with its Q3 2011 earnings release, APAM announced that given its faster-than-expected progress, the company is targeting an additional $100mm of cost savings by 2013, leading to a combined target of $350mm. With 78mm shares outstanding, an additional $100mm in annual cost savings “moves the needle” significantly. As part of this increase, APAM will focus on further industrial optimization and rationalization in Europe, systematic benchmarking in Brazil and new sourcing initiatives, in addition to conversion to biomass at Timoteo, investment in a new hot annealing and pickling line at Gueugnon, investment in a new induction furnace at Imphy and service center expansion in Campinas. The company also announced 120 job reductions that have been agreed upon with trade unions, and management also mentioned purchasing synergies for nickel and scrap that could further expand LJ’s value creation potential.

While peers ACX and OUT1V missed 3Q expectations and have guided to sequential decrease in earnings due to lower volumes and lower base prices, APAM guided above analyst estimates due to cost reductions, FX tailwinds, and signs of demand stabilization. While the stainless steel outlook remains uncertain, APAM continues to improve operations and financial positioning and pay shareholders a 4.7% dividend yield until valuation improves.

Valuation: APAM’s strong execution and value creation in a very difficult environment suggest the company should earn a premium multiple. However, based on a conservative multiple on what we see as “normalized earnings” (i.e. historical normalized EBITDA of ~$700mm plus LJ contribution), APAM offers equity investors significant upside as illustrated below.

Catalyst