Description

Mittal Steel – MT

Mittal Steel is set to become the world’s largest steel company around the end of Q1 2005 with the acquisition of International Steel Group (Wilbur Ross’ vehicle for the consolidation of US steel companies including the former Bethlehem Steel, LTV, Acme Steel, others). While max318 recently wrote up ISG as an arbitrage play (an arbitrage that has largely narrowed), the underlying merits of Mittal Steel were hardly addressed from a fundamental basis. As a result, we are writing up Mittal Steel to provide a perspective on this cheap way to invest in the resulting company as a long-term investment. If you like the thesis outlined below, there are several trades you can put on depending on your risk reward tolerance. You can buy ISG and then tender for MT or you can buy MT directly. Given MT’s valuation (trading under 6x PE on a pro forma basis, you can also try a pair trade by buying MT and shorting a more expensive steel stock or steel futures to hedge out a significant part of the commodity risk in the near or longer term.

As outlined below, MT (however you decide to play it) is attractive on the basis of valuation, commodity dynamics, outstanding management with a huge stake in the outcome, and competitive dynamics, good liquidity and ability to buy in size

The Company

Mittal Steel is being formed through a two part transaction. In the first step (completed in mid December 2004), Ispat International – 11th largest steel producer in the world (122 million shares outstanding) a public company traded in NY and Amsterdam issued 525 million shares to acquire LNM Holdings, a privately held company and one of the top five steel producers in the world (and the producer with the highest profits by far in the world). To understand this transaction, you need to know some history. Ispat was actually formed in 1997 by carving out some of the assets of privately held LNM holdings. While we are not sure which assets were selected for the carve out, the reason for the transaction was probably to create a currency to conduct acquisitions. The company first went public in August 1997 and then in 1998 acquired Inland Steel in the US. Meanwhile, LNM Holdings the private company continued to grow successfully and is incredibly profitable generating operating earnings of $3.2 billion on revenues of $9.9 billion in just the first 9 months of 2004. Lakshmi N. Mittal the brilliant steel visionary and entrepreneur (more about him below) and his family continued to own LNM as well as the largest and controlling voting stake in Ispat International. In step one, therefore, all the Mittal Steel holdings were combined into Ispat and Ispat was renamed Mittal Steel.

In step two, Mittal Steel (ticker MT) will acquire International Steel Group (ISG) – 100 million shares outstanding - which is traded in NY. The total consideration is $42 per share of ISG (currently trading at $40.50 per share). Holders can elect to receive all cash, 50% cash/50% stock, or all stock. The stock is subject to a collar depending on the price of MT for the 20 trading days prior to closing. The Mittal Family will own about 90% of the combined company (valuing their stake at $24 billion) and making them one of the wealthiest families in the world.

Summary Pro-forma Financials and valuation

Based on the current price of MT, after all the transactions are completed and assuming the current price, there will be around 700 million shares of MT outstanding representing a current market value of $27 billion plus pro forma net debt of about 3.2 billion for a firm value of approximately $30 billion at current levels.

2004 revenue for the combined company were estimated to be $31.5 billion. 2004 Operating earnings projected to be $6.8 billion and the lower end of EPS at $7.20 per share (excluding any purchase accounting adjustment – also assumes issuance of maximum number of shares – now unlikely). One a per share basis, MT is being valued at about 5x PE. In contrast, Nucor – a well managed steel company that is not as global has a PE of 10.7x (with an 8.6 billion market cap of equity).

The Industry and Steel Dynamics

The Steel industry has gone through a tough decade that seems to have begun turning sometime in 2002. In the late 1990s, most of the major and midsized steel players in the US were in Chapter 11. Many of these companies were uncompetitive/insolvent based on overcapacity, high cost production, pension obligations, high debt levels, labor issues, etc. Over 35 companies were in chapter 11. The US segment clearly needed significant consolidation and rationalization. However this is a cyclical industry and the lack of investment in production eventually sows the seeds of future success. ISG is the result of one set of such consolidations. While the US govt. imposed temporary tariffs, the tariffs have been removed. A number of factors swung in favor of the producers, including rising demand from emerging countries and China in particular, increase in transport costs (making local production more competitive), and an improving economy. On the flip side, irrational competitors in chapter 11, high energy costs (a major input), and rising raw material costs hurt on the expense side. Never the less, 2003 and 2004 were increasingly hard markets for the price of steel and the steel companies began to produce a lot of cash flow. The current PE multiples (generally mid to high single digits) reflect the view that earnings are unsustainable (in the short and medium term) and that industry won’t stay disciplined.

However, the long-term secular trends due to China and India demand, as well as benefits of consolidation, and the long-period of difficult suggest that expectations are still too low and then the industry may enjoy more opportunity, at least in the medium term (if you believe Jim Rogers for a while to go). For reasons outlined below, MT is probably the best managed company in the industry with a lot of other advantages – including low cost producer status and has a number of structural advantages compared to any other company in the steel business. At this valuation, it offers a compelling risk reward.

Management

Lakshmi Mittal is one brilliant entrepreneur and visionary execution oriented value investor. Understanding his background and how the company got to where it is today is helpful and central to the investment thesis. Mittal is Indian Born but lives in London. He comes from a Steel making family with a plant in India. He built his fortune by being a contrarian – buying up failing and underperforming steel assets around the world. He is an outstanding operator and in each case has been able to turnaround failing assets through a combination of better operations, marketing, and some focused capital expenditures. Throughout his career in the steel industry, he has repeated this pattern again and again. Lakshmi seems to have that rare combination of being a great operator and investor with a long-term strategic vision better than almost anyone else in the industry.

Mittal is now an unmatched global powerhouse that will be very well positioned strategically based on products across the entire range of the industry, vertical integration (upstream and downstream), global customer base and production, scale in each market, and low cost production. In steel, there are basically two types of production processes. The Integrated (Old) Mill process that involved a number of steps and the Mini-Mill (ala Nucor) process that is far more efficient and skips a number of steps by using steel scrap. However, as mini-mills have gotten greater and greater share (and perhaps for other reasons), scrap prices continue to (generally rise). One of the reasons Mittal is a low cost producer is that Mittal was early to understand that this trend meant that scrap would be a key competitive consideration for the Mini-mills. Realizing this, Mittal is the largest producer of something called DRI (which is a scrap substitute) for its own mini-mills. By producing DRI, Mittal’s mini-mills can either buy scrap if it is cheaper or just use its own DRI as an input. This strategy combined with an intense focus on cost leadership has made Mittal the leader and this will continue to be a big advantage going forward. In addition, the company controls significant upstream assets including Coal, Coke, and Iron Ore. Due to these factors, Mittal is and will be the high margin and low cost producer to the industry.

The Mittal Family’s 90% stake means that they will continue to focus on building long-term value. Wilbur Ross is another smart investor who will have a significant stake and sit on the board of the new company.

Competitive Advantages

Other competitive advantages include the Company very diversified base of customers and production facilities. Scale in each market and plants that are in many cases close to local demand. Low debt and a history of skill acquisitions mean that the Company can and probably will be opportunistic in the future. Mittal is a very decentralized company with each subsidiary running independently and moving quickly to optimize its mix for its customer base and market conditions.

Commodity Risk

In the near term, there is certainly commodity risk and if steel prices fall, revenues and cash flow would decrease. However, since Mittal is the low cost producer, it has an edge in most environments. In addition, the lower dollar is a big advantage of Steel (at least local US production of it) because not only is domestic steel more competitive, but also overtime it will make US industry more competitive thereby increasing the demand for steel for capital equipment and for end product production.

Upside

Mittal is cheap on both a relative and absolute basis. It is one of the best run best managed most global and lowest cost companies in the industry. It has the best management. Company can see upside from continued good steel markets, management and efficiencies of the ISG assets, and additional acquisitions on an opportunistic basis. You can hedge out commodity risk by shorting a more expensive steel market or through shorting futures.

Catalyst

Company can see upside from continued good steel markets, management and efficiencies of the ISG assets, and additional acquisitions on an opportunistic basis. You can hedge out commodity risk by shorting a more expensive steel market or through shorting futures.