What a difference one deal can make. The management of Ternium (NYSE:TX) had been considered one of the best in the Latin American steel sector, and the company was generally well thought of with its mix of cost integration in Mexico and near-monopoly in Argentina. Recently, though, the company paid a huge premium to take a major position in a Brazilian steel company and analysts have put the company in the penalty box as a result.

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Familiar Conditions in Core Markets
The global slowdown in the steel market has not been helping Ternium sentiment lately. As Mexico's economy is so tied to the U.S., conditions in the U.S. seem to inevitably spill over into Mexico and this has been true for the steel market as well. Argentina, too, has seen some sequential slowing in shipments and pricing - a trend repeated broadly through the world.

Longer term, though, Ternium has some valuable core businesses. In Mexico, the company is a specialist in flat-rolled steel (used in automotive and machinery products) and owns iron ore mines that supply much of its internal needs. With ArcelorMittal (NYSE:MT) supposedly on the hunt for Mexican iron ore assets, there's a fair chance that investors will see an uptick in the implied value of Ternium's long-life mines.

Argentina is a different story, but still attractive in its own way. Although the Argentine operations don't have the same sort of input independence (this subsidiary, Siderar, has to buy its iron from Vale (Nasdaq:VALE), it has a virtual monopoly on the domestic Argentine flat-roll steel industry. With Argentina seeing not only good growth in construction (residential and commercial), but also trying to foster manufacturing sector growth, demand has been pretty solid of late. (For related reading, see Sneaky Subsidiary Tricks Can Cloud Financials.)

A Big Bite in Brazil
Ternium's biggest problem is that it recently paid a huge premium to get involved in Brazilian steel. Brazil has long been an interesting market for steel. On one hand, there's a lot of presumed demand from the growth in construction, manufacturing, and energy, to say nothing of building tied to major international sporting events. On the other hand, it's a very competitive market with major players like Gerdau (NYSE:GGB) and Companhia Siderurgica Nacional (NYSE:SID).

Ternium took its place as part of an investor group that acquired a controlling stake of leading flat-roll producer Usiminas. Not only did this transaction put into doubt Ternium's former plans for building a greenfield slab facility, it came at a huge cost. Estimates do vary, but analysts calculate that Ternium paid about 15-20 times normalized EBITDA - a huge premium for any steel maker, but especially one with nothing particularly exceptional or extraordinary about it.

As if to highlight some of the risks of this deal, not only has Ternium taken on debt to fund the transaction, but now there are rumors that the CEO of Ternium Mexico will move to Usiminas. While Ternium should have a deep bench, it certainly raises the risk for the company and puts its former reputation as a sober, value-driven enterprise in some doubt.

The Bottom Line
Although I don't like the price that Ternium paid for its piece of Usiminas, it doesn't really alter the fact that the company still has attractive assets in Mexico and Argentina. While steel companies have come off a bit since the late-2011 rally has petered out, Ternium has a lot of the same improving fundamentals to look forward to, with well-respected U.S. mini-mills like Nucor (NYSE:NUE) and Steel Dynamics (Nasdaq:STLD).

Ternium has historically carried a forward EBITDA premium between 5.5 and 6.0. Since the Usiminas transaction, analysts have slashed that fairly considerably. I don't really agree with this, as the Brazilian transaction is a sunk cost and it does not look as though performance at Usiminas is going to drag down overall company-wide results.

Still, even using a five times premium to 2012 EBITDA estimates suggests that Ternium is undervalued by about 25% (or 40% using the old 5.5 times multiple). That puts it in pretty good shape amongst other steel makers and suggests it is at least worthy of a look. Nothing about the steel market is guaranteed for 2012, but the possibility of improving market fundamentals and a recovery in sentiment could make Ternium a better-than-average prospect for market-beating gains. (For related reading, see A Clear Look At EBITDA.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.



Tickers in this Article: TX, SID, GGB, MT, STLD, NUE

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