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Friday, February 18, 2011

ArcelorMittal And The Steel Catch-Up Trade (MT, VALE, AA, FCX, PKX)

Tickers in this Article: AA, BHP, CAT, DE, FCX, MT, NUE, PKX, STLD, VALE
The financial news often seems to talk about commodities as though they all trade together. The reality, though, is altogether different. While it is true that producers of copper, aluminum, and steel all depend to some extent on a healthy global economy, there can be a great deal of inconsistency between the individual commodities. So while iron giant Vale (Nasdaq: VALE) and aluminum king Alcoa (NYSE:AA) have done well over the past year, Freeport McMoRan (NYSE:FCX) has far surpassed them while ArcelorMittal (NYSE:MT) has been quite the laggard. 

Maybe that begins to change in 2011, and maybe investors should freshen up their due diligence on the largest player in the steel business.
A Solid End to a Tough YearAlthough 2010 was hardly a disaster for ArcelorMittal or the steel industry as a whole, the memory of the boom years of 2007 and 2008 are still fresh in many people's minds. With certain commodities like copper hitting all-time highs recently, patience has been a little harder to come by in a steel sector still suffering from a sluggish economic recovery in North America and Western Europe.

Still, ArcelorMittal ended the year on a solid note. Revenue rose 19% from the year-ago level (and 5% sequentially) and topped $20 billion. EBITDA was down 14% from the third quarter, but still higher than the consensus expectation and this quarter's number was arguably cleaner (that is, there were fewer non-operating items influencing the number).

Shipments climbed 3% on a sequential basis, and the company produced 21.6 metric tons of steel in the period. That was enough to give the company a 69% utilization rate - a rate that is below the point where the company can really operate at top efficiency.

Looking Ahead

 Fourth quarter results looked surprisingly good in Europe on a revenue basis (profitability was not so strong), and the performance in the U.S. was OK as well. That said, the company did guide to a stronger first quarter and a utilization rate of around 76%.

The real question that investors in ArcelorMittal, POSCO (NYSE:PKX), Nucor (NYSE:NUE) and Steel Dynamics (Nasdaq:STLD) care about, though, is whether this recovery can continue. For now the answer would seem to be "yes." Construction has not recovered yet in the Western economies, but continues apace in places like China, Brazil and India. Moreover, a lot of steel goes into the heavy-duty equipment produced by the likes of Caterpillar (NYSE:CAT) and Deere (NYSE:DE) and those businesses are seeing very strong revenue and ordering patterns right now.

The Bottom Line 

ArcelorMittal probably does not get all of the credit it is due. Sure, it is "just a steel company," but it is one with a rather remarkable track record of maintaining positive free cash flow and solid free cash flow margins. What's more, the company has led the way in vertical integration and supplies a large percentage of its internal needs for both coal and iron ore - leaving it less exposed to the pricing power of Vale, Teck (NYSE:TCK), BHP Billiton (NYSE:BHP) and so on.

What's more, investors do not always seem to appreciate that there will always be a need for companies like ArcelorMittal. Mini-mills are efficient and have a valuable role to play, but the quality of their steel is not the same and cannot necessarily be used in all of the same applications (though many mini-mill operators like Nucor will add certain components into the mix to improve the quality).
Analysts do not seem completely sold on the strength or sustainability of a recovery in steel, and investors may still be able to find a bargain here. Clearly a global slowdown would be bad news for the sector, as would out-of-control production increases in China (which has happened before). All of that said, ArcelorMittal is a stock that looks like it should be trading closer to the high $40s than the high $30s.

Disclosure I am long CAT, DE and FCX shares.

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