Ternium Continues To Surpass Expectations And Still Seems Too Cheap

Ternium (TX) confounds me at times. This Mexico-focused steelmaker has an above-average track record when it comes to margins and returns on capital, operates in a pretty stable region, has access to multiple growth markets, and has been investing in growth projects at what appear to be good future IRRs. And yet, Ternium trades at one of the lowest forward multiples in the group even after a good run in the share price.

As Ternium continues to beat and raise, my expectations go up as well. I do see some risk that EBITDA could reach a near-term peak in 2019 or 2020, but the companys leverage to recoveries in Argentina and Brazil makes that a tough call and there are still significant opportunities to gain share in its home market. Even at 4x my new 2018 EBITDA estimate, it looks like theres double-digit upside left in these shares.

Another Strong Quarter In A Strong Sector Upswing

Like many other steel companies, Ternium had a better than expected first quarter, but here again the company outperformed peers like ArcelorMittal (MT), Gerdau (GGB), and Steel Dynamics (STLD) with a 6% beat on the top line and a 13% beat at the EBITDA line.

Revenue rose 45% yoy (and 7% qoq), but curiously, at least relative to other steel companies, price was actually a headwind for the annual comp (down 1%). Price was a stronger factor in the sequential comp, though, with a healthy mid-single-digit improvement. All of Terniums reporting units saw double-digit yoy revenue growth, with Mexico (close to 50% of revenue) up 17%, Southern (which is largely, but not wholly, Argentina) up 25%, and Other (which includes the U.S., Brazil, and Colombia) up 224%, as well as Mining up 11%. Volume was strong across the board, and pricing was okay in both Mexico and the Southern region.

Input cost pressure is an issue across the sector, but Ternium saw just a one-point decline in gross margin and a 30bp decline in EBITDA margin from last year. EBITDA rose 43% yoy and steel EBITDA per ton was up 1% to $189 a strong number compared to ArcelorMittal (around $130 after converting from metric tonnes), Steel Dynamics (around $172), and Gerdau (below $110 overall and around $150 in the core Brazilian ops).

More To Come?

Overall, Terniums operating environment looks pretty favorable. In Mexico, the majority of the companys steel is sold to industrial customers (including auto OEMs) and the benefits of the recent surge in prices in North America should linger due to lags in contract terms. Terniums operations are also largely sheltered from Section 232 issues and NAFTA-related risks still appear manageable.

There is still a lot of uncertainty about what potential changes to NAFTA will mean for Mexicos fast-growing auto industry (a major end-market for Ternium), as well as the impact of the presidential election on the economy, but Ternium still has the opportunity to displace the roughly 35% to 40% share of imported steel in the Mexican market (and closer to 65% in the auto market). I’d also note that other steelmakers, including ArcelorMittal and POSCO (PKX) seem to agree on the potential of Mexico and are expanding capacity (which is a longer-term risk).

Argentina is also looking better and better. Argentina isnt a huge market, with apparent consumption of around 5Mtpa, but both construction and vehicle production have been growing strongly this year and Terniums place as the only flat-roll operator in Argentina gives it good leverage to this long-awaited recovery (and while 5Mtpa isnt large in global terms, its large relative to Ternium).

Brazil, too, is seeing its economy turn around. Ternium owns close to 40% of Usinminas (USZNY), Brazils third-largest producer by capacity, and Usinminas is uncommonly leveraged to Brazil, as it exports relatively little of its production. Auto, appliance, and industrial/capital goods production has already started to recover in Brazil, but Gerdau management believes that the recovery in construction (the largest consumer of steel in Brazils economy) wont really get underway until later this year.

Id also note again that Ternium continues to invest in growth projects, including a hot-roll, hot-dip, and pre-painting facility in Mexico that will largely serve auto customers and a bar mill in Colombia that will most likely serve the construction industry (but also some industrial and oil/gas customers). This makes Ternium something of an outlier in that it is increasing capex when many steel companies are saying their priority is capital return then again, ArcelorMittal continues to look for acquisitions, Steel Dynamics just announced an acquisition, and Nucor (NUE) has been investing in multiple projects (organic and M&A).

The Opportunity

North American steel prices will probably soften as 2018 goes on, but Terniums contracts will lead to a longer cycle. Whats more, Brazil and Argentina are both now in recovery mode. That makes it harder to estimate Terniums peak EBITDA for the cycle its almost certainly going to come later than for North America and Europe-focused producers, and at the risk of its different this time, maybe there wont be an especially noticeable/sharp peak for Ternium in this cycle.

Terniums strong performance, and the better than expected recoveries in Argentina and Brazil, have led me to revise my revenue estimates such that the changes add a point to my long-term revenue growth estimate (around 4%), though I continue to look for mid-single-digit FCF margins over the long term.

EV/EBITDA is the preferred approach to valuing steel stocks, and Ive significantly boosted my 2018 EBITDA expectations on both higher revenue and better margin leverage. A 4x multiple to my new estimate supports a mid-$40s fair value, and Id note again that a 4x multiple is very low on a relative basis and not really all that fair considering how Ternium stacks up with margins, ROIC, and other performance metrics. Give the stock a more peer-like 5.5x to 6x multiple and youre talking about a $65 to $70 stock.

The Bottom Line

Ternium has already had a great run, and Im hesitant to chase a cyclical stock at this point in the cycle. Id also note that some of the last holdouts on the sell-side are coming around and upgrading the shares and/or raising their fair value estimates. That makes me a little nervous, but Ternium has shown over and over again that it can run itself well and I believe the growth opportunities in Mexico, Brazil, and Argentina are real. Consequently, I think this is still a name to consider even at this point in the cycle.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.