109-007-1

Arcelor
Undervaluation :
Threat or Opportunity?

01/2009-5476

This case was written by Theo Vermaelen, 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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109-007-1

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 Doll 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 worlds largest steel producer. In pursuit of this goal, Arcelor had, over the
past few years, increased its cash balances to over 4bn 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 worlds 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 companys 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 multiples in the industry. Although Arcelor had debt capacity and
significant free cash balances, the undervalued shares would restrict managements 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 coke1 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 worlds 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
1

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-term 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 demands extreme
sensitivity to business cycles. Prior to 2001 the steel industry experienced a prolonged period
of poor performance. Historically such periods resulted from periods 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 Tinto, 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
margins.
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
3
4

International Iron & Steel Institute.

Smale, William, Steel Industry Feels the Squeeze, BBC News; March 1, 2005.
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. Arcelors steel products included flat and long carbon steels as well as
stainless steel (exhibit 2). These products were marketed to the companys customer base of
manufacturers of automobiles, home appliances, construction materials, and packaging.
Despite the fragmentation of the world market, the vast majority of Arcelors 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.
Arcelors 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-term strategy
of Arcelor was to pursue continued growth through a combination of mergers and share
acquisitions. 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 worlds most profitable steel manufacturers, 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 Chinas growing demand. Arcelor Chairman
Guy Doll 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--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 4bn in cash and had reduced its net debt from 7bn
in 2002 to just 2.5bn (See exhibit 3 and 4 for historical financials). Over that time period the
market capitalization of the company had increased from 6.0bn to 10.8bn. 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 Arcelors 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 Chinas 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.
Insiders 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 Forecasts
While the forecasts for continued growth certainly boded well for the steel industry (exhibit
7), it was clear that Arcelor would need to develop its presence in emerging markets to fully
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 Arcelors 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
Arcelors 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 Arcelors 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--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 market 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 to a long-term debt-asset ratio of 40 %. He cited an empirical study on share
repurchase tender offers which predicted that the total abnormal 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
Arcelors 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 Arcelors management considered what projects to pursue in 2005, a number of
important questions would need to be tackled:
1. What should be the fair value of Arcelors stock price, assuming the forecasts in Exhibit 8
and the companys 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
Arcelors 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 its 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

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
-

46.9
42.8
32.4
31.6
30.2
21.4
20.8
19.0
17.9
17.6
16.7
14.6
13.7
13.0
12.8
12.1
11.3
11.3
10.9
9.3
660.7

Total World

1067.0

MARKET
SHARE
4.4%
4.0%
3.0%
3.0%
2.8%
2.0%
1.9%
1.8%
1.7%
1.6%
1.6%
1.4%
1.3%
1.2%
1.2%
1.1%
1.1%
1.1%
1.0%
0.9%
61.9%

COMPANY
Arcelor
Mittal Steel
Nippon Steel
JFE
POSCO
Baosteel
US Steel
Corus Group
Nucor
ThyssenKrupp2
Riva
Gerdau
Evraz
Sumitomo
Severstal
SAIL
Anshan
Magnitogorsk
China Steel
Wuhan
Others

Source: International Iron & Steel Institute

1
2

million metric tons crude steel output

50% of HKM included in ThyssenKrupp

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Exhibit 2
Source of Revenue
A. Revenues by Division (m)
2003
Flat Carbon Steel
Long Carbon Steel
Stainless Steel
DTT
Other
Total

2004

13,994
4,381
4,280
7,954
145
30,754

16,139
6,221
4,577
8,267
163
35,367

B. Revenues by Geography (m)

2003
Europe
North America
South America
Other
Total

2004

20,729
2,127
1,193
1,874
25,923

24,259
2,308
2,146
1,463
30,176

Source: 2004 Annual Report

Note: Divisional revenues include intercompany sales

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Exhibit 3
Arcelor Balance Sheet (m)
2003

2004

Cash & Short Term Inv.

Receivables
Total Inventories
Total Current Assets
Net Property, Plant & Equip.
Investments in Affiliates
Deferred Tax Assets
Other Assets
Total Assets

1,890
4,631
5,497
12,018
8,947
1,758
1,436
449
24,608

4,043
5,129
6,801
15,973
11,230
1,366
1,284
1,369
31,222

Accounts Payable
Short Term Debt and Current LTD
Other Payables
Other Current Liabilities
Total Current Liabilities
Long Term Debt
Benefits
Deferred Taxes
Other Long Term Provisions
Other Liabilities
Total Liabilities

4,348
1,551
2,194
295
8,388
4,871
2,451
289
983
163
17,145

4,997
2,293
2,848
249
10,387
4,348
2,539
629
920
82
18,905

730

1,415

2,665
4,795
-419
-308
6,733
24,608

3,199
5,397
2,709
-403
10,902
31,222

Minority Interest
Subscribed Capital
Share Premium
Consolidated Reserves
Translation Reserve
Common Shareholders' Equity
Total Liabilities & Equity

Source: 2004 Annual Report

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Exhibit 4
Arcelor Income and Cash Flow Statements (m)
A. Income Statement
2002
Sales

2003

2004

24,533

25,923

30,176

2,109

2,455

4,734

EBIT

875

965

3,587

Pre-Tax Income

348

557

3,240

-186.00

257.00

2,314.00

-0.37

0.52

4.26

EBITDA

Net Income
EPS

B. Cash Flow Statement

2002

2003

2004

Net Income/Starting Line

Deprec., Depl. & Amortiz.
Other Cash Flow
Funds from Operations
Funds from Other Op. Activ.
Net Cash Flow Operations

-140
1,234
329
1,423
523
1,946

416
1,490
-45
1,861
641
2,502

2,717
1,147
67
3,931
-726
3,205

Capital Expenditures
Net Assets from Acq.
Disposal of Fixed Assets
Increase in Investments
Decrease in Investments
Net Cash Flow Investing

1,312
0
1,072
435
84
591

1,293
0
112
577
683
1,109

1,353
302
566
414
192
1,382

0
2,464
3,581
33
0
167
0
-1,251

0
1,891
2,444
85
0
218
0
-686

0
1,205
1,578
1,136
64
249
-96
354

10
114

-56
651

-24
2,153

Inc./Dec. Short Term Borrowing

Long Term Borrowing
Reduction in Long Term Debt
Proceeds from Stock Issue
Purchase/Redemption of Stock
Cash Dividends
Other Source/Use Financing
Net Cash Flow Financing
Effect of Exchange Rates on Cash
Net Cash Flow

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Exhibit 5
Arcelor Equity Performance
Share Price
20

/share

17.5

15

12.5

Market Data
Share Price ()
Shares Outstanding (000)
Market Capitalization (m)

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2002
11.34
532,366
6,037

12

2003
13.37
533,041
7,127

Jul-05

Jun-05

May-05

Apr-05

Mar-05

Feb-05

Jan-05

Dec-04

Nov-04

Oct-04

Sep-04

10

2004
16.97
639,774
10,857

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Exhibit 6
Worldwide Crude Steel Production 1960-2004
1200

million metric tons

900

600

300

0
1960

1970

1980

Year

MMT1

2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1990
1985
1980
1975
1970
1965
1960

1067
969
904
850
848
789
777
799
750
752
770
719
717
644
595
456
347

1990

2000

Annual
Growth
10.1%
7.2%
6.4%
0.2%
7.5%
1.5%
-2.8%
6.5%
-0.3%
-0.5%
1.4%
0.1%
2.2%
1.6%
5.5%
5.6%
-

Source: International Iron & Steel Institute

1

million metric tons crude steel output

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Exhibit 7
Global Steel Value Forecasts
Year
2009e
2008e
2007e
2006e
2005e
2004
2003
2002
2001
2000

Value
($bn)
1077
1074
1046
990
913
822
553
431
366
437

Annual
Growth
0.3%
2.7%
5.7%
8.4%
11.1%
48.8%
28.2%
17.7%
-16.1%
-

MMT1
2204
2138
2067
1989
1892
1778
1653
1557
1476
1465

Annual
Growth
3.1%
3.4%
3.9%
5.1%
6.4%
7.5%
6.1%
5.5%
0.7%
-

Source: Global Steel Data Monitor Industry Profile

Figures include crude steel, pig iron, & direct reduced iron
million metric tons output

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Exhibit 8
Arcelor Forecasts
A. Free Cash Flow
2004
Revenues
EBIT
Taxes
NOPAT
Depreciation
Less Capex
Less WCR
UFCF

30,174
3,587
511
3,076
1,147
-1,424
-1,159
1,601

2005e
32,634
4,268
982
3,286
1,170
-2,000
-455
2,001

2006e
32,805
2,927
878
2,049
1,198
-2,000
-31
1,216

2007e
32,092
3,284
985
2,299
1,225
-2,000
131
1,655

2008e
32,413
2,651
795
1,856
1,225
-1,225
-59
1,797

B. Key Relationships
2004
Sales Growth
EBIT Margin
Tax Rate
NOPAT Margin
Dep/Sales
Capex/Sales
WCR
WCR/Sales

11.9%
14%
10.1%
3.8%
4.7%
5582
18.5%

2005e
8.2%
13.1%
23%
10.1%
3.6%
6.1%
6,037
18.5%

2006e
0.5%
8.9%
30%
6.2%
3.7%
6.1%
6,068
18.5%

2007e
-2.2%
10.2%
30%
7.2%
3.8%
6.2%
5,937
18.5%

2008e
1.0%
8.2%
30%
5.7%
3.8%
3.8%
5,996
18.5%

C. Capital Employed
2004
WCR
PPE
Invested Capital
ROIC

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5582
11,230
16,812
16.0%

2005e
6,037
12,060
18,097
18.2%

15

2006e
6,068
12,862
18,930
10.8%

2007e
5,937
13,637
19,574
11.7%

2008e
5,996
13,637
19,633
9.5%

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Exhibit 9
Comparable Company Data
A. Market Risk & Capital Structure

Arcelor
Mittal
Voestalpine
Outokumpu
Corus Group
Acerinox
ThyssenKrupp

Beta
1.30
1.40
1.04
1.18
1.73
1.09
1.23

Net Debt-toAsset Ratio

18%
-3%
32%
54%
38%
18%
40%

Tax Rate
2004
14.0%
13.0%
24.0%
20.0%
18.4%
34.0%
42.0%

Sales

WCR/Sales

PPE/Sales

EBIT/Sales

18.5%
18.5%
28.1%
33.5%
20.8%
37.3%
24.3%

37%
34%
36%
38%
30%
34%
27%

11.9%
28.0%
9.5%
6.6%
6.7%
12.4%
4.8%

B. Sales Ratios

Arcelor
Mittal
Voestalpine
Outokumpu
Corus Group
Acerinox
ThyssenKrupp

Copyright 2009 INSEAD

30,279
22,197
5,779
7,136
9,311
4,039
39,342

16

01/2009-5476

109-007-1

Exhibit 10
Forecasted EBITDA Multiples August 2005

Arcelor ()
Mittal ($)
ThyssenKrupp ()
Evraz ($)
Corus Group ()
Acerinox ()
Voestalpine ()
Outokumpu ()
Industry Average

Copyright 2009 INSEAD

EBITDA
2005e
5,438
6,699
3,304
2,033
1,008
589
847
665

17

EV/EBITDA
2005e
2.7
4.0
4.9
3.2
2.9
6.6
3.1
7.8
4.4

EV/EBITDA
2006e
3.5
3.4
5.3
3.8
5.9
7.6
3.7
3.9
4.6

01/2009-5476

109-007-1

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