Ternium (NYSE: TX)

Ternium is a leading steel company in Latin America, manufacturing and processing a wide range of flat and long steel products for customers in the construction, home appliances, capital goods, container, food, energy and automotive industries. Ternium has a production capacity of finished steel products of approximately 10.4 million tons per year (of which 8.7 million tons correspond to flat steel products, largely serving the automotive and machinery industries and 1.7 million tons correspond to long steel products, generally used in the construction sector. 7.2 million tons correspond to facilities located in North America and 3.2 million tons correspond to facilities located in South and Central America), and shipped approximately 8.1 million tons of steel products in 2010. Ternium is a competitive steel producer due to its proximity to customers and high-quality raw material sources, state-of-the-art and flexible production facilities and downstream integration into value-added steel products.

Ternium is the leading supplier of flat steel products in Mexico and Argentina.

In 2010, approximately 57% of Ternium’s sales were made to North America, 41% to South and Central America, and 2% to Europe and other markets.

The company has grown through acquisitions. But in the last years, and until this week’s offer for Usiminas, the company halted its purchases to develop its own projects and to deleverage from US $2.9 B net debt in 2007 to a net cash position of US $0.7 B in 2010; becoming by far the less leveraged company in the sector.

Thesis:

The stock is one of the cheapest steel names globally in terms of multiples, although Ternium faces similar steel price conditions but a stronger demand outlook (Latam & Mexico exposure) and it doesn’t have direct exposure to China and its construction and Real State sectors, where many of the “steel bears” worries lie. Its worth noting that any decline in steel prices will affect TX, though we think it is in a better position than most of its peers hence we don’t agree with the discount implicit in the stock.

Low cost producer:

The combination of a portfolio of state-of-the-art, low cost steel production mills, access to diversified sources of raw materials, including proprietary iron ore mines in Mexico, diversified technology base, including blast furnace based, mini-mill based and non-integrated based steel processing facilities, and cost-competitive labor sources makes Ternium a low-cost producer of steel and a cost-competitive producer of value-added products.

Regional Industry Leader and differentiated business model 

Ternium has a leading participation in the market for flat steel products in Mexico and Argentina and is a significant supplier of steel products in Colombia and in various other countries in South and Central America. TX operates in a region that is exposed to great industrial activity (ie. Mexico’s auto industry), strong infrastructure needs and high expected economic growth. 

Ternium owns iron ore mines and a pelletizing plant in Mexico, which with it supplies much of the company’s raw materials, 60% of the company’s needs.

The company believes its mining reserves have the potential to expand annual output to increase its production without purchasing additional mines. Here lies one of TX’s main competitive advantages as it can grow its production and continue its self-sufficiency model in Mexico. ArcelorMittal, recently expressed its interest in purchasing iron ore assets in Mexico.

Siderar (Ternium’s Argentine subsidary) has a 98% market share being the only flat-rolled steel producer in Argentina, a market that has not come under import pressure, hence presents much less price volatility than other countries. This mix between vertically integrated mills in Mexico and an iron ore dependent mill with a natural monopoly in Argentina is in our opinion the great differentiator of TX business model with other steelmakers, as it minimizes volatility in its operating results.

Industry’s main risks:

Steel prices are volatile and are sensitive to trends in cyclical industries, such as the construction, automotive, appliance and machinery industries, which are significant markets for Ternium’s products.

As demand for steel has surged in China, steel production capacity in that market has also increased, and China is now the largest worldwide steel producing country, accounting for approximately half of the worldwide steel production. Due to the size of the Chinese steel market, a slowdown in steel consumption in that market could cause a sizable increase in the volume of steel offered in the international steel markets, bringing about pressure on sales and margins of steel companies operating in other markets and regions. Ternium’s strong presence on its region and its proximity to its clients will be an important factor to undermine the impact when happening these events.

Despite the recent consolidation trend, the global steel market remains highly fragmented. In 2010, the five largest steel producers, ArcelorMittal, Hebei, Baosteel, Angang and Wuhan, accounted for 19% of total worldwide steel production, compared to 15% for the five largest steel producers in 2000. Considered as a whole, the steel industry still remains considerably fragmented, compared with market conditions characterizing certain of its main suppliers and customers like iron ore suppliers and the automotive industry.

Usiminas acquisition

Ternium has made an expensive US $2.2 B bid for a 22.5% share of the voting capital in Brazilian steelmaker Usiminas, offering an 80% premium to its market price and a 40% premium to the Usiminas average share price of the last six months.

GS estimates, the deal values Usiminas at 15.5X 2012E EV/EBITDA vs. Ternium’s 2.8X 2012E EV/EBITDA. The deal also values Usiminas at US $1,975/ton or 9% below GS estimated replacement value (it has rarely traded at its replacement value) vs. Ternium at US $462/ton.

On the other hand the deal values Usiminas at US $2,300 per ton of finished steel, over 6x Ternium’s current market valuation of US $380 per ton.

Ternium has much favorable cost position than Usiminas as it has better access to energy and raw materials.

We see this acquisition as an expensive way to get to a new market, TX is abandoning a Greenfield project, and to get rid of competition.

However, in our opinion, we still get a huge margin of safety at TX current prices. And there are important opportunities arising from this acquisition….

Positives to TX’s Usiminas stake:

Management is optimistic about the acquisition, as it will lead to value creation through the modernization of the Brazilian company and the consolidation of the steel markets in the region.

The new group will become one of the main players in the Latam steel market. This strategic alliance will seek to increase bargaining power in its markets.

Ternium will fully integrate its operations upstream and downstream, thus gaining in production efficiencies (e.g. Siderar can provide slab to Usiminas) and Siderar will gain access to the 26mtpy Brazilian steel market.

Value creation will be something that all companies involved in the transaction will pursue by turning Usiminas into a more efficient steel producer.

TX's management can assist Usiminas to reach its full potential, as has been the case of prior acquisitions in Venezuela and Mexico. 

We give management the benefit of the doubt in this transaction as their track record shows they’ve done well in past acquisitions that were labeled as expensive. For example TX bought Hylsamex back in 2005 for US $2.2 B or US $690/ton of production; since then Mexico production came from 3.2 mtpy in 2005 to 7.4 mtpy of Ternium Mexico in 2010.

Additionally we believe that the timing for an entrance to the Brazilian steel market as a consolidated player couldn’t be better.

As host of FIFA World Cup (2014) and the Olympics (2016), Brazil is expected to invest massively in new infrastructure. The government has projected spending in infrastructure and public projects to be in the range of US$ 959 B between 2011 and 2016 or near 50% of 2010 Brazilian GDP. 

Brazilian currency (Real) has seen an important appreciation over the last years; an eventual adjustment will benefit local producers by making steel imports less competitive.

As well TX/USIM will become one of the main suppliers of the LatAm auto industry.

Brazil is now the world's fourth largest auto market and the sixth largest vehicle producer. For 2011, auto production should reach 3.7m units, up 5% over 2010, while GDP grows some 3.5%. This growth is expected to continue steadily in the coming years.

An important fact to understand Brazil’s potential is that 82% of its total car production is destined to the domestic market. To put this on perspective, Mexican total car production of 2.3 M of units could only satisfy 64% of the Brazilian total domestic auto market.

Brazil is still far away from market saturation. This year 19 new vehicles for every 1,000 people will be purchased, compared to 60/1,000 in the US in the boom years. And (as Mexico) is one of the main car manufacturing clusters in the world.

Valuation

Making a conservative approach to TX valuation, we calculated TX multiples after the Usiminas stake, just taking into account the new debt required for the deal and maintaining TX operations as they are today (no synergies taken into account).

This lead us to the conclusion that taking this new debt into TX valuation, the company still trades at a discount of its peers; notwithstanding TX’s structural advantages, as having a dominant position in growing markets with significant competitive advantages like its local vertical integration, its closeness to clients and being one of the industry players less exposed to volatility in commodity prices.

And on top of that the stock has been hammered by the market because of a deal that will give the company a great opportunity to grow in an appealing market and to consolidate as the regional leader.

Note that as of 3Q2011 Ternium holds more than US $2.3 B in inventories, which are not included in this valuation… We think there is no doubt there’s value here.