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Arcelor

Undervaluation : Threat or Opportunity?

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.

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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 4€bn 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, € 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, limestone, and coke 1

- 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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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 produced.4 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 International Iron & Steel Institute. 3 Smale, William, "Steel Industry Feels the Squeeze," BBC News; March l, 2005. 4 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 1 0.8€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 Wr!S ~ler~r thr~t A r~elor wnnln nee n tn nevelnn its nresenre in em erPin a mr~rkets tn fnllv

/-' J. I Q Q -- - .J

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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Exhibit 1 2004 Worldwide Crude Steel Production

RANK MMT1 MARKET

COMPANY SHARE

1 46.9 4.4°/o Arcelor

2 42.8 4.0°/o M itta I Steel

3 32.4 3.0% Nippon Steel

4 31.6 3.0% JFE

5 30.2 2.8°/o POSCO

6 21.4 2.0°/o Baosteel

7 20.8 1. 90/o US Steel

8 19.0 1.8°/o Corus Group

9 17.9 1. 7°/o Nucor

10 17.6 1.6°/o ThyssenKrupp2

11 16.7 1.6% Riva 12 14.6 1.4°/o Gerdau

13 l 13.7 1.3% Evraz 14 13.0 1.2°/o Sumitomo 15 12.8 1.2°/o Severstal

16 12.1 1.1 u;o ~AIL

17 11.3 1.1 °/o Anshan 18 11.3 1.1 °/o Magnitogorsk 19 10.9 1.0°/o China Steel 20 9.3 0.9°/o Wuhan - 660.7 61.9°/o Others

Total World 1067.0

Source: International Iron & Steel Institute

1 million metric tons crude steel output 2 50% of HKM included in ThyssenKrupp

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Exhibit 2 -Source of Revenue

A. Revenues by Division (Cm)

2003

Flat Carbon Steel 13,994 Long Carbon Steel 4,381 Stainless Steel 4,280 DTT 7,954 Other 145 Total 30,754

B. Revenues by Geography (Cm)

Europe NortA America South America Other

!Total

Source: 2004 Annual Report

2003

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

25,923

2004

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

163 35/367

2004

24,259 2,308 2,146 1.463

3o,i7GI

Note: Divisional revenues include intercompany sales

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Exhibit 3 Arcelor Balance Sheet (€m)

2003 2004

Cash & Short Term Inv. 1,890 4,043

Receivables 4,631 5,129

Total Inventories 5,497 6,801

Total Current Assets 12,018 15,973 Net Property, Plant & Equip. 8,947 11,230

Investments in Affiliates 1,758 1,366

Deferred Tax Assets 1,436 1,284

Other Assets 449 1,369

Total Assets 24,608 31,222

Accounts Payable 4,348 4,997

Short Term Debt and Current LTD 1,551 2,293

Other Payables 2,194 2,848

Other Current Liabilities 295 249

Total Current Liabilities 8,388 10,387 Long Term Debt 4,871 4,348

Benefits" 2,451 2,539

Deferred Taxes 289 629

Other Long Term Provisions 983 920

Other Uabl!!tles 163 82 Total Liabilities 17,145 18,905

Minority Interest 730 1,415

Subscribed Capital 2,665 3,199 Share Premium 4,795 5,397 Consolidated Reserves -419 2,709 Translation Reserve -308 -403

Common Shareholders' Equity 6,733 10,902 Total Liabilities & EQuity 24,608 31,222

Source: 2004 Annual Report

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

A. Income Statement

2002 2003 2004

Sales 24,533 25,923 30,176

EBITDA 2,109 2,455 4,734

EBIT 875 965 3,587

Pre-Tax Income 348 557 3,240

Net Income -186.00 257.00 2,314.00

EPS -0.37 0.52 4.26

B. Cash Flow Statement

2002 2003 2004

Net Income/Starting Line -140 416 2,717 Depree., Depl. & Amortiz. 1,234 1,490 1,147 Other Cash Flow " 329 -45 67 Funds from Operations 1,423 1,861 3,931 Funds from Other Op. Activ. 523 641 -726 Net Cash Flow - Operations 1,946 2,502 3,205

Capital Expenditures 1,312 1,293 1,353 Net Assets from Acq. 0 0 302 Disposal of Fixed Assets 1,072 112 566 Increase in Investments 435 577 414 Decrease in Investments 84 683 192 Net Cash Flow - Investing 591 1,109 1,382

Inc./Dec. Short Term Borrowing 0 0 0 Long Term Borrowing 2,464 1,891 1,205 Reduction in Long Term Debt 3,581 2,444 1,578 Proceeds from Stock Issue 33 85 1,136 Purchase/Redemption of Stock 0 0 64 Cash Dividends 167 218 249 Other Source/Use - Financing 0 0 -96 Net Cash Flow- Financing -1,251 -686 354

Effect of Exchange Rates on Cash 10 -56 -24 Net Cash Flow 114 651 2,153

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Exhibit 5 Arcelor Equity Performance

20

17.5

Cl) ... ttl

.r:; 15 Ill

........ v

12.5

10 <:t ~ <:t <:t 0 0 0 0

I I I I c. .... > u Cl) u 0 Cl)

Ill 0 z c

Market Data

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

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It) 0

I c:: ttl ....,

Share Price

It) It)

0 0 I I

.c ... Cl) ttl LL :::E

2002

11.34 532,366

6 037

12

It) It) 0 0

I I ... > c. ttl <( :::E

2003

13.37 533,041

7 127

It)

0 I

c:: ::s ....,

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It)

0 ..!. ::s ....,

2004

16.97 639,774

10 857

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Exhibit 6 Worldwide Crude Steel Production 1960-2004

900

Ul c 0 .... u ·;: .... Q) 600 E c g E

300

0 1960 1970 1980 1990 2000

Year I MMT1 I

Annual Growth

2004 1067 10.1% 2003 969 7.2°/o 2002 904 6.4% 2001 850 0.2°/o 2000 848 7.5°/o 1999 789 1.5°/o 1998 777 -2.8% 1997 799 6.5% 1996 750 -0.3°/o 1995 752 -0.5% 1990 770 1.4% 1985 719 0.1% 1980 717 2.2°/o 1975 644 1.6°/o 1970 595 5.5% 1965 456 5.6% 1960 347

Source: International Iron & Steel Institute 1 million metric tons crude steel output

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Exhibit 7 Global Steel Value Forecasts

Year Value Annual

MMT1

($bn) Growth 2009e 1077 0.3°/o 2204 2008e 1074 2. 7°/o 2138 2007e 1046 5. 7°/o 2067 2006e 990 8.4°/o 1989 2005e 913 11.1% 1892 2004 822 48.8°/o 1778 2003 553 28.2°/o 1653 2002 431 17. 7°/o 1557 2001 366 -16.1 °/o 1476 2000 437 - 1465

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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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

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A. Free Cash Flow

2004

Revenues 30,174 EBIT 3,587 Taxes 511 NOPAT 3,076 Depreciation 1,147 Less Capex -1,424 Less .0.WCR -1,159 UFCF 1 601

B. Key Relationships

2004

Sales Growth EBIT Margin 11.9% Tax Rate 14% NOPAT Margin 10.1% Dep/Sales 3.8% Capex/Sales 4.7% WCR 5582 WCR/Sales 18.5%

C. Capital Employed

2004

WCR 5582 PPE 11,230 Invested Capital 16,812 ROIC 16.0%

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Exhibit 8 Arcelor Forecasts

2005e 2006e

32,634 32,805 4,268 2,927

982 878 3,286 2,049 1,170 1,198

-2,000 -2,000 -455 -31

2 001 1 216

2005e 2006e

8.2% 0.5% 13.1% 8.9%

23% 30% 10.1% 6.2% 3.6% 3.7% 6.1% 6.1% 6,037 6,068

18.5% 18.5%

2005e 2006e

6,037 6,068 12,060 12,862 18,097 18,930 18.2% 10.8%

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2007e 2008e

32,092 32A13 3,284 2,651

985 795 2,299 1,856 1,225 1,225

-2,000 -1,225 131 -59

1 655 1 797

2007e 2008e

-2.2% 1.0% 10.2% 8.2%

30% 30% 7.2% 5.7% 3.8% 3.8% 6.2% 3.8% 5,937 5,996

18.5% 18.5%

2007e 2008e

5,937 5,996 13,637 13,637 19,574 19,633 11.7% 9.5%

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Exhibit 9 Comparable Company Data

A. Market Risk & Capital Structure

Net Debt-to- Tax Rate Beta Asset Ratio 2004

Arcelor 1.30 18% 14.0% Mittal 1.40 -3% 13.0% Voestalpine 1.04 32% 24.0% Outokumpu 1.18 54% 20.0% Corus Group 1.73 38% 18.4% Acerinox 1.09 18% 34.0% Thyssen Krupp 1.23 40% 42.0%

B. Sales Ratios

Sales WCR/Sales PPE/Sales EBIT /Sales

Arcelor 30,279 18.5% 37% 11.9% Mittal 22,197 18.5% 34% 28.0% Voestalpine 5,779 28.1% 36% 9.5% Outokumpu 7,136 33.5% 38% 6.6% Corus Group 9,311 20.8% 30% 6.7% Acerinox 4,039 37.3% 34% 12.4% ThvssPnKrunn 3Q 342 24.]0/0 ?7010 4.8%

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Exhibit 10 Forecasted EBITDA Multiples August 2005

EBITDA EV/EBITDA EV /EBITDA 2005e 2005e 2006e

Arcelor (C) 5,438 2.7 3.5 Mittal ($) 6,699 4.0 3.4 ThyssenKrupp (C) 3,304 4.9 5.3 Evraz ($) 2,033 3.2 3.8 Corus Group (£) 1,008 2.9 5.9 Acerinox (C) 589 6.6 7.6 Voestalpine (C) 847 3.1 3.7 Outokumpu (C) 665 7.8 3.9 Industry Average 4.4 4.6

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