In the event that a full recovery occurs, two companies that are well positioned to yield high returns are Gerdau (GGB) and ArcelorMittal (MT). While only the latter is rated a "strong buy" on the Street, the former has particularly demonstrated strong operational ability, navigating a storm of volatile underlying demand. I find that both firms have favorable risk/reward and are properly hedged against stagnation in Europe and North America.
From a multiples perspective, both companies are fairly attractive. Gerdau trades at a respective 13.2x and 7.3x past and forward earnings; ArcelorMittal trades at a respective 13.7x and 7.3x past and forward earnings. Dividend yields are around 90 bps higher at 4% for the preferred choice, ArcelorMittal.
In an earlier article here, I highlighted just how undervalued Gerdau was. Since the piece was published, the stock outperformed the S&P 500 by around 424 bps at 12%. At the third quarter earnings call, Gerdau's CEO, Andre Johannpeter, noted favorable results in a challenging economy:
Even in view of the great volatility of the financial market, Gerdau had very good performance in the third quarter due to the growing demand for steel in the markets where we operate and also due to good management of our team which allowed us to increase our cash position, to reduce our net debt and also other financial and G&A and administrative expenses…
We had 4.8 million tonnes in terms of consolidated shipments an (addition) of 10% with the third quarter of last year and year-to-date from January to September, shipments reached 14.5 million tonnes which represented an increase of 12% when we compared it to the – with the first nine months of 2010.
Even during uncertainty, steel production grew by 14% y-o-y to 5M tonnes. This suggests that the company could be more structurally safe than what the market acknowledges. The steel producer specializes in long-rolled, which is less vulnerable to macro downside than others. In addition, the company is reaping substantial benefits from Brazil with soaring demand for infrastructure and steal beams. Even in light of the impressive backdrop, management is characteristically reserved and warns investors about the uncertainty. At this point, the bearish sentiment could be overdone with the normalization of steel markets in Latin America and North America. Moreover, the company's blast furnaces allow for high volumes, which is especially beneficial if the economy does fluctuate. Going forward, a major catalyst for the firm is its iron ore deposit.
Consensus estimates for Gerdau's EPS are that it will decline by 28.7% to $1.07 in 2011 and then grow by 10.3% and 50% in the following two years. Assuming a multiple of 12.5x and a conservative 2012 EPS of $1.09, the rough intrinsic value of the stock is $13.63, implying 59% upside. Even if the multiple were to plummet to 8x and 2012 EPS turns out to be a staggering 16.1% below consensus, the stock would barely fall.
ArcelorMittal similarly offers high upside with little downside. The steel producer is reducing leverage and restructuring operation to unlock efficiency. Net debt is modeled to peak at around $26.5B in the fourth quarter and then decline rapidly thereafter. Investors would be wise to recall how the company rallied from the midsts of the financial crisis. It is now trading at the historical low-end - a surge could be nearing.
Consensus estimates for ArcelorMittal's EPS are that it will grow rapidly from $2.02 in 2010 to $3.66 in 2013. Assuming a multiple of 12x and a conservative 2012 EPS of $2.27, the rough intrinsic value of the stock is $27.24, implying 45.5$ upside. Accordingly, the steel producer merits its "strong buy" rating.