Value Investing

Undervalued Ternium SA (ADR) Well Positioned For Growth With Its CSA Acquisition

One of the cheapest stocks in our all All Investable – Stock Screener is Ternium SA (ADR) (NYSE:TX).

Ternium is a leading steel producer in Latin America, with an annual production capacity of approximately 11.0 million tons of finished steel products. The company manufactures and processes a broad range of value-added steel products for customers active in the construction, automotive, home appliances, capital goods, container, food and energy industries. With production facilities located in Mexico, Argentina, Colombia, the southern United States and Guatemala, Ternium serves markets in the Americas through its integrated manufacturing system and extensive distribution network. In addition, Ternium participates in the control group of Usiminas, a Brazilian steel company.

A quick look at the company’s share price over the past twelve months (below) shows that the stock has risen 109% to $26.30 just 7% off its 52 high of $28.04.

(Source, Google Finance)

While the twelve month rise in the company’s share price has been phenomenal, closer inspection shows the company remains undervalued.

Ternium recently released it Q4 2016 and FY2016 results (below) which show total revenues fell by 8% to $7.2 Billion from $$7.9 Billion compared to FY2015. Net income for FY2016 rose significantly to $700 million, $596 million of which is attributable to Ternium’s equity owners, from just $8 million compared to FY2015. But what’s most noticeable are the improvements in the company’s gross margins and operating margins which rose 31% and 79% respectively.

Fiscal Period (Amounts in Millions) Dec16
Preliminary
Dec15 Dec14 Dec13
Revenue 7,224 7,877 8,726 8,530
Cost of Goods Sold 5,384 6,477 6,925 6,600
Gross Profit 1,840 1,400 1,801 1,930
Gross Margin % 25.47 17.77 20.64 22.62
Operating Income 1,142 639 1,056 1,109
Operating Margin % 15.8 8.12 12.1 13.01
Net Income 596 8 -199 455

(Source, Company reports)

There’s no question that 2016 was a great year for Ternium and management is doing a great job of running the company shipping almost 10 million tons of steel. Ternium had FY2016 EBITDA of $1.5 Billion, an EBITDA margin of 21% and an EBITDA per ton of $160 which is well above its competitors. Management has also stated that it expects the trend to continue with growth coming from the steel market in Mexico and improvement in Argentina.

Mexico has proven to be a powerhouse for the company’s bottom line making up 66% of the company’s FY2016 total steel shipments. Of the 9,764 thousand tons shipped in FY2016 6,405 thousand tons went to Mexico, an 8% improvement compared to FY2015.

(Source, Company reports)

One the main reasons that the company’s operating margins in FY2016 were 79% higher can be attributed to the 472,000 thousand ton increase in Mexico due to higher realized prices, its automotive industry, and home appliances and construction. Governmental trade measures against unfair steel trade practices in the U.S. and Mexico also benefited Ternium due to lower steel imports in the region.

The company has stated that steel consumption in Mexico could soften in 2017 due to uncertainties over NAFTA’s future terms of trade. There’s a great deal of speculation at the moment from Mexican automakers around NAFTA. Speculation surrounds President Trump, his proposed renegotiation of NAFTA, and a proposed tax on imports from Mexico.

What shouldn’t be forgotten is that a tax on automobile imports from Mexico also has a downstream impact on a number of U.S. jobs and auto-part makers. Auto-manufacturing in Mexico relies heavily on the supply chain between the two countries and the auto parts that come from the U.S. Approximately 40% of the content in the automobiles manufactured in Mexico comes from the U.S. In addition to auto-parts, a number of U.S. jobs associated with supply chain rail and trucking would also be affected.

Despite Trump offering inducements to keep U.S. auto manufacturers in the United States, this month Ford announced its plans to open two auto-parts plants in Mexico later this year. This followed last month’s news that General Motors Canada was cutting 625 jobs at its Ingersoll assembly plant near London, Ontario, and moving those jobs to Mexico, where labor is cheaper.

So it appears that the future of auto-manufacturing in Mexico remains bright despite the speculation. Ternium expects sequentially higher shipment volumes in Mexico in the first quarter of the year, reflecting a restocking in the value chain in response to strengthening steel prices.

Ternium also expects to see improvements in its Southern Region as some of Argentina’s steel consuming sectors start to show positive signs, together with improved expectations for the neighboring Brazilian economy. Regarding the Argentine market, CEO Daniel Novegil said, “I am very positive about Argentina because you know the market is recovering. We are expecting an increase in 2017 of 7% on a year basis against the previous year for steel consumption.” Sectors that are doing very well in Argentina include agribusiness, infrastructure, construction projects, and alternative energy.

In addition to growth in steel consumption in Mexico and the Southern region there are two other important developments that will benefit Ternium in terms of its future growth prospects.

Recent Acquisition

The first is the recent EUR1.5 billion (US$1.6 Billion) acquisition of Thyssenkrupp’s CSA facility in Rio de Janeiro, Brazil. CSA is a steel slab producer with assets that include a steel-making facility with shipments of 4.3 million tons and EBITDA of EUR256 million (US$270 million). The facility has an annual production capacity of 5 million tons of high-end steel slabs, a deep-water harbor and a 490 MW combined cycle power plant. The deal includes the assignment of 2.0 million tons per year to Thyssenkrupp’s former Calvert re-rolling facility in Alabama, U.S. The acquisition will require antitrust clearance in several jurisdictions, including Brazil, Germany and the U.S.

When you consider that Ternium purchased approximately 3.7 million tons of steel slabs in FY2016 from third parties to supply to its customers, completion of the CSA acquisition means Ternium will have production capacities of up to 5 million tons of slabs per year. The deal is expected to close on or before September 30, 2017.

Regarding the acquisition Daniel Novegil said: “Upon completion of this transaction, Ternium is adding another state-of-the-art facility into its industrial system. This will enable us to enhance our differentiation. The facility’s specialization in high-end steel slabs, combined with a coordinated product development and supply chain management effort with our high-end steel capacity in Mexico and Argentina, will support new integration opportunities for the manufacturing of sophisticated finished steel products for our customers. This, in turn, will strengthen our business in strategic industrial sectors across Latin America.”

CSA currently generates EBITDA of EUR260 million (US$275 million) on shipments of 4.3 million tons. Ternium expects normalized EBITDA per ton of around $60 from the CSA facility which equates to $280 million to $290 million per year without taking into consideration any other synergies.

CSA provides Ternium with a state-of-the-art technology facility with just-in-time iron ore deliveries provided through a railroad system that goes directly into the mill and coal to feed the coking oven plants through its own harbor. The result should be significant cost savings, freight efficiency, inventory, and opportunities to streamline logistics as well as low cost iron ore and coal supply.

Moreover, the strategic location of the plant means Ternium will have three facilities in the three largest steel markets in Latin America; Mexico, Brazil, and Argentina.

Unfair Competition – China

The second important development that will benefit Ternium in terms of its future growth prospects is the crackdown by the U.S. Department of Commerce towards Chinese steel companies faced with overcapacity due to the drop in steel consumption in China.

Earlier this month The U.S. Department of Commerce hit Chinese steel companies with duties ranging from 64 percent to 191 percent, in the latest round of anti-dumping and countervailing duties. The Commerce Department’s International Trade Agency wrapped up a yearlong investigation into stainless steel sheet and strip imports with a final finding that Chinese companies had dumped their products in the U.S. and had unfairly benefited from government subsidies. According to Ternium, in the past five years, the number of trade investigations against China has doubled throughout the world, and in Latin America 75% of current cases are against China.

Regarding unfair trade from China, during his latest FY2016 earnings call, Daniel Novegil said, “The NAFTA region has been very efficient to take a step to defend our region from unfair trade, especially from China.” He added, “And both countries are facing a threat, common threat that is China. So, I see the U.S. and Mexico complementing each other, working together, coordinating trade policies, and facing other threats coming from unfair trade and coming from subsidies, especially from China.”

Ternium continues to have solid growth prospects in all of its markets, particularly Mexico. The company will also benefit from its new steel making acquisition CSA, and protection from unfair competition from Chinese steel makers.

Loads of Free Cash Flow

Ternium is a very well run company, a quick look at the company’s trailing twelve month quarterly cash flow statements (below) shows that the company had operating cash flow of $1.1 Billion (ttm) and Capex of $435 million (ttm). That equates to Free Cash Flow of $664 million (ttm), and based on its current market cap of $5.03 Billion means that Ternium has a FCF/Price Yield of 13% (ttm). It’s important to remember that the company’s cash flows will be further boosted with the $280 million to $290 million per year in EBITDA that Ternium expects to generate from its CSA acquisition without taking into consideration any other synergies.

Fiscal Period (Amounts in Millions) Dec16
Preliminary
Sep16 Jun16 Mar16
Net Income 145 264 174 124
Cash Flow from Operations 278 220 364 237
Purchase Of Property, Plant, Equipment -100 -105 -132 -98
Free Cash Flow 178 115 231 140

(Source, Company reports)

Management has also shown that its shareholder friendly with its free cash flow by providing a nice dividend yield of 4% (ttm), and it appears the dividend payouts are set to grow. During the company’s latest FY2016 earnings call CFO Pablo Brizzio said, “As a company and our Board of Directors is showing significant confidence in our business to increase the dividend payment. It’s clear that we believe that this company will continue to generate money and continue to generate very good results.”

While the company doesn’t have a strict dividend policy, Brizzio added, “It’s very important from our side to propose this level of dividend that is an increase after two years of paying $0.90 per ADS and, prior to that, a little lower number. The dividend as we are proposing right now is a dividend yield of more than 4%, a payout ratio of more than 30%, which is a number you should look [for] in the future.”

Strong Balance Sheet

In addition to generating solid free cash flow the company also has a very strong balance sheet. Based on the company’s preliminary FY2016 results (below) Ternium had $328 million in cash and cash equivalents and total debt of $1.2 billion. With the ability to generate free cash flow in the order of $664 million (ttm), and a FCF/Price Yield of 13% (ttm) this level of debt is easily manageable.

Fiscal Period (Amounts in millions) Dec16
Preliminary
Cash, Cash Equivalents, Marketable Securities 328
Current Portion of Long-Term Debt 822
Long-Term Debt 397

(Source, Company reports)

Valuation

As mentioned, the company had $328 million in cash and cash equivalents and $1.2 Billion in total debt at the end of FY2016. If we subtract the cash and cash equivalents from the company’s total debt the company has net debt of $891 million. With its current market cap of $5.03 Billion when we add net debt-over-cash and minority interests Ternium has an Enterprise Value (EV) of $6.7 Billion.

When we consider that the company generated $664 million (ttm) in Free Cash Flow that means Ternium has a FCF/EV Yield of 10% (ttm).

We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–if you were to purchase the entire company. EV is calculated as:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents.

With an Enterprise Value (EV) of $6.7 Billion and Operating Earnings* of $1.1 Billion (ttm), that means Ternium is currently trading on an Acquirer’s Multiple of 6.16 or, 6.16 times Operating Earnings*.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

With a FCF/Price Yield of 13% (ttm), a FCF/EV Yield of 10% (ttm), and an Acquirer’s Multiple of 6.16, or 6.16 times Operating Earnings* that places Ternium squarely in undervalued territory. It’s also important to note that Ternium currently trades on a P/E around 14 compared to its 5Y average of 20 and the industry average of 54.

Summary

There’s no question that 2016 was a great year for Ternium which saw its share price rise by 109%. With FY2016 EBITDA of $1.5 Billion, EBITDA margins of 21% and an EBITDA per ton of $160, Ternium is operating well above its competitors. While there is still speculation over NAFTA’s future terms of trade the company continues to have solid growth prospects in all of its markets, particularly Mexico and will benefit greatly from its new steel making acquisition, CSA.

CSA provides Ternium with a state-of-the-art technology facility with just-in-time iron ore deliveries provided through a railroad system that goes directly into the mill and coal to feed the coking oven plants through its own harbor. The result should be significant cost savings, freight efficiency, inventory, and opportunities to streamline logistics as well as low cost iron ore and coal supply.

Combine that with the company’s excellent track record of being operationally efficient, its ability to generate strong free cash flows, and its strong balance sheet. Ternium is also started to receive protection against unfair competition from Chinese steel makers and is well positioned for continued growth thanks to its strategic geographic location.

In terms of its valuation, Ternium has a FCF/Price Yield of 13% (ttm), a FCF/EV Yield of 10% (ttm), and an Acquirer’s Multiple of 6.16, or 6.16 times Operating Earnings*. The company is currently trading on a P/E around 14 compared to its 5Y average of 20, all of which indicates that Ternium is still undervalued. Plus, the company provides a nice dividend yield of 4% which is expected to grow in coming years.