Ternium hit short-term steel price and low margins hard (NYSE:TX)

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Tougher times usually see investors run to quality, but that hasn’t benefited Ternium (New York stock market :TX) this year, while shares of this Latin American steelmaker have fallen about 13% since my latest updateunderperforming steel dynamics (STLD) and Nucor (NUDE) by a wide margin, as well as ArcelorMittal (MT) and Gerdau (GGB). Given Ternium’s leverage on the North American auto industry recovery and longer-term relocation, I think this underperformance is short-sighted, but it’s also true that Ternium is looking at lower EBITDA margins through 2023/2024 and a competitive Mexican steel market.

I continue to believe that Ternium is undervalued and further believe that the relative valuation has become significantly more attractive. Probably not a name that will get much love over the next six months as prices and spreads continue to weaken, but I see upside in the $40s as investors finally return to margins strengths, cash generation and balance sheet and positive growth prospects.

Better Achievements, Higher Costs

Turning to third quarter results, Ternium benefited from better price realizations, but higher production costs resulted in lower than expected EBITDA and working capital requirements continue to weigh on cash generation at short term.

Revenue fell 10% year-over-year and 7% quarter-over-quarter, due to a 7% drop in prices (both year-over-year and quarter-over-quarter) ) which was nonetheless better than expected, while volumes were down 3% year-over-year and flat sequentially. Compared to expectations, revenues were about 4% higher than expected.

Revenues from the Mexican business fell 17% yoy and 12% qoq, with prices down 18% yoy and 14% yoy and volumes up 1% yoy and 2% quarter-on-quarter. South (Argentina) segment revenue increased 7% YoY and 1%, with prices up 14% YoY and 4% YoY and volumes down 7% YoY and 3% quarter-on-quarter. Revenue in the “Other” segment (which includes the United States, Colombia and Brazil) fell 9% yoy and 1% yoy, with prices up 2% yoy and flat sequentially and volumes down 11% YoY and 2% YoY. Mining revenue fell 23% YoY and 9% YoY, with prices down 21% YoY and 8% YoY and volumes down 2% YoY and 8% YoY. 1% quarter-on-quarter.

Gross margin was down 2,350bps yoy and 1,170bps qoq to 19.4% as the company saw higher input prices (energy, raw materials, labor, etc.) . Steel gross margin followed essentially the same trajectory, falling 2250bps yoy and 1170bps yoy to 19.1%.

Adjusted EBITDA fell 64% yoy and 45% qoq, missing around 8%, with margin down 2,450 bps yoy and 1,110 bps qq at 16, 5%. Steel EBITDA per ton decreased 63% YoY and 46% QoQ to $219, and Ternium saw a 30% YoY and 7% QoQ increase in cash cost per ton.

Comparisons with other steelmakers are a bit difficult due to the different markets they serve (and Steel Dynamics and Nucor have large steel manufacturing companies), but perhaps still useful to readers.

Steel Dynamics reported an 11% year-over-year sales improvement (and a 9% sequential decline), helped by stronger shipments (up 13% year-on-year and 1% quarter-on-quarter in Steel Operations and up 3% YoY and stable QoQ in Steel Manufacturing), while Adjusted EBITDA fell 4% YoY and 21% YoY, with a margin of 23.8% . Nucor reported sales growth of 2% YoY and contraction of 11% YoQ, with EBITDA down 15% YoY and 30% YoY and an EBITDA margin of 25, 3%.

All things considered, Ternium remains a very efficient operator. The three companies don’t present their financials in a way that facilitates individual comparisons, but Ternium’s steel operating profit of $175 per ton isn’t far off from Steel Dynamics’ $208, and Ternium is basically in line with Nucor’s EBITDA. per ton of steel.

Short-term pain, but longer-term opportunity

In the short term, there is not much that will significantly improve for Ternium or for the steel industry in general. Customers have replenished inventory, and lower end-user demand is leading to lower orders and lower prices. To that end, hot-rolled spot prices have fallen about 20% over the past three months and 65% over the past year in the United States, while Mexican prices have fallen 11 % and 52%, respectively.

At the same time, while commodity prices have started to decline, input costs are still weighing on activity and spreads. I expect US hot rolled coil prices to stabilize around $700, but I think they could stay in that vicinity for a while. I expect Ternium to continue to have a price premium over this (due to its leverage over Argentina, Brazil and Colombia), but prices around $900 at 1 $050 is still a marked correction from the $1,300-plus of 2021 and 2022. Ternium will gain further money at realized prices around $1,000/ton, especially as input costs rise. normalize, but I expect EBITDA margins in the mid-teens and single-digit returns on equity from spreads under pressure over the next two years.

In the short term, I have some concerns about demand from Mexican industrial customers (Ternium is more reliant on industrial demand than construction), as weaker demand in the United States for housing, appliances and goods industries will lead to lower demand for steel in Mexican factories. . Likewise, the automotive industry continues to struggle with component shortages and irregular production schedules. Brazil also saw some cracks in demand (although I’m a bit more bullish on overall demand), while Argentina was more stable.

Longer term, I think there are good reasons to be optimistic about Ternium’s opportunities. The supply chain risks exposed by the pandemic are already driving increased interest in convenience supply chains, and Mexico offers advantages over China in wages, convenience and politics. I expect to see a major relocation of production from Asia to Mexico over the next ten years, leading to an increase in demand for steel not only for products produced in future mills, but also for factories, electrical infrastructure and other infrastructure. needed to support this growth.

Ternium is also tapping into growth opportunities in the automotive space. Well over half of the steel used by automotive OEMs producing cars in Mexico is imported from outside Mexico, and import substitution remains a growth opportunity – Ternium has responded to more requests from automotive OEMs to certify automotive grade steel components, and I expect this to accelerate. The only “but” here is that the company is going to have to add capacity, with the company likely to spend $3-4 billion at some point over the next four years to add approximately 3M capacity to 4Mpta in Mexico.

Perspectives

In the near term, low spot prices, high input costs and high cost inputs coming out of inventory will put pressure on margins. Ternium is also moving forward with some necessary maintenance investments in Brazil (coking plants and blast furnace), and will spend billions to expand its Mexican capacity – I think that’s a good long-term use of capital, but this will be done without short-term cash pressure. I also believe that adding capacity in Colombia might be an option at some point in the future.

A weaker global economy could put further pressure on steel demand, but I don’t think US prices can stay below $700/tonne sustainably given the industry is more consolidated, more disciplined and much more geared towards electric arc furnaces (which can be scaled up/down more easily than blast furnaces) than in the past.

I expect revenues to bottom out around $13 billion to $13.5 billion, with EBITDA margins falling to 14% to 15% at the bottom before bouncing back to 20% in 2025 Long term, I expect EBITDA margins to average around 17.5% to 18%, with FCF margins in the high 10% (around 8%).

The essential

Discounted cash flows suggest that Ternium is currently significantly undervalued, even with a significant decline in FCF likely over the next four years (from $2.15 billion in FY21 to around $550 in $600 million in fiscal year 23/24). Even with a low teen discount rate, however, the company’s long-term cash flows with price realizations in the $1,000-$1,050 range support a high total annualized return for teens from from here. I also use a blended EV/EBITDA approach using a 4x multiple to my full cycle EBITDA estimate and a 3x multiple to my 12 month estimate which gives me a fair value at short term around $40.

Ternium could stay under pressure for a bit longer, as I don’t see investors flocking to the name until they believe hot rolled prices have bottomed out. Likewise, I expect continued concerns about the cash outflow needed to fund greater capacity. Longer term, however, I believe the company will continue to exploit its import substitution opportunities in Mexico and benefit from offshoring in Mexico, while benefiting from improving conditions in Argentina and Brazil. It’s a contrarian call that will take time to work, but I think Ternium is a name for investors to consider again.

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