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An Undervalued Steel Play With a Margin of Safety

·3-min read

Around a decade ago, I made a significant investment in South American steel producer Ternium SA (NYSE:TX). At the time, I thought the company was deeply undervalued and investors did not appreciate its capital generation potential.

I sold the investment for a small profit in the years after, but I have kept a close eye on the business ever since.

If I had held onto the company, I would have earned a much higher return. Over the past 10 years, the stock has produced a total return of 8.6%, outperforming the steel industry overall, which returned just 3.8% per annum over the same timeframe.

Investing for growth

Today, the company is a different beast from the one I owned around 2014. After two years of bumper profits, it has eliminated debt from its balance sheet and now stands in a great position to capitalize on emerging market opportunities.

At the end of its latest fiscal period, Ternium had a positive cash balance of $1.3 billion, a very favorable position for an industrial company. Net profit hit $4 billion last year, allowing it to make substantial investments and eliminate its debt pile.

However, while the business has been moving forward over the past couple of years, the current economic environment seems to be scaring off investors.

The stock has fallen substantially from a multiyear high of around $55 per share at the end of August 2021. At the time of writing, the stock is trading around $33 per share.

An Undervalued Steel Play With a Margin of Safety
An Undervalued Steel Play With a Margin of Safety

You might be wondering why I am bullish on a steel company just as the world teeters on the edge of a recession driven by high energy and commodity prices.

Usually, I would not recommend these types of companies because they are incredibly exposed to inflationary pressures and commodity price volatility. However, over the past decade, this company has proven that it can cope with changes in commodity prices and pass higher costs on to customers.

The reason why it can pass higher costs on is the fact Ternium mainly manufactures high-quality finished steel, which is both more expensive to manufacture but also commands a higher profit margin. It has invested significant amounts of money in its steel facilities over the past couple of years to increase quality steel output. Most recently, it outlined plans to invest $1 billion in expanding a plant in northern Mexico to increase finished steel output for the automotive industry.

As other steel companies are starting to look to reduce capital spending, Ternium is still spending, which may put it in a good position to capture business as the environment changes. It has a strong balance sheet to capitalize on any opportunities and weather uncertainty if and when it emerges.

That is another factor to consider. So far, the economy seems to be holding up pretty well to the storm. If a prolonged downturn does not emerge, it makes sense for the business to be investing now rather than later because it might be able to achieve better deals on construction materials if others are not buying.

There is also scope for a substantial dividend from this business. Wall Street brokers have penciled in a dividend per share of $3 for the current year, giving a dividend yield of 8.9% on the current share price.

Whats more, even though analysts expect earnings per share to fall 40% this year and a further 40% in 2023, the stock is still only trading at a 2023 forward price-earnings multiple of 4.7. Therefore, it looks dirt cheap.

So while there are plenty of risks on the horizon, this well-managed, cash-rich company could be well placed to navigate the challenges. Its bargain basement valuation also provides a margin of safety for investors.

This article first appeared on GuruFocus.