Arcelor by miguel Silveira

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Arcelor Undervaluation : Threat or Opportunity?

Ol/2009-5476 This case was written by Thea Verrnaelen, Professor of Finance, with research assistance provided by David Andrade, Brattle Group Senior Associate, as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 2009 INSEAD To ORDER COPIES OF !NSEAD CASES,

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INSEAD In August 2005 it was obvious that it would be another good year for The Arcelor Group.

Looking to the future, Board President and CEO Guy Dolle and the management team of Arcelor were in many ways faced with an enviable situation. The steel industry was rebounding from a period of overcapacity as dramatic increases in demand continued to drive higher steel prices, increased sales and larger profits. The company had an expressed vision of steadfastly, but rationally pursuing continued growth opportunities in order to maintain its standing as the world's largest steel producer. In pursuit of this goal, Arcelor had, over the past few years, increased its cash balances to over 4â&#x201A;Źbn while decreasing net debt and increasing debt capacity. On paper the company looked poised to continue its growth strategy through future mergers or share acquisitions. However, there was some cause for concern as well. The dramatic increases in worldwide steel demand, particularly in China, the world's number one consumer of steel, were driving shortages in raw materials. Increasing raw materials prices and scarcity put significant pressures on operating margins and limited growth. In addition, Arcelor management was concerned that the current market price, â&#x201A;Ź 18.63, did not reflect the company's prospects. Based on its forecasts of free cash flows and its cost of capital which was set at 8 %, it believed its stock was significantly undervalued. Moreover, the company was selling at one of the lowest EBITDA mul6ples in the industry. Although Arcelor had debt capacity and significant free cash balances, the undervalued shares would restrict management's ability to use equity as an efficient acquisition currency. At the same time, there was good reason to fear that undervalued shares combined with its substantial cash balances might make Arcelor a takeover target. Although Arcelor was a large firm, it could not assume that it was entirely safe from a hostile bidder.

The Steel Industry Steel is an iron alloy that is malleable enough to allow molding. Its material properties make it an ideal candidate for enormous number of applications. It is a composite material with over 3500 grades in use, each with its own physical and chemical properties. Steel is manufactured in one of two ways: from raw materials or from scrap. The majority of worldwide steel is created from three principle raw materials - iron ore, 1 limestone, and coke - in blast or basic oxygen furnaces. These raw materials are produced worldwide and together constitute the primary variable production costs for "new" steel. Other inputs include alloying elements such as nickel, chromium, and manganese. Steel production is energy intensive driving some companies to self-produce a portion of their energy requirements. Integrated steel mills carry out all of the basic components of steel production: converting ore to molten iron, converting pig (or raw) iron into steel, and producing intermediate and finished shapes. New steel accounts for 63% of worldwide annual production. Steel is one of the world's most recyclable products, as its properties remain unchanged with each recycling and over 99% of steel is recoverable from scrap. Steel is typically produced from scrap at mini-mills in electric arc furnaces (EAFs). In 2004, approximately 34% of Coke is a coal byproduct produced by baking coal without oxygen to remove unwanted gases. The remaining coke is then used to the fuel blast furnaces in which steel is produced.

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INSEAD worldwide steel was produced from recycled materials. 2 Although mini-mills are typically smaller facilities and produce a smaller variety of steel products, they cost less to install, require less labor, and can be operated in locations where integrated facilities are infeasible. Furthermore, EAFs are capable of starting and stopping regularly and thus these facilities can respond more dynamically to changes in demand. Although much had been made of the rising costs and the short-term availability problems of procuring raw material supplies, high fixed costs were also very important drivers of industry profitability. Steel production is a highly capital intensive industry. Integrated production facilities are only economical at capacities above 2m ton per year and may cost more than $4bn to install. In addition these plants require significant ongoing capital expenditures. Furthermore, integrated steel production facilities must typically be run continuously for several years at a time, due to the extreme stress caused by heating and cooling the blast furnace and the high energy cost involved. Although it is possible to scale back production dynamically, the industry often experiences periods of over- and under-capacity. Capacity retirements are equally difficult, involving high shutdown costs (e.g., environmental, labor reductions) and typically significant political obstacles. Industry fragmentation and production technology limitations make it difficult for suppliers to adequately respond to short-tem1 changes in demand. The steel industry is highly cyclical due to the relative inflexibility of production facilities, lack of coordination among fragmented industry participants, and steel demand's extreme sensitivity to business cycles. Prior to 2001 the steel industry experienced a prolonged period of poor perfonmmr,p Historir811y SW'h rerinds resulted from reriods of over production resulting in capacity and inventory gluts that took several years to resolve. The industry fragmentation also placed significant strains on profitability margins as both raw material suppliers and steel consumers operate in highly concentrated industries. The top 3 iron ore suppliers, CVRD, BHP Billiton and Rio Tin to, account for 70% of the iron ore market. 3 The auto industry is similarly concentrated with the top 5 producers accounting for 55% of units 4 produced. The concentration of suppliers and consumers leaves steel producers with very little bargaining power. In addition, many steel applications often require strict manufacturing specifications for safety reasons. This creates a lack of differentiation between producers and a tendency towards commoditization that places even further pressure on margms. Despite a recent period of consolidation, the steel industry remained highly fragmented in 2004. Although it was the largest worldwide producer of steel, Arcelor accounted for only 4.4% of the 1,067 million metric tons produced worldwide. The top 20 firms accounted for only 40% of worldwide production (Exhibit 1). Although the industry had a long history of fragmentation, this was largely a historical byproduct of two related phenomena: 1) countries wanting captive control of steel production facilities to insure adequate supplies for military and civil uses of steel and 2) tariffs and subsidies provided to artificially boost the competitiveness of local producers. As many once government controlled companies were now privatized, industry insiders expected a renewed drive for profitability to continue driving future consolidation. 2 3 4

International Iron & Steel Institute. Smale, William, "Steel Industry Feels the Squeeze," BBC News; March l, 2005. Global Automobile Manufacturers: Industry Profile, Data Monitor; April 2006

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Arcelor In February 2002 The Arcelor Group was created by the merger of three European steel companies, Aceralai (Spain), Arbed (Luxembourg), and Usinor (France) with the goal of establishing a global leader in the steel industry. This vision would be realized by exploitation of cost synergies across raw materials purchasing, production technology, marketing, and management that would add €300m to earnings by 2003 growing to €700m by 2006. In 2004, the group estimated achieved cost reduction synergies of €560m. The group maintained production facilities worldwide with focused presence in Europe and the Americas. Arcelor's steel products included flat and long carbon steels as well as stainless steel (exhibit 2). These products were marketed to the company's customer base of manufacturers of automobiles, home appliances, construction materials, and packaging. Despite the fragmentation of the world market, the vast majority of Arcelor's business was concentrated in Europe where the group could effectively dominate local steel markets. This led to some positive returns to scale and some local bargaining power. Arcelor's management and other industry analysts believed that due to rising materials costs and other economic pressures significant gains would be achieved through continued industry consolidation. Additionally, shortages in raw materials supplies led some insiders to conclude that a period of vertical integration was likely to begin. In light of this, the long-tenn strategy of Arcelor was to pursue continued growth through a combination of mergers and share acqmsttlons. Over the next 5 to 10 years, Arcelor aspired to become one of the 4 or 5 companies it believed would together represent over 40% of the global production. At the same time, the group realized that most of the growth in steel consumption would occur in the so-called "BRICET" countries (Brazil, Russia, India, China, Eastern Europe, and Turkey). Arcelor needed to enhance its presence in these economies to benefit from this growth. Although steel is more or less a commodity, transportation costs are non-negligible and therefore a local presence is a significant advantage. To realize its goals for growth and geographic diversification, Arcelor had recently acquired majority control one of the world's most profitable steel manufacturer's, Cia Siderurgica de Tubarao (CST) in Brazil, to boost its international presence. At the same time it was pursuing strategic alliances with partners in Asia to meet China's growing demand. Arcelor Chairman Guy Dolle believed that in order to successfully pursue his vision of "mega-mergers or significant acquisitions in the future," the company needed to improve its share price performance and profitability. Despite the poor performance of the steel industry as a whole vis-a-vis other materials industries, Arcelor continued to outperform many of its peers in terms of profitability. By the end of 2004, the company had amassed 4€bn in cash and had reduced its net debt from 7€bn in 2002 to just 2.5€bn (See exhibit 3 and 4 for historical financials). Over that time period the market capitalization of the company had increased from 6.0€bn to 10.8€bn. Although this represented a 80% increase in the market capitalization, there was some feeling that the shares remained undervalued by the market. (see exhibit 5 for stock price information) In particular, given Arcelor's large cash balances combined with the fresh memory of their poorly justified acquisition of Belgian steel company Cockerill-Sambre a few years ago, it seemed possible that the market was worried about that management would invest the extensive cash balances in another ill-advised acquisition in their quest for growth.

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Industry Outlook The steel industry has seen rapid production increases over the past several years (see exhibit 6}, spurred on by China's growth. On the surface, this growth has been a boon helping to make companies more profitable due to rising steel prices. However, this tremendous growth has come at a cost. Global capacity has struggled to keep up with demand and raw materials prices for scrap, iron ore and coke have risen as Asian producers, bolstered by low labour costs, have shown the ability to pay premium prices to secure raw material supplies. With the 2008 Olympics on the horizon as well as several other large projects, the Chinese demand showed no signs of abating. Producers, especially those in the West, expected to face continued materials shortages and therefore constrained production capabilities. lnsiders believed that growth would continue for the next few years but that it would continue to be focused in Asia and other developing economies. The economics of the steel industry were expected to slowly improve as consolidation and vertical integration activities continued. Raw material prices were currently high and forecasted to remain so for a few years. Nonetheless, analysts believed there would be some immediate relief from their current all-time highs.

Arcelor ForeJ::asts While the forecasts for continued growth certainly boded well for the steel industry (exhibit 7). it /-'

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take advantage of forecasted growth. Recent European demand growth was modest and analyst forecasts suggested that it was unlikely to improve significantly in the near future. Furthermore, as a European-based producer, Arcelor was particularly sensitive to energy prices in the region. Recent Kyoto-inspired regulations on emissions would impact the company directly through limitations on its own emissions and indirectly through increases in the cost of electricity. Although the company self-supplied a significant portion of its energy requirements, these economic shifts would disadvantage Arcelor's margin with respect to some of its peers. Exhibit 8 contains forecasts for Arcelor for 2005-2008. Historical and forecasted data on value drivers of Arcelor and some comparable firms is provided in Exhibit 9 and 10.

Share Buybacks Arcelor's financial advisor recommended that Arcelor changes its capital structure and provide a strong signal to the market that it is undervalued by repurchasing shares. Share repurchases can be executed via four methods: a fixed price tender offer, a Dutch auction offer, an open market purchase or a private purchase. In a fixed price tender offer the company offers to purchase a specific number of shares at a predetermined price over a specified time window. The company may buy more shares than originally desired and often retains the right to withdraw the offer if it is not fully subscribed. Typically the tender price in a fixed price tender exceeds the prevailing market price. In a

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Dutch auction offer the company determines a minimum and a maximum repurchase price market. Each shareholder then chooses her minimum acceptable selling price and the company pays then to all the stockholders the lowest price that will fetch the number of shares sought. In an open market purchase, the company buys back its shares on the market at the prevailing price. Thus, open market purchases are often believed to be "cheaper" than fixed price tender offers, although a repurchase in the open market will take more time than a tender offer. Less commonly, companies may directly approach individual investors to directly negotiate the repurchase of their shares. Given Arcelor's substantial cash balances and the presumption that its shares are undervalued a share repurchase seemed like a natural way to address its problem of undervaluation. A secondary advantage for Arcelor of a share repurchase is that it would allow the company to simultaneously adjust its capital structure. Although the company had explained that it had reduced its net debt position to increase its possibilities to finance future acquisitions with new debt, the low debt levels vis-a-vis its competitors may have enhanced the attractiveness of Arcelor as a takeover target. The advisor recommended that the company makes very strong signal by making a fixed price repurchase tender offer for 140 million of its own shares at € 26 per share, a 40 % premium over the current m;.trket price. The repurchase could be financed out of excess cash. Moreover, the advisor believed that the press release should contain a strong statement that the capital structure change "is the first move in the direction of a permanent increase in financial leverage w a long-term clebr-asser rario of 40 %··. He cired an empirical study on share repurchase tender offers which predicted that the total abnonnal return to all shareholders (TOTALR) could be predicted by the following regression: TOTALR = 0.6 x Premium+ 0.25 x Percentage of shares repurchased. Hence a repurchase for a large percentage of shares at a significant premium would lift Arcelor's stock price significantly. This would make a takeover bid for Arcelor more expensive as empirical evidence showed that, on average, successful bidders have to pay a 40 % premium above the pre-bid price. One of the directors questioned the wisdom of the repurchase tender offer strategy. "Why pay € 26 to investors that leave the company? Why not buy shares on the open market, which should benefit long-term shareholders, rather than the non-believers and other short-term speculators? We should consider the undervaluation of the stock as an opportunity, not as a threat" Another director complained that "repurchasing shares is against our consolidation strategy. There are several interesting takeover targets in the pipeline, and we should use the cash to finance these acquisitions. The market expects us to pursue our consolidation strategy. Doing a buyback will lower our stock price, not increase it."

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Case Questions Before Arcelor's management considered what projects to pursue m 2005, a number of important questions would need to be tackled:

1. What should be the fair value of Arcelor's stock price, assuming the forecasts in Exhibit 8 and the company's WACC of 8 %? What do the forecasts in Exhibit 8 imply about the competitive advantage of Arcelor in the short run and in the long run? In the summer of 2005 there were 640 million shares outstanding. 2. Is the WACC of 8 %a reasonable number? Currently the company can borrow at 3.5%, not much above the risk-free rate of 3 %. 3. Should the company consider adjusting its capital structure? What would happen to Arcelor's "fair value" if it moves its long-term target debt-to-asset ratio to 40 %? How would the WACC change? Assume that when this happens it's borrowing rate increases to 4 %. 4. Arcelor is considering three alternative strategies ( 1) a fixed price tender offer for 140 million shares at €26 per share (2) an open market repurchase program for 182 million shares at an average (expected) price of€ 20 (3) hold on to the € 3.64 bn cash to finance a future acquisition. If the goal of the company is to maximize its long-term stock price, which alternative would you recommend?

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Sources Arcelor 2004 and 2005 Annual Report World Steel in Figures 2006, International Iron & Steel Institute; 2006. Smale, William, "Steel Industry Feels the Squeeze," BBC News; March 1, 2005. Global Automobile Manufacturers: Industry Profile, Datamonitor; April 2006 Global Steel: Industry Profile, Datamonitor; May 2005 R&I Sector Reports: Rating the Steel Industry, Ratings and Investment Information, Inc. Steelonthenet.com Morgan Stanley Equity Research Report; November 15, 2004. Deutsche Bank Equity Research Report; November 11, 2004 Credit Suisse First"Boston Equity Research Report; January 6, 2005 & January 19, 2005. Arcelor Profile. Datamonitor: June 2006

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INSEAD Exhibit 1 2004 Worldwide Crude Steel Production

RANK

MMT

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 -

46.9 42.8 32.4 31.6 30.2 21.4 20.8 19.0 17.9 17.6 16.7 14.6 13.7 13.0 12.8 12.1 11.3 11.3 10.9 9.3 660.7

Total World

1067.0

MARKET SHARE 4.4°/o 4.0°/o 3.0% 3.0% 2.8°/o 2.0°/o 1. 90/o 1.8°/o 1. 7°/o 1.6°/o 1.6% 1.4°/o 1.3% 1.2°/o 1.2°/o 1.1 u;o 1.1 °/o 1.1 °/o 1.0°/o 0.9°/o 61.9°/o

COMPANY Arcelor Mitta I Steel Nippon Steel JFE POSCO Baosteel US Steel Corus Group Nucor 2 ThyssenKrupp Riva Gerdau Evraz Sumitomo Severstal ~AIL

Anshan Magnitogorsk China Steel Wuhan Others

Source: International Iron & Steel Institute 1

million metric tons crude steel output

50% of HKM included in ThyssenKrupp

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109-007-1 INSEAD Exhibit 2 Source of Revenue A. Revenues by Division (Cm)

2003 Flat Carbon Steel Long Carbon Steel Stainless Steel DTT Other Total

2004

13,994 4,381 4,280 7,954 145

16,139 6,221 4,577 8,267 163

30,754

35/367

B. Revenues by Geography (Cm)

2003 Europe NortA America South America Other !Total

2004

20,729 2,127 1,193 1,874

25,923

24,259 2,308 2,146 1.463

3o,i7GI

Source: 2004 Annual Report Note: Divisional revenues include intercompany sales

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109-007-1 INSEAD Exhibit 3 Arcelor Balance Sheet (â&#x201A;Źm) 2004

2003 Cash & Short Term Inv. Receivables Total Inventories Total Current Assets Net Property, Plant & Equip. Investments in Affiliates Deferred Tax Assets Other Assets Total Assets Accounts Payable Short Term Debt and Current LTD Other Payables Other Current Liabilities Total Current Liabilities Long Term Debt Benefits" Deferred Taxes Other Long Term Provisions Other Uabl!!tles Total Liabilities

Minority Interest Subscribed Capital Share Premium Consolidated Reserves Translation Reserve Common Shareholders' Equity Total Liabilities & EQuity

1,890 4,631 5,497

4,043 5,129 6,801

12,018

15,973

8,947 1,758 1,436 449

11,230 1,366 1,284 1,369

24,608

31,222

4,348 1,551 2,194 295

4,997 2,293 2,848 249

8,388

10,387

4,871 2,451 289 983

4,348 2,539 629 920

163 17,145

82 18,905

730

1,415

2,665 4,795 -419 -308

3,199 5,397 2,709 -403

6,733 24,608

10,902 31,222

Source: 2004 Annual Report

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Exhibit 4 Arcelor Income and Cash Flow Statements (€m)

A. Income Statement 2002 Sales EBITDA EBIT Pre-Tax Income

Net Income EPS

2003

24,533 2,109 875 348 -186.00 -0.37

2004

25,923 2,455 965 557 257.00 0.52

30,176 4,734 3,587 3,240 2,314.00 4.26

2003

2004

B. Cash Flow Statement

2002 Net Income/Starting Line Depree., Depl. & Amortiz. Other Cash Flow " Funds from Operations Funds from Other Op. Activ. Net Cash Flow - Operations

-140 1,234 329 1,423 523 1,946

416 1,490 -45 1,861 641 2,502

2,717 1,147 67 3,931 -726 3,205

Capital Expenditures Net Assets from Acq. Disposal of Fixed Assets Increase in Investments Decrease in Investments Net Cash Flow - Investing

1,312 0 1,072 435 84 591

1,293 0 112 577 683 1,109

1,353 302 566 414 192 1,382

0 2,464 3,581 33 0 167 0 -1,251

0 1,891 2,444 85 0 218 0 -686

0 1,205 1,578 1,136 64 249 -96 354

10 114

-56 651

-24 2,153

Inc./Dec. Short Term Borrowing Long Term Borrowing Reduction in Long Term Debt Proceeds from Stock Issue Purchase/Redemption of Stock Cash Dividends Other Source/Use - Financing Net Cash Flow- Financing Effect of Exchange Rates on Cash Net Cash Flow

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Exhibit 5 Arcelor Equity Performance

Share Price

17.5

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2002

Share Price (C) Shares Outstanding (000) Market Capitalization (Cm)

11.34 532,366 6 037

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2003

13.37 533,041 7 127

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2004

16.97 639,774 10 857

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109-007-1 INSEAD Exhibit 6 Worldwide Crude Steel Production 1960-2004

900 Ul

....0 u ·;: .... Q)

600

g E 300

0 1960

1970

Year

2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1990 1985 1980 1975 1970 1965 1960

1990

1980

MMT

1067 969 904 850 848 789 777 799 750 752 770 719 717 644 595 456 347

2000

Annual Growth

10.1% 7.2°/o 6.4% 0.2°/o 7.5°/o 1.5°/o -2.8% 6.5% -0.3°/o -0.5% 1.4% 0.1% 2.2°/o 1.6°/o 5.5% 5.6%

Source: International Iron & Steel Institute 1

million metric tons crude steel output

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INSEAD Exhibit 7 Global Steel Value Forecasts

Year

Value ($bn)

Annual Growth

2009e 2008e 2007e 2006e 2005e 2004 2003 2002 2001 2000

1077 1074 1046 990 913 822 553 431 366 437

0.3°/o 2. 7°/o 5. 7°/o 8.4°/o 11.1% 48.8°/o 28.2°/o 17. 7°/o -16.1 °/o -

MMT

2204 2138 2067 1989 1892 1778 1653 1557 1476 1465

Annual Growth

3.1 °/o 3.4°/o 3.9°/o 5.1 °/o 6.4°/o 7.5°/o 6.1 °/o 5.5°/o 0. 7°/o -

Source: Global Steel Data Monitor Industry Profile Figures it:Jclude crude steel, pig iron, & direct reduced iron 1

million metric tons output

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INSEAD Exhibit 8 Arcelor Forecasts A. Free Cash Flow 2004 Revenues EBIT Taxes NOPAT Depreciation Less Capex Less .0.WCR UFCF

30,174 3,587 511 3,076 1,147 -1,424 -1,159 1 601

2005e

32,634 4,268 982 3,286 1,170 -2,000 -455 2 001

2006e

32,805 2,927 878 2,049 1,198 -2,000 -31 1 216

2007e

32,092 3,284 985 2,299 1,225 -2,000 131 1 655

2008e

32A13 2,651 795 1,856 1,225 -1,225 -59 1 797

B. Key Relationships 2004 Sales Growth EBIT Margin Tax Rate NOPAT Margin Dep/Sales Capex/Sales WCR WCR/Sales

11.9% 14% 10.1% 3.8% 4.7% 5582 18.5%

2005e

8.2% 13.1% 23% 10.1% 3.6% 6.1% 6,037 18.5%

2006e

0.5% 8.9% 30% 6.2% 3.7% 6.1% 6,068 18.5%

2007e

-2.2% 10.2% 30% 7.2% 3.8% 6.2% 5,937 18.5%

2008e

1.0% 8.2% 30% 5.7% 3.8% 3.8% 5,996 18.5%

C. Capital Employed 2004 WCR PPE Invested Capital ROIC

5582 11,230 16,812 16.0%

2005e

6,037 12,060 18,097 18.2%

2006e

6,068 12,862 18,930 10.8%

2007e

5,937 13,637 19,574 11.7%

2008e

5,996 13,637 19,633 9.5%

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Exhibit 9 Comparable Company Data A. Market Risk & Capital Structure

Arcelor Mittal Voestalpine Outokumpu Corus Group Acerinox Thyssen Krupp

Beta 1.30 1.40 1.04 1.18 1.73 1.09 1.23

Net Debt-toAsset Ratio 18% -3% 32% 54% 38% 18% 40%

Tax Rate 2004 14.0% 13.0% 24.0% 20.0% 18.4% 34.0% 42.0%

Sales

WCR/Sales

PPE/Sales

EBIT /Sales

11.9% 28.0% 9.5% 6.6% 6.7% 12.4% 4.8%

B. Sales Ratios

Arcelor Mittal Voestalpine Outokumpu Corus Group Acerinox

30,279 22,197 5,779 7,136 9,311 4,039

18.5% 18.5% 28.1% 33.5% 20.8% 37.3%

37% 34% 36% 38% 30% 34%

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?7010

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INSEAD Exhibit 10 Forecasted EBITDA Multiples August 2005 EBITDA 2005e Arcelor (C) Mittal ($) ThyssenKrupp (C) Evraz ($) Corus Group (£) Acerinox (C) Voestalpine (C) Outokumpu (C) Industry Average

EV/EBITDA 2005e

5,438 6,699 3,304 2,033 1,008 589 847 665

EV /EBITDA 2006e

2.7 4.0 4.9 3.2 2.9 6.6 3.1 7.8

3.5 3.4 5.3 3.8 5.9 7.6 3.7 3.9

4.4

4.6

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