Ternium Hit Hard On Near-Term Steel Price And Margin Weakness (NYSE:TX)

Rolls of galvanized steel sheet inside the factory or warehouse

Vladimir Zapletin/iStock via Getty Images

Tougher times usually see investors run toward quality, but that hasn’t benefited Ternium (NYSE:TX) this year, as the shares of this Latin American steelmaker have fallen about 13% since my last update, underperforming Steel Dynamics (STLD) and Nucor (NUE) by a wide margin, as well as ArcelorMittal (MT) and Gerdau (GGB). Given Ternium’s leverage to a recovering North American auto industry and longer-term reshoring, I think this underperformance is short-sighted, but it is also true that Ternium is looking at weaker EBITDA margins through 2023/2024 and a competitive Mexican steel market.

I still believe Ternium is undervalued, and I further believe that the relative valuation has become meaningfully more attractive. This is likely not a name that will get much love over the next six months, as prices and spreads continue to weaken, but I see upside into the $40s as investors eventually come back to the strong margins, cash generation, and balance sheet and the positive growth outlook.

Better Realizations, Higher Costs

Looking back at third quarter results, Ternium benefited from stronger price realizations, but higher production costs drove a weaker than expected EBITDA and working capital needs continue to weigh on near-term cash generation.

Revenue fell 10% year over year and 7% quarter over quarter, driven by a 7% decline in pricing (both yoy and qoq) that was nevertheless better than expected, while volumes declined 3% yoy and were flat sequentially. Relative to expectations, revenue was about 4% better than expected.

Revenue from Mexican operations fell 17% yoy and 12% qoq, with pricing down 18% yoy and 14% qoq and volumes up 1% yoy and 2% qoq. Revenue from the Southern segment (Argentina) rose 7% yoy and 1%, with price up 14% yoy and 4% qoq and volume down 7% yoy and 3% qoq. Revenue from the “Other” segment (which includes the U.S., Colombia, and Brazil) fell 9% yoy and 1% qoq, with price up 2% yoy and flat sequentially and volume down 11% yoy and 2% qoq. Mining revenue fell 23% yoy and 9% qoq, with price down 21% yoy and 8% qoq and volume down 2% yoy and 1% qoq.

Gross margin declined 2350bp yoy and 1170bp qoq to 19.4%, with the company seeing higher prices for inputs (energy, raw materials, labor, et al). Steel gross margin followed basically the same trajectory, falling 2250bp yoy and 1170bp qoq to 19.1%.

Adjusted EBITDA fell 64% yoy and 45% qoq, missing by about 8%, with margin falling 2450bp yoy and 1110bp qoq to 16.5%. Steel EBITDA per ton declined 63% yoy and 46% qoq to $219, and Ternium saw a 30% yoy and 7% qoq increase in the per-ton cash cost.

Comparisons to other steelmakers are a little challenging because of the different markets they serve (and Steel Dynamics and Nucor have large steel fabrication businesses), but perhaps still of use to readers.

Steel Dynamics reported an 11% yoy sales improvement (and 9% sequential decline), helped by stronger shipments (up 13% yoy and 1% qoq in Steel Operations and up 3% yoy and flat qoq in Steel Fabrication), while adjusted EBITDA fell 4% yoy and 21% qoq, with a margin of 23.8%. Nucor reported 2% yoy sales growth and 11% qoq contraction, with EBITDA down 15% yoy and 30% qoq and an EBITDA margin of 25.3%.

Relatively speaking, Ternium remains a very efficient operator. The three companies don’t report financials in a way that facilitates easy one-to-one comparisons, but Ternium’s $175 steel operating profit per ton isn’t dramatically far off of Steel Dynamics’ $208, and Ternium is basically in line with Nucor’s EBITDA per-ton in steel.

Short-Term Pain, But Longer-Term Opportunities

In the short term, there’s not much that’s going to get meaningfully better for Ternium or the steel industry in general. Customers have rebuilt their inventories and declining end-user demand is leading to weaker orders and falling prices. To that end, spot hot-rolled prices have fallen about 20% in the last three months and 65% over the last year in the U.S., while Mexican prices have fallen 11% and 52%, respectively.

At the same time, while commodity prices have started to ease, input costs are still squeezing the business and spreads. I do expect that prices for hot rolled coil in the U.S. should stabilize around $700, but I believe they could remain in that vicinity for some time. I expect that Ternium will continue to enjoy a price premium over that (due to its leverage to Argentina, Brazil, and Colombia), but prices around $900 to $1,050 are still a marked correction from the $1,300-plus of 2021 and 2022. Ternium will still make money at realized prices around $1,000/ton, particularly as input costs normalize, but I expect mid-teens EBITDA margins and mid-single-digit returns on equity from the pressured spreads over the next couple of years.

In the short term, I do have some concerns about demand from Mexican industrial customers (Ternium is more leveraged to industrial demand than construction), as weaker demand in the U.S. for housing, appliances, and industrial goods will drive weaker steel demand at Mexican factories. Likewise, the auto industry continues to struggle through component shortages and erratic production schedules. Brazil, too, has seen some cracks in demand (though I’m a little more bullish on overall demand), while Argentina has been steadier.

Longer term, I think there are solid reasons to be bullish on Ternium’s opportunities. The supply chain risks laid bare by the pandemic are already leading to increased interest in near-shoring supply chains, and Mexico offers advantages over China on wages, proximity, and politics. I expect to see meaningful near-shoring moving production from Asia to Mexico over the next ten years, driving increased steel demand not only for the products produced in the factories-to-come, but also for the factories, electrical infrastructure, and other infrastructure needed to support that growth.

Ternium is also executing on growth opportunities in the auto space. Well more than half of the steel used by auto OEMs producing cars in Mexico is imported from outside of Mexico, and import substitution remains a growth opportunity – Ternium has been fielding more inquiries from auto OEMs to certify auto-grade steel components, and I expect this to accelerate. The one “but” here is that the company is going to have to add capacity, with the company likely to spend $3B to $4B at some point over the next four years to add around 3M-4Mpta capacity within Mexico.

The Outlook

In the near term, weak spot prices, high input costs, and high-cost inputs coming out of inventory will pressure margins. Ternium is also moving forward with some needed maintenance capex in Brazil (coking facilities and a blast furnace), and will be spending billions to expand its Mexican capacity – I believe this is a good long-term use of capital, but it will pressure free cash flow in the short term. I also believe that adding capacity in Colombia could 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 U.S. prices can stay below $700/ton on a sustained basis given that the industry is more consolidated, more disciplined and much more skewed to electric arc furnaces (which can be scaled up/down more readily than blast furnaces) than in the past.

I’m expecting revenues to bottom out around $13 billion to $13.5 billion, with EBITDA margins dipping to 14% to 15% at the trough before rebounding toward 20% in 2025. Long term, I expect EBITDA margins to average out around 17.5% to 18%, with FCF margins in the high single-digits (around 8%).

The Bottom Line

Discounted cash flow suggests that Ternium is meaningfully undervalued now, even with a significant decline in FCF likely over the next four years (from $2.15B in FY’21 to around $550M-$600M in FY’23/FY’24). Even with a low-teens discount rate, though, the long-term cash flows from the business with realized prices in the $1,000-$1,050 range support a high-teens total annualized return from here. I also use a mixed EV/EBITDA approach using a 4x multiple to my full-cycle EBITDA estimate and a 3x multiple to my 12-month estimate, and that gives me a near-term fair value of around $40.

Ternium could remain under pressure a while longer, as I don’t see investors flocking to the name until/unless they believe hot rolled prices have bottomed. Likewise, I expect ongoing concern about the cash outflows needed to fund more capacity. Longer term, though, I believe the company will continue to execute on its import substitution opportunities in Mexico and benefit from near-shoring into Mexico, while also benefiting from improved 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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