LatAm Steel Metals and mining

Transcription

1 October 27, 2016 GBM Initiating coverage on LatAm Steel. We rate the industry as Neutral. Continuous volume growth should be the tune in the region in the following years; economic recovery, sustained import duties, weaker F/X, and infrastructure plans support this. Notably, even higher volumes than projected are possible, but they depend on strategic decisions, which are hard to predict at the moment, such as reigniting blast furnaces (demand), and the rationale of old competitors entering into new markets (supply). On the other hand, we believe that the strong margin recovery seen this year will slow down going forward, especially in Mexico and Argentina, as steel prices have started to drop, while some input prices are recovering from their bottom levels. Moreover, the debt burden in the industry is considerable, a situation that could become complicated if the recovery is delayed for several reasons, including the countries fiscal imbalances. Finally, China s normalization factor is important as it is unpredictable, making us wary regarding the sector. Brazil: Weak situation but slowly improving. Margin recovery is in sight due to improving economic perspectives and lower import pressures at current BRL levels. Major cost-cut initiatives implemented by the companies have also helped the equation. While restocking activity could start as soon as 4Q16, physical usage of steel could come several quarters after this point. Construction activity should recover in 2018, after fiscal adjustment is confronted by the current government. Rodrigo Garcilazo Carreon rgarcilazo@gbms.cl +56 (2) Guillermo Estrada Madrazo gestradam@gbm.com.mx + 52 (55) ext Glauco Legat gdecastro@gbms.cl +56 (2) Mexico: After a strong 2016, we see modest growth ahead. Margins will peak in the next quarter, as they will enjoy higher steel prices, coupled with weak raw material prices; however, prices have started to weaken. Moreover, imported material remains a menace/opportunity for local producers as it represents more than a third of consumption. Lower expected growth rates derive from a weak oil & gas sector, commitment to reach fiscal surplus in the country. On the other hand, the auto sector should continue growing at highsingle digits. Argentina: Recovery is coming, but long-term margins should contract. After a poor 2016 in terms of shipments, volumes should recover considerably in the next years. We expect a general restocking during 2017, while agricultural demand is already recovering. After this point, construction, which is the main component of demand (~50%), could improve thanks to the infrastructure and private sectors. The automotive should be the last sector to recover, as it depends on local consumption and Brazilian demand. Higher competition and economy openness should pressure margins in the long-term vs. historical levels We view TERNIUM (Outperformer) as the most attractive stock in the region, as it is a direct play on a recovery of Argentina; in Mexico it has further space to grow in the value added chain. TX has a strong balance sheet, and is the cheapest stock in our radar. We view USIMINAS (Performer) as a very risky option to invest, given its heavy debt burden compared to its cash flow capabilities in the short and medium term. Even though it has the highest leverage to a recovery in the Brazilian market, the battle at the controlling group could delay its turnaround. GERDAU (Outperformer) is also an option to play a late recovery in Brazil and the US, and has the best market strategy and corporate culture; valuation is acceptable given these attributes and its strong FCF generation going forward. 1

2 Company Rating Price Target Upside (%) TERNIUM Market Outperformer $ % Company Rating Price Target Upside (%) USIMINAS ON R$ % USIMINAS PN Market Performer R$ % USNZY US % Company Rating Price Target Upside (%) GERDAU ON R$ % GERDAU PN Market Outperformer R$ % GGB US % Investment Thesis: Despite the volatility in the steel industry, TX remains impressive all around, being one of the most profitable steelmakers worldwide, with a strong FCF generation and a solid balance sheet. The positive outlook is driven by favorable demand trends in Mexico and strategic projects, which will trigger further cost reductions, and higher value added products. Current valuations do not reflect the company s leading position, as stripping out TX s non-argentinian operations at a 5.8x EV/EBITDA multiple and USIMINAS stake at market value, Argentinian operations are trading implicitly at 0.4x EV/EBITDA. How we differ from consensus? We have lower consolidated margins than consensus, especially for 2017 (17.6%), 2018 (17.2%), and perpetuity (16.0%), as we believe that Argentina s margins will shrink vs. historical levels as the economy normalizes; and that Mexico s margins will increase at a slower pace (+100 bps in the period). On the other hand, we are more optimistic regarding Argentina than consensus in terms of volumes, estimating a 5.8% CAGR in the period. Valuation Approach: We used a 5-year explicit period DCF (US$26.7 per share), and a perpetuity considering an 85% capacity utilization rate with a 16% EBITDA margin. WACC is 10.8%. In addition, we used a Sum-Of-The-Parts (US$27.7 per share), where our adjusted EV/EBITDA is 5.8x (Mexico 6.0x, Southern Region 5.0x, Others 5.0x). The stock is trading at 4.9x EV/EBITDA 2017e. Investment Thesis: USIMINAS could be a bet over the turnover in the Brazilian domestic outlook beyond 2017 due to its high leverage both financially and operationally, which should benefit from higher volumes. However, even considering this potential recovery, we believe the balance of risks does not properly reward its own specific issues especially the major conflict between its controlling shareholders. How we differ from consensus? We have lower consolidated margins than consensus, especially for 2017 (9.3%) and 2018 (11.1%), as we believe the recovery in Brazil will be slower and the competition in its own territory and market from GERDAU s new Ouro Branco plant should be considered. In terms of valuation, by weighting our salvage value 10%, which yields a significantly higher value compared to market prices, we are recognizing the value that can be unlocked with the correct strategy execution and a good economy. 2

3 Valuation Approach: We used a 5-year explicit period DCF (R$4.7 per share), and a perpetuity considering an 85% capacity utilization rate with a 15% EBITDA margin discounted by a WACC of 14.2% (35% weight). In addition, we used a normalized 6.5x EV/EBITDA multiple (R$5.0 per share) with a weight of 55%. Finally, a salvage value (R$15.6 per share), where we paid a 50% discount to the current replacement value of the company s steel producing capacity (US$750 per ton), US$10 per ton for the capacity of the mining division, 7.5x for EV/EBITDA Usiminas Mecanica, and 5.0x for Transformation), with a weight of 10%. The stock is trading at 12.2x EV/EBITDA 2017e. Investment Thesis: GERDAU holds a global leadership position in long steel and specialty steels; moreover, we believe that GERDAU is better positioned than other companies due to its important regional diversification. We should note that the company also has a resilient cash flow generation, which will increase going forward. Finally, it has a clearer market strategy, and higher operating flexibility, due to its mix between mini-mill and integrated plants. How we differ from consensus? We have slightly lower top line estimates in general, as we believe that the North American segment (special steels included) will continued pressured in the short term. In terms of margins, we estimate a normalized margin of 17% for Brazil, which is conservative compared to street estimates of around 20%. Moreover, we think that special steels will recover slowly in view of a late recovery in the auto and oil & gas sectors in Brazil, and overcapacity in the segment in North America. Valuation Approach: We used a 5-year explicit period DCF (R$11.4 per share), and a perpetuity considering an 75% capacity utilization rate with a 15% EBITDA margin discounted by a WACC of 13.0%. In addition, we used a normalized EV/EBITDA multiple of 7.0x (R$14.3 per share) with a weight of 33.3%. Finally, we used an EV/EBITDA 2017e (R$9.7 per share), with a weight of 33.3%. The stock is trading at 7.1x EV/EBITDA 2017e. 3

4 Index TERNIUM... 5 I. Introduction... 6 II. Investment Thesis... 8 III. Financial Summary IV. Valuation V. Company Description USIMINAS...34 I. Introduction II. Investment Thesis III. Financial Summary IV. Valuation V. Company Description GERDAU...55 I. Introduction II. Investment Thesis III. Financial Summary IV. Valuation V. Company Description Global Steel Industry Brazil Steel Industry Mexico Steel Industry Argentina Steel Industry

5 TERNIUM Market Outperformer 2017 Price Target US$27 Price US$ M Price Range 10.5 / 24 Shares Outstanding Market Cap 4,755 Float 24.4% Net Debt 1,348 Minority Interest 732 EV 6,953 Dividend Yield 4.8% 2015 TTM 2016e 2017e Revenue 7,878 7,274 7,011 7,296 EBITDA 1,073 1,243 1,487 1,286 Net Profit FCF 1,101 1, EPS P/E 79.5x 22.5x 7.5x 9.1x EV/EBITDA 6.5x 5.6x 4.4x 4.9x P/BV 1.2x 1.2x 1.0x 1.0x *Data in US$ Million Rodrigo Garcilazo Carreon rgarcilazo@gbms.cl +56 (2) Guillermo Estrada Madrazo gestradam@gbm.com.mx + 52 (55) ext Glauco Legat gdecastro@gbms.cl +56 (2) TERNIUM: The best vehicle to participate in LatAm industry We are initiating coverage on TERNIUM with a 2017 price target of US$27 per share, and a Market Outperformer rating, implying a 14% upside potential from current prices. Despite the volatility in the steel industry, TX remains impressive all around, being one of the most profitable steelmakers worldwide, with a strong FCF generation and a solid balance. The positive outlook remains for the company, driven by favorable demand trends in Mexico, coupled with strategic projects, which will trigger further cost reductions, and higher value added. Our projections and investment thesis rely on the following points: Positive leverage on Mexico s long term dynamics, given the company s exposure to the automotive and construction sectors, coupled with Techgen and Tenigal s projects; TX will be able to increase steel shipments, despite a competitive environment. Southern region operations should remain healthy, becoming a medium-term driver for the company. TX has been able to pass through Argentina s economic transition, delivering double-digit margins through its vertically integrated operations and a strong market share, being the largest flat-steel producer in Argentina. Current valuations do not reflect the company s leading position. Stripping out Mexican Assets, the rest of the company (~45% of the EBITDA) would be trading at an implicit 1.9x EV/EBITDA multiple. Solid financials, with a promising outlook. We expect EBITDA to increase at a CAGR of 7.6%, maintaining defensive characteristics, such as FCF generation, high dividend yield, and a low debt profile, which opens opportunities for strategic options. TX is trading at discounted valuations. The company is currently trading at a 4.9x 2017e EV/EBITDA, representing a 25% discount vs. LatAm peers. 5.0x 4.5x 4.0x 3.5x 3.0x 2.5x 2.0x Oct-15 Nov-15 EV/EBITDA FWD TX vs. MXLA Index P/BV Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 85% 65% 45% 25% 5% -15% TX US MXLA INDEX -35% 1.2x 1.1x 1.0x 0.9x 0.8x 0.7x 0.6x 0.5x Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr x May-16 Jun-16 Jul-16 Aug-16 Sep-16 5

6 I. TERNIUM: A leading steel producer in Latin America. TERNIUM engages in the manufacture and processing of flat and long steel products, welded pipes, bars, and wire rods, pre-painted sheets, cold-rolled products, and hot-rolled flat products, which are used in the automotive, construction, home appliances, and energy industries, among others. It has production and distribution centers in the United States, and plays a leading role as a steel producer in Argentina, Mexico, Colombia, and Guatemala; in addition, TX has iron ore mines in Mexico and has a network of service and distribution centers throughout Latin America. Furthermore, the company has a participation in USIMINAS control group. In terms of capacity, TERNIUM has a finished annual steel production capacity of 11.0 million tons, and 4.0 million tons of iron ore pellets. Moreover, the company became the leading supplier of flat steel products in Argentina and Mexico, and a significant supplier of steel products in Colombia and Central America. The company s ADSs began trading on the New York Stock Exchange (NYSE), on February 1, 2006, under the ticker TX. TERNIUM s sales are made in different countries, such as Mexico, the Southern Region (Argentina, Bolivia, Chile, Paraguay, and Uruguay), and other markets (Colombia, United States, Guatemala, Costa Rica, Nicaragua, Panama, and Honduras). TX has commercial offices in many countries providing the company with greater opportunities to enter into new international markets. Revenues US$7,877 Steel 97% EBITDA US$1,073 Steel 98% CAPEX US$467 Steel 90% Mining 10% Mining 3% Mining 2% TERNIUM Market Cap Index ADR Float Revenues EBITDA 4,163 NYSE TX 24.4% US$7,877 US$1,073 Regional Operations Business Mexico Southern Region Other Markets Steel Mining STEEL MINING Products Semi-finished Hot-rolled Cold-rolled Coated Roll-formed and tubuluar tubular Others Capacity Finished steel 11.0 Mtpy Estimated mine life Las Encinas 8 years/peña Colorada 16 years Source: GBM with company data *Figures in US$million of 2015 results Slabs, billets, and round bars flat products, merchant bars, reinforcing bars, stirrups and rods Coils, sheets Tinplate Plate and and galvanized products Tubes, beams, panels, decks, Pre-engineered metal building Pig iron systems and pig iron Sale volumes 9.6 Mtons Iron ore facilities Mines Product Production Op. Since Iron ore 3.1 Mtons pellets and (ROM) and 1.9 Las Encinas Aquila magnetite Mtons of 1970 concentrate saleable Consoricio Peña Colorada (stake 50%) Peña Colorada Iron ore pellets and magnetite concentrate 7.9 Mtons (ROM) and 3.5 Mtons of saleable Sale volumes 3.6 Mtons

7 TERNIUM TX has steel production and processing facilities in North, Central, and South America. By December, 2015, the company had a production capacity of 11.0 Mtons of finished steel products. Of this capacity, approximately 9.1 million tons correspond to flat products and 1.9 million tons to long products. Country * Installed finished steel Capacity (Mtons) Utilzation rate % of total revenues % of steel shipments Weighted US$/Ton Mexico 7,200 82% 56% 62% $734 Southern Region 2,900 88% 33% 27% $1,006 Other Markets * % 12% 12% $812 Total 11,000 87% 7,875 9,600 $815 *Utilization rate for Mexico and Other Markets (sales/capacity) Source: GBM with company data TX s principal production facilities and production units Mexico Argentina Colombia USA Guatemala El Salvador Nicaragua Costa Rica Total Integrated Mills Downstream Service Center Distribution Center Source: GBM with company data TX steel sales mix Steel Shipments 1H16 Shipments by market (Argentina) Shipments by market (Mexico) Home appliances 9% Automotive 16% Energy 6% Building & infrastructure 51% Mexico 66% Argentina 21% USA 4% Automotive13% Agriculture 15% Other Industries 20% Automotive25% Rest of the industrial sector 30% Other industries 18% Colombia 6% Other 3% Construction 52% Construction 45% TX sales by steel product Steel production methods CAPEX Cold-rolled 15% Coated 38% Hot-rolled 39% Roll-formed and tubuluar 6% Others 1% Semifinished 1% BF/BOF 28% DRI/EAF 38% Slab processing 34% Argentina 40% Mexico 45% Mining 12% Other 3% 7

8 II. Investment Thesis We are initiating coverage of TERNIUM with a Market Outperformer rating and a US$27 per share 2017e price target, implying an 14% upside from current levels. Steel stocks have presented an impressive YTD rally, and certainly, the real question is whether there is further room for the upside, in such a volatile industry environment. However, based on a discounted valuation, we believe TERNIUM is an attractive option. Our thesis relies on the following points: Solid fundamentals in the company s P&L and balance sheet, coupled with a robust FCF generation, gives TX a unique position. TERNIUM is one of the leading steel producers in LatAm, offering one of the strongest balance sheets, (net debt/ebitda ratio of 1.1x by 2Q16). This will enable the company to develop further projects and/or participate in opportunistic M&A, providing growth opportunities in the coming years. TERNIUM s business model makes it possible to capture significant synergies, having competitive advantages in South, Central, and North America. TX s EBITDA per ton has averaged US$127 in the last 12M; nonetheless, it will rise further to US$153 by 2016, while normalizing in 2017 to US$128. Lastly, we expect strong FCF generation, yielding 19% in 2016, 9% in 2017, and 9%e in 2018, respectively. Positive growth prospects in Mexico. The company will benefit from Mexico s steel demand. We expect apparent steel consumption to increase 3.4, 4.7, and 4.8% YOYe, in 2016, 2017, and 2018, respectively. In addition, 55% of TX s sales mix are channeled to the industrial sector (includes automotive ~25%), while the rest (45%), is linked to construction sector. We expect vehicle production to reach 4.9 million units by 2020, implying 8% CAGR from 2010 to On the other hand, investment in the infrastructure sector should slowly materialize, mainly driven by the construction of the NAICM airport. Overall, Mexico accounts for 56% of the company s net revenues. What s more, the US anti-dumping duties imposed against flat-steel imports from China, and similar measures taken in Mexico, have become a game changer for Mexico s flat steel prices, increasing barriers and delivering a more positive environment. In addition, TX will be able to gain market share over steel imports, through the Pesqueria expansion (400 to 830 Ktpy). Currently, steel imports in Mexico represent ~35% of steel consumption. The right exposure. Argentina apparent steel demand should remain pressured in 2016 (-9% YOY), given the country s economic transition. In the medium term, the country s GDP should expand 3.1% YOY by 2017, implying a 6% YOY increase in apparent steel use. That said, TERNIUM holds an unrivaled (~90%) market position, being the sole flat-steel producer in the country; in addition, new infrastructure plans could materialize, boosting construction demand, which accounts for 50% of the country s flat-steel demand. In terms of valuation, Argentinean operations are excessively discounted, in our view. Valuing TX s non-argentinian operations at a 5.8x EV/EBITDA (2017e peers average) and USIMINAS stake at market value, Argentinean assets would be trading at an implicit 0.4x EV/EBITDA multiple. In sum, despite the economic transition, Argentina s operations remain very profitable, with EBITDA margins of 16% 2017e. TX is an appealing growth story, with overly discounted valuations. TX is attractively valued and we believe its leading position is not priced in at current levels. TX 2017e valuation levels (EV/EBITDA 4.9x and 9.1x P/E) stand considerably below its N.A peers, at 21% and 35% discounts, respectively. 8

9 Investment Case Pros and Cons Pros TX should maintain high margins, through its vertical integration business model, with its own service centers and iron ore mines. Through its geographic diversification and integrated operations, TX is able to create synergies, as it has a strong international presence. TX is highly exposed to an economic recovery, given its strong market shares in Mexico and Argentina. High exposure to Mexico s automotive industry. TX has more than ten years of iron ore proven reserves. Further cost-cutting initiatives, mainly through Techgen power plant in Mexico. A higher spread in slabs, scrap, and energy prices vs. HRC mean higher profitability margins in Mexico. We expect this spread to normalize by 2017; still benefiting 2H16 results. Cons A slowdown in the world s economy could lead to a deceleration in the steel industry, modifying the trade balance and consequently, affecting steel prices. A prolonged weakness in Argentina s economy could imply lower steel demand for a longer time. Slower than expected growth prospects in Mexico, due to a slowdown in the automotive industry and a cut in infrastructure spending. No solution in sight regarding Nippon and TX confrontation in USIMINAS controlling block. TX and Nippon misunderstanding could affect its Tenigal (JV) operations in Mexico. Risks - Worldwide steel surplus capacity may result in unfair trade practices in the international steel market and/or intense competition, endangering Ternium s ability to sustain adequate profitability. - Ternium s performance is tied to the price of raw materials (such as iron ore, coal, and slabs), and other commodities (electricity and gas). Prices are often volatile because of several factors, including those affecting supply and demand, political, social, and economic conditions. - Ternium operates and sells its products in different countries, and as a result, it is exposed to foreign exchange rate volatility. As an example, during December 2015, the Argentinean peso devaluated against the US dollar by 25.7%; the accrued devaluation during 2015 was 34.4%. - Most of Ternium s workers are represented by labor unions and are covered by collective bargaining or similar agreements. Strikes often happen in the industry during or after the negotiations of these agreements, causing production to halt, and having a direct effect on financial performance. - Mexican law indicates that all of the natural resources in the country belong to the nation, so mines are given as concessions to explore and exploit. If the authority determines that Ternium is not in compliance with the list of obligations of concessionaries or decides to change its laws, it may terminate the concession. - Sustained high inflation in Argentina could negatively affect the results of Ternium s operations and its financial position, as peso denominated costs at Siderar increase, thereby affecting its cost-competitiveness; as a result margins could be affected. 9

10 Key expectations in the company Top line should be mainly driven by Mexico s revenue growth prospects, being the most important division, accounting for 56% of the company sales. We are estimating a CAGR of 4.6% in volumes, mainly due to the country s favorable steel demand, given the boom of the automotive industry where we expect an increase of 1.0 million units in , coupled with infrastructure investment in the long term. In addition, antidumping duties have become a game changer, as imports are more than one third of consumption. Talking about the Southern Region, TX holds an unrivaled market position, which should translate into higher steel volumes ( CAGR: 1.7%). Lastly, Other Markets should raise volumes marginally ( CAGR: 3%) given the company s strategy to maximize margins over volumes. Overall, we expect a CAGR of 2.4% on TX s revenues, reaching US$8.87 billion (vs. US$7.88/2015). Focusing on profitability, TX should be able to sustain high margins in the long term, given its upstream and downstream integration, providing further cost reductions. Mexico should deliver a strong EBITDA/ton in 2016e ( CAGR: 7.6%), driven by cost-cutting efforts. Lower raw material prices (energy, gas, slabs, and scrap) opened an important spread vs. HRC prices (+20% YTD) delivering higher EBITDA margins YTD; this effect should normalize by Moreover, EBITDA growth is mainly explained by the ramp-up of Pesqueria hot-dip galvanizing plant. In Argentina, we expect EBITDA/ton growth of 2.5 and 5% by 18/19e. After all of the above, we estimate that annual EBITDA will increase at high single digit rates from e. We estimate a normalized EBITDA margins of 16.5%. TERNIUM s net revenues Figures in US$ million 10,000 CAGR e: 2.4% 8,726 7,878 8,000 7,011 7,296 6,000 4,000 2,000 TERNIUM s EBITDA Figures in US$ million 1,800 1,600 1,400 1,200 1, % 56% 30% 32% 7,774 8,428 8,874 61% 61% 60% 61% 61% 26% 27% 28% 28% 28% 13% 11% 12% 12% 11% 11% 11% e 2017e 2018e 2019e 2020e TX Revenues Mexico Southern Region Other Markets CAGR e: 7.6% 1,471 1, % 1, % 1,286 1,340 1,417 1, % 17.6% 17.2% 16.8% 17% e 2017e 2018e 2019e 2020e TX EBITDA EBITDA mg. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% TX s bottom line should also bring significant improvements, mainly boosted by operating efficiencies and lower financial costs. Regarding the company s taxes, we estimate an effective tax rate of 34% going forward. In addition, we expect net profit to deliver a CAGR of 69%. Robust FCF generation. TX has a strong cash flow generation capability, with an average generation of US$1 billion in the last two years. Looking forward, we are estimating that the company s cash conversion rate will stand above 35%. In addition, we estimate high singledigit FCF yields for the coming years, averaging 11%. This will enable the company develop further projects, and maintain an unleveraged balance sheet. TERNIUM s Free cash flow Figures in US$ million 1,200 1, ,101 1,096 23% 23% % 9% % 14% e 2017e 2018e 2019e 2020e TX FCF FCF Yield 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: GBM estimates 10

11 III. Fact sheet Financials (US$ Mill) 2015 TTM 2016e 2017e 2018e Operating Data 2015 TTM 2016e 2017e 2018e P&L Shipments (Ktons) Revenue 7,878 7,274 7,011 7,296 7,774 Mexico 5,933 6,290 6,350 6,535 6,782 Var (%) -9.7% -14.4% -11.0% 4.1% 6.6% Southern Region 2,552 2,393 2,238 2,350 2,500 COGS 6,477 5,736 5,364 5,705 6,060 Other Markets 1,115 1,127 1,148 1,183 1,218 Var (%) -6.5% -17.4% -17.2% 6.4% 6.2% Mining 3,636 3,443 3,672 3,745 3,820 Gross Profit 1,400 1,538 1,648 1,591 1,714 Gross Mg. 17.8% 21.1% 23.5% 21.8% 22.0% Revenues Operating Profit , Mexico 4,388 4,212 4,265 4,418 4,685 Operating Mg. 8.1% 11.4% 15.3% 11.9% 11.8% Southern Region 2,544 4,744 1,855 1,985 2,153 EBITDA 1,073 1,243 1,487 1,286 1,340 Other Markets Var (%) -27.0% -0.5% 38.5% -13.5% 4.2% Mining EBITDA Mg. 13.6% 17.1% 21.2% 17.6% 17.2% Interest (82) (67) (60) (8) 31 Prices (Weighted US$ / ton) Taxes (207) (266) (356) (271) (310) Mexico Net Profit Southern Region Var (%) 157.4% 164.7% 958.1% -17.1% 14.4% Other Markets Net Mg. 0.8% 2.9% 9.0% 7.2% 7.7% Mining Balance Sheet Valuation 2015 TTM 2016e 2017e 2018e Cash ,051 EPS Accounts Receivable P/E 79.5x 22.5x 7.5x 9.1x 7.9x Inventory 1,579 1,362 1,341 1,458 1,549 EV/EBITDA 6.5x 5.6x 4.4x 4.9x 4.7x Fixed Assets 4,208 4,160 4,164 4,245 4,322 P/B 1.2x 1.2x 1.0x 1.0x 0.9x Total Assets 8,063 8,147 8,685 9,162 9,648 P/Sales 0.6x 0.7x 0.7x 0.7x 0.6x Accounts Payable Debt 1,521 1,527 1,527 1,527 1,527 Return 2015 TTM 2016e 2017e 2018e Total Liabilities 3,260 3,321 3,262 3,295 3,296 ROA 0.7% 2.6% 7.3% 5.7% 6.2% Equity 4,803 4,826 5,423 5,867 6,352 ROE 1.2% 4.4% 11.7% 9.0% 9.5% ROIC -1.9% 0.0% 5.4% 3.8% 4.9% FCF FCF Yield 23.2% 24.3% 19.2% 9.1% 9.3% Operating Profit , Dividend Yield 3.8% 4.4% 4.8% 4.1% 3.4% +Depreciation Buyback Yield 0.0% 0.0% 0.0% 0.0% 0.0% -Cash tax Working Capital Leverage 2015 TTM 2016e 2017e 2018e -CAPEX Debt/Equity 0.3x 0.3x 0.3x 0.3x 0.2x Free Cash Flow 1,101 1, Net Debt/EBITDA 1.3x 1.1x 0.7x 0.6x 0.4x Interest Coverage -7.8x -12.4x -17.9x x 29.1x Cost / Ton TX Turnover (Days of) 2015 TTM 2016e 2017e 2018e Accounts Receivable Inventory EBITDA / Ton Payables TX Cash Conversion Liquidity 2015 TTM 2016e 2017e 2018e EV / Ton Current Ratio 6.8x 6.9x 8.7x 8.9x 9.6x TX Quick Ratio 1.2x 1.5x 2.2x 2.5x 3.1x Source: GBM estimates 11

12 Financial Summary by division Mexico Mexico TTM 2016e 2017e 2018e 2019e 2020e CAGR (15-20) 5.3% 8.5% 7.0% 2.9% 3.8% 5.9% 3.2% Shipments 5,632 5,933 6,290 6,350 6,535 6,782 7,185 7, % Utilization rate 78% 82% 87% 88% 91% 89% 94% 97% -15.3% -19.2% -8.9% 0.4% 2.3% 3.2% 1.7% Price (US$/ton) % -10.6% -12.3% -2.8% 3.6% 6.0% 9.3% 5.0% Revenues 4,909 4,388 4,212 4,265 4,418 4,685 5,121 5, % 162.7% 810.2% 83.6% -0.4% 10.5% 15.5% 16.4% Op. Profit % % % % % % % % 22.1% 741.9% 72.2% 37.7% 0.1% 6.4% 11.3% 10.4% EBITDA % % % % % % % % 12.5% 709.3% 58.8% 28.7% -2.7% 2.6% 5.0% 6.9% EBITDA/ton % Southern Region Southern Region TTM 2016e 2017e 2018e 2019e 2020e CAGR (15-20) 1.6% -8.0% -12.3% 5.0% 6.4% 6.4% 4.5% Shipments 2,511 2,552 2,393 2,238 2,350 2,500 2,660 2, % Utilization rate 87% 88% 83% 77% 81% 86% 92% 96% -4.6% -11.0% -16.4% 2.4% 1.9% 1.6% 2.0% Price (US$/ton) 1, % -3.8% -16.2% -27% 7.0% 8.5% 8.1% 6.6% Revenues 2,644 2,544 2,200 1,855 1,985 2,153 2,327 2, % -41% -34.0% -26.5% -1.1% 9.8% 12.8% 9.8% Op. Profit % % % % % % % % -0.2% -36% -32.8% -27.5% 0.4% 9.0% 11.6% 8.8% EBITDA % % % % % % % % -0.7% -37% -26.9% -17.3% -4.4% 2.5% 4.9% 4.1% EBITDA/ton % Other Markets Other Markets TTM 2016e 2017e 2018e 2019e 2020e CAGR (15-20) -10.0% -4.9% 3.0% 3.0% 3.0% 3.0% 3.0% Shipments 1,238 1,115 1,127 1,148 1,183 1,218 1,255 1, % Utilization rate 138% 124% 125% 128% 131% 135% 139% 144% -13.1% -15.6% -8.6% -0.3% 0.2% 3.2% 1.7% Price (US$/ton) % -21.9% -19.9% -6% 2.8% 3.1% 6.3% 4.7% Revenues 1, , % -92% -9.2% 446% -28% -19% -20% 3% Op. Profit % % % % % % % % 21.4% -89% -8.9% 301.1% -25.5% -17.1% -19.5% 7.1% EBITDA % % % % % % % % 16.4% -88% -3.9% 289.4% -27.7% -19.5% -21.9% 4.0% EBITDA/ton % Source: GBM estimates -Figures in Ktons and US$million Utilization rate (volume sales over capacity) 12

13 IV. Valuation DISCOUNTED FREE CASH FLOW APPROACH H16e 2017e 2018e 2019e 2020e Perpetual FCF Ternium Mexico A % Siderar % Other Markets % Mining % EBITDA 649 1,262 1,310 1,362 1,484 1,295 EBITDA Adjusted 555 1,061 1,090 1,121 1,221 1,065 Stake 85% 84% 83% 82% 82% 82% FCF FCF Adjusted Present Value ,432 ENTERPRISE VALUE 6,255 - Net Debt 2Q16 1, % 448 Equity Value (US$) 5,355 Shares Outstanding (000's) 200 Price Target 26.7 WACC Breakdown Mexico Argentina Others DCF Assumptions % Equity 85.0% 85.0% 85.0% WACC 10.8% % Debt 15.0% 15.0% 15.0% Perpetual G 3.7% Risk Free 5.1% 7.0% 5.3% Capacity Rate 85.0% Beta EBITDA Margin 16.0% Market Risk Premium 5.0% 5.5% 5.0% Maint. CAPEX 400 Cost of Equity 11.1% 14.2% 11.3% Cost of Debt 6.1% 8.0% 6.3% Corporate Tax Rate 33.0% 35.0% 30.0% WACC 10.0% 12.8% % 2017 PT 27.2 A: Adjusted for TENIGAL's stake 13

14 EV to EBITDA Multiple Approach EV/EBITDA 2017e EBITDA 2017e STAKE Equity Value Ternium Mexico A 6.0x % 3,371 Siderar 5.0x % 989 Other Markets 5.0x % 1,271 Mining 5.0x 52 90% x 1,262 84% 5,866 - Net Debt 2017e % 448 Equity Value (US$) 5,560 Shares Outstanding (000's) 200 Price Target 27.7 Ternium's Strip down TX market cap 4,755 Net debt 2017e 753 TX enterprise value 5,508 Mexico operations EV/EBITDA 2017e 6.0x EBITDA 2017e 631 Mexico 3,371 Other Markets EV/EBITDA 2017e 5.0x EBITDA 2017e 254 Other markets 1,271 A: Adjusted for TENIGAL's stake We are initiating coverage on TX with a Market Outperformer rating and a 2017 PT of US$27 per share (14% upside potential), as current prices do not include the company s upcoming projects. Our price target is a 60% / 40% blend of DCF (US$26.7) and 2017e EV/EBITDA multiple approach (US$27.7). EV/EBITDA Multiple approach: Mining EV/EBITDA 2017e 5.0x EBITDA 2017e 52 Mining 234 USIMINAS Stake in USIMINAS at Market 511 DCF Assumptions: Argentina operations EBITDA CAGR 7.6%. Residual EV 120 Corporate tax rate 33%. EBITDA 324 TX s perpetuity based on 85% LT utilization rate with an EBITDA mg of 16%. EV/EBITDA Argentina 0.4x WACC 10.8%: (Cost of equity 12.2% Cost of debt 6.8%) Maintenance CAPEX of US$400 million, representing 1.1x depreciation. USIMINAS equity value is the result of our DCF, salvage value and EV/EBITDA multiple valuations. We are using a 2017e EV/EBITDA multiple of 5.8x, based in the average of the company s main peers by segments. Valuation adjusted based in economic participation, including Tenigal JV (51%). 14

15 TX s balance sheet Balance Sheet Cash Accounts Recievable Inventory Total Assets Accounts Payable Total Liabilities Net debt Majority Equity e 2017e 2018e 2019e 2020e ,051 1,438 1, ,134 1,579 1,341 1,458 1,549 1,682 1,758 3,349 2,582 2,761 3,157 3,566 4,143 4,712 2,165 1,521 1,527 1,527 1,527 1,527 1,527 2,091 1,701 1,817 1,826 1,851 1,899 1,927 1,952 1, ,697 4,033 4,624 5,004 5,405 5,809 6,199 Debt profile: To date, TX s weighted average interest rate is 3.4%. This figure considers rates for each instrument in its corresponding currency and is weighted using the US dollar equivalent. Currently, the company s debt stands at US$1.52 billion. Furthermore, cash and cash equivalents stand at US$178.9 million. That said, the company s net debt currently stands at US$1.35 billion Thereafter Total Non-current Debt 0 259, ,763 28,346 28,346 63, ,237 Fixed rate Floating rate 0 259, ,763 28,346 28,346 63, ,608 Current Debt 913, ,786 Fixed rate 461, ,409 Floating rate 452, ,377 TOTAL 913, , ,763 28,346 28,346 63,942 1,521,023 TX s debt by currency TX s interest rates TX s credits maturity USD 89% ARP 7% COP 3% OTHER. 0.97% Variable 70% Fixed 30% 70% 60% 50% 40% 30% 20% 10% 0% 60% 17% 15% 2% 2% 4% 15

16 V. TERNIUM S history Ternium started operations in 1961 under the name of Propulsora SIiderurgica in Argentina. Eight years later, it began to produce cold-rolled coils. By the 90s, through a series of strategic investments, it became an integrated steel producer. In 1993, it merged with Aceros Parana (a State owned company), Sidercom, Aceros Revestidos, and Bernal. After this merger, the company changed its name to Siderar. By the end of 1997, the Amazonia consortium San Faustin, Siderar, Usiminas, Hylsamex, and Sivensa won the bidding for the privatization of 70% of Sidor and the government of Venezuela kept the other 30%. In 2003, Amazonia had to do a debt restructuring and its participation in Sidor was reduced to 60% while the position of Venezuela s government increased to 40%. Shortly after, it transferred 20% to present and former employees. On August 22, 2005, the company acquired an indirect 99.3% stake in Mexican company Hylsamex (a producer of steel products and iron ore) along with its subsidiaries, and the equity owned by ALFA, in both Amazonia and Ylopa (a steel producer focused on both flat and long products). One year later, the company launched an initial public offering of 24,844,720 American Depositary Shares (ADS) in the United States, each representing 10 shares of the company at a price of US$20. The company used the resources of this IPO mainly to repay its debt. By April 29, 2007, the company agreed to acquire (9.3%) Grupo Imsa. Three months later, it acquired the remaining 90.7% for US$1.56 billion. After that, Imsa changed its name to Ternium Mexico, and in March, 2008, Hylsamex merged with Ternium Mexico. Thus, Siderar became a shareholder of Ternium Mexico with a 28.7% stake. A month later, the National Assembly of Venezuela passed a resolution whereby the shares of Sidor, along with all its assets, were property of the state. This turned into an expropriation. At that moment, Ternium controlled 59.7% of Sidor while CVG (Venezuelan Corporation at Guyana) owned 20.4% and Sidor employees, 19.9%. The new decree stated that the government could not own less than 60% of Sidor and its subsidiaries. During 2010, Ternium continued its aggressive expansion plans, with the acquisition of a 54% ownership interest in FERRASA through a capital contribution of US$74.5 million, as well as an acquisition of 54% in Ferrasa Panamá for US$5 million. Additionally, it signed an agreement with Nippon Steel Corporation to form a joint venture in Mexico, Tenigal, each holding 51 and 49%, respectively. Moreover, on January 31, 2011, Technit Group acquired 2.78 million ADRs at US$36, each. In that same year, Ternium bought in the market million shares at a price of US$3.6, each, from Usinas Siderúrgicas de Minas Gerais. With this transaction, Usiminas relinquished entirely its stake in Ternium. In January 2012, Ternium joined the control group of USIMINAS, a leading steelmaking and mining company in Brazil. Ternium Investments holds 27.7% (TX 22.7% and Tenaris Confab 5%) of Usiminas voting shares. In addition, on October 30, 2014, Ternium bought an additional 10.2% stake in Usiminas ON shares from Previ (Caixa de Previdência dos Funcionários do Banco do Brasil) for R$617 million. Lastly, Usiminas shareholders meeting approved an issuance of ordinary shares. Existing shareholders had rights to subscribe the proposed capital increase at any time prior to May 23, Ternium subscribed 76.5 million ordinary shares for a total of US$110.9 million; that said, TX and its subsidiaries now own 34.6% of USIMINAS ordinary shares. Overall, TX represents 20.0% of USIMINAS capital. 16

17 TERNIUM s Timeline 2 Ternium Merged with Aceros Parana 2005 Techint acquires Hylsamex 2006 IPO-ADS NYSE 2007 IMSA acquisition Ternium started operations in 1961 under the name of Propulsora Siderurgica. Production of coldrolled coils began. Company name changes to Siderar. 1977, 9 Amazonia won bid for Sidor privatization. 2003, Amazonia stake in Sidor 60%, Venezuelan government 40%. For US$2.2 billion. 3.7 million tons of crude steel 24,844,720 ADS (10 shares per ADS). Public offer in the US (NYSE). Transaction of US$ million buying 9.3% in IMSA. The remaining 90.7% for US$1.56 billion TX Mexico 2009 Sidor Nationalization 2010 Ferrasa Panama 2010 JV Nippon Usiminas IMSA renamed as Ternium Mexico and Hylsamex merged into Ternium Mexico. Ternium sold its 59.7% stake to CVG for US$1.97 billion. Sidor had 4.5 million tons of crude steel capacity and produced 3.5 million tons in Ternium completed the acquisition of a 54% ownership interest in Ferrasa. On April 7, 2015, Ternium acquired the remaining 46% minority interest. Ternium 51% stake and Nippon Steel 49% in Tenigal JV. Hot-dip galvanizing g g plant in Monterrey, (Pesqueria) production began in K tons per year. TX holds 39.6% of USIMINA s TX holds ordinary 34.6% of USIMINA s shares ordinary and 1.8% shares of the company s and 1.8% of the preferred company shares. s TX represents preferred shares. 23.1% of USIMINA s TX represents capital. 20% of USIMINA s capital. *Source: Company data 17

18 About TERNIUM s operations in Mexico Mexico has the Guerrero, Norte, and Puebla integrated production facilities. The Guerrero unit consists of a DRI (Direct Reduced Iron), which feeds the processed iron ore along with scrap to produce crude steel through mini-mill technology, to further process into semi-finished product, specializing in flat steel production through hot and cold rolled coils. This facility sources all of its iron ore requirements from Mexico s mines, along with the energy and natural gas from the Mexican grid. The Norte unit uses scrap to process crude steel through the mini-mill steelmaking technology, sourcing its scrap and electricity requirements from the Mexican grid. This unit serves as a main long producing business line, through the production of billets and rebar for the construction business. Lastly, The Puebla facility is very similar to the Guerrero plant, the difference being the type of steel products, which in this case are rebar, wire rod, and round bars. Moreover, TX Mexico has the Juventud, Churubusco, Monclova, Universidad, and Pesqueria units in the processing (downstream) business. These plants focus on the production of finished steel, by using several methods like hot rolling, cold rolling, and coating. What s more, the Apodaca industrial/commercial unit, Varco-Prudent unit, and San Luis unit, are service centers focused on the production of slitter, cut to length, tubes, and profiles, which are mainly used by the construction industry. All in all, TX s utilization rate in Mexico stands at 82%, from a total installed finished steel capacity of 7.2 Mtons. STEEL Production process Peña Colorada For its steel production, TERNIUM uses iron ore as one of its main inputs. As the company is currently seeking to improve its operating processes, it owns and operates two mines, with just small quantities of iron ore being sold to third parties, while the rest is internally consumed. Profile Line Tube Line Las Encinas S.A. de C.V. (Ternium has 100% of the interests). It engages in the extraction of iron and has one open pit mine called Aquila, located in the state of Michoacan. In addition, las Encinas owns the Palomas mine, which is expected to start operations this year (2016) iron ore reserves total approximately 15 Mtons. Source: GBM with company data Production Plant Capacity (Ktpy) Direct Reduced Iron plant 2,710 Electric Arc Furnace 4,010 Vacuum Degassing 840 Thin Slab Caster 2,330 Billet Continous Caster 1,600 Hot-rolling Mill (flat products) 5,990 Skin-Pass Mill 2,630 Hot-rolling Mill (long products) 1,110 Pickling Line 5,150 Cold Rolling Mill 3,620 Electrolytic Cleaning 1,940 Annealing Line 1,590 Temper Mill 2,040 Inspection Line 1,130 Hot Dip Galvanizing Line 1,830 Color-Coating Line 620 Slitter 1,940 Cut to length 570 Roll forming Line 510 Panel line 80 MINING Las Encinas Peña Colorada Quantity Capacity Quantity Capacity Crushing Plant 2 5, ,000 Concentration Plant 1 3, ,000 Pelletizing Line 1 1, ,100 - Figures in Ktons. -Concentration plant refers to iron ore processing capacity Source: GBM with company data Reserves Proven Probable Total Mtons %Fe Mtons %Fe Mtons %Fe Las Encina Consorcio Peña Colorada S.A. de C.V. (Ternium accounts for 50% of this mine while Arcelor Mittal accounts for the rest). The open pit mine is being operated by Consorcio Peña Colorada; it has a concentrating plant and two-line pelletizing facility making up the largest iron ore mine in Mexico. TX is required to buy 50% of the mine s annual production. 18

19 7,000 6,000 5,000 4,000 3,000 2,000 1, ,985 4,243 TX also owns the El Encino, El Chilillo, and Cerro Nahuatl mines, which are exhausted. Currently, the crushing and transfer facilities at El Encino are still working, and they will remain open to receive, process, and transfer material to the Alzada pelletizing plant. Past performance In 2015, Mexico contributed 56% of TX s revenues. Most of the company s customers 5,632 5,933 are located near plants, TX s products are mainly sold to construction companies, 3,857 3,636 industrial customers, service center industries, and independent distributors; Mexico s steel shipments represent 62% of TX s total volumes Mexico steel volumes -Figures in Ktons 4,864 5,000 4,230 4,000 3,000 2,000 1, Figures in US$ million Mining volumes 4, Mexico revenues Mining revenues Mexico US$/ton Mining US$/ton -Figures in US$ Source: GBM with company data Furthermore, iron ore represents 2.6% of the company s sales. Iron ore shipments are destined for internal consumption, but surpluses are exported to China. In 2015, Ternium Mexico sourced 100% of its iron ore requirements from the Las Encinas and Peña Colorada mine. Production costs. With the mini-mill technology, the main inputs in Mexico s units are slabs, iron ore, scrap, natural gas, and electricity. Slabs. ArcelorMittal is the main supplier in Mexico. International markets also supply TX s facilities. Moreover, Siderar supply slabs to the Mexican facilities, following the completion of the new continuous caster in its San Nicolas unit. In 2015, 3.4 Mtons of slabs were purchased at market-based prices. Iron ore. On January 1, 2013, TX committed to buy 50% of the annual production from the Peña Colorada mine. Mexican steel facilities obtain 100% of their iron ore needs from TX s mining companies; thus, it is estimated that Ternium consumes 1.0 ton of iron ore to produce one ton of crude steel at the mini-mill facilities in Mexico. Scrap. Around 57% of TX s scrap requirements are obtained in Mexico through its own steel scrap collecting operations. The other 43% is purchased in the US. In terms of consumption, around 0.4 tons of scrap are required to produce one ton of crude steel. Electricity. In 2015, the CFE supplied 63% of TX Mexico s total energy; the other 47% was purchased under a supply agreement with Iberdrola and Tractebel Energia de Monterrey. The company consumes 0.7 MWH of energy to produce one ton of crude steel. Iberdrola contract. Iberdrola currently supplies 23% of TX s plants in Mexico. The contracted capacity stands at MW. In April 2014, the contract was terminated and renegotiated. Now, Iberdrola granted a credit of US$750,000 per MW (111.2 MW) totaling US$83.4 million. in addition, Iberdrola recognized US$15 million to TX through discounted rates. All in all, for approximately two years, electricity rates have been similar to those in the previous contract. After this, energy rates will increase to market rates with a 2.5% discount. Tractebel Energía de Monterrey contract. The contract with TX amounts to US$114.8 million and will last until TX pays Tractebel for the energy delivered and for the purchased capacity on a monthly basis. Natural Gas. The company purchases gas from PEMEX. Prices are determined by the Energy Regulatory Commission (CRE). TX consumes 8.6 MBTU to produce one ton of crude steel. In 2015, Ternium invested US$211 million in Mexico, representing 45% of the company s total CAPEX. The mining segment accounted for 12% (Las Encinas US$9 million, and Peña Colorada US$46 million). During the year, TX began construction of a second slitting line at the Churubusco unit. Once the completion TX s annual processing capacity of slitted steel products will increase by 200 Ktons. Furthermore, the company invested to upgrade Churubusco s hot-rolling mill; this will allow an 230 Ktpy increase in the mill s capacity. Focusing on 2016, TX is investing in environmental and safety conditions in its Mexican facilities, mainly at the Guerrero unit. Thus, it will continue with the expansion of capacity at the Churubusco and San Nicolas units. Speaking about the mining division, CAPEX will continue at the Peña Colorada mine. In order to increase processing capacity and raise iron ore concentrate production to 4.5 million tons, the project should be completed this year. 19

20 TX competes against several companies in Mexico. In flat products, the main competitor is AHMSA. POSCO and Grupo Villacero are other significant competitors in the galvanized steel division. Focusing on the rebar and wire rod market, TX s competitors are ArcelorMittal and DeAcero. Its competitors in the welded pipe market are Tuberia Laguna and Maquilacero. In Mexico, Ternium has twelve steel production or processing units, consisting of three integrated facilities: one producing flat steel, and the other two, long steel. In addition, Mexico has five downstream flat steel processing facilities, seven service centers, and ten distribution centers. TX s crude steel production is based on the electric arc furnace (mini-mill technology), and on the purchase of crude steel slabs from third parties. The company produces billets, bars, and slabs through a variable combination of DRI and steel scrap. Semi-finished steel is then processed into finished products. TX uses hot-rolling, cold-rolling, coating, paneling, and tubing, among other methods. In Mexico, the company purchases semi-finished products from third parties, as the processing capacity is higher than the steel-making capabilities. GBM estimate utilization rate (volume sales over capacity) 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Utilization Rate Latent Capacity Mexico s steel shipments % 55% 57% 58% The mining business % 60% 61% 61% % 62% 62% 64% 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q % 7.6 Mtons 7.2 Mtons 7.3 Mtons 7.4 Mtons 7.2 Mtons 7.2 Mtons 67% 67% 68% 67% 78% % Steel shipments % 4.1% 3.6% % % 82% 70% 68% 66% 64% 62% 60% 58% 56% 54% % of steel shipments -Figures in Mtons % 2.6% 2.6% 2.6% 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 6% 5% 5% 4% 4% 3% 3% 2% Key markets end demand in Mexico Mexico steel revenues Mexico s CAPEX Mining revenues % of total revenues Steel CAPEX Mining CAPEX % of total CAPEX -Figures in US$million -Figures in US$million e Steel shipments to industrial costumers -Figures in Mtons % % 53% % 56% 56% 56% 56% 55% 55% % 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 Steel revenues -Figures in US$billion % % 486 % of total revenues 56% 45 57% % 75% 70% 65% 60% 55% 50% 45% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 20

21 The Southern Region The San Nicolas plant in Argentina produces steel based on Blast Furnace (BF) and Basic Oxygen Furnace (BOF) methods, where iron ore pellets, lumps, sinter, and coke are mixed and melted; thus, San Nicolas sources all of its iron ore and coal needs from international markets, but it produces most of its energy needs from its own power plant. This plant produces cold- and hot-rolled steel for the construction industry. Moreover, Canning, Haedo, Florencio Varela, and Ensenada are the processing (downstream) units, and they transform semi-finished steel into finished products (i.e. galvanized and electrogalvanized sheets, slitted products, and rolled-formed products), which are destined to the automotive, construction, and home appliance sectors. Overall, TX has an installed finished steel capacity of 2.9 Mtons; currently, 88% is being used. Production Process Source: GBM with company data Production Asset Capacity (Ktpy) Coke Plant 1,100 Sinter Plant 1,480 Blast Furnace (crude steel) 3,220 Basic Oxygen Furnace 3,500 Vacuum Degassing 1,200 Slab Continous Caster 5,630 Hot-rolling Mill (flat products) 2,850 Skin-Pass Mill 990 Pickling Line 1,910 Cold Rolling Mill 1,840 Electrolytic Cleaning 230 Annealing Line 1,330 Temper Mill 2,020 Inspection Line 1,150 Electro-Tinplatine line 160 Hot Dip Galvanizing Line 600 Electro Galvanizing line 110 Color-Coating Line 120 Slitter 420 Cut to length 1,000 Roll forming Line 460 Profile Line 80 Tube Line 190 Source: GBM with company data 21

22 Past performance 2,800 2,400 2,000 1,600 1, Steel shipments in Argentina -Figures in Ktons 3,200 2,800 2,400 2,000 1,600 1, ,633 2,511 2,552 9% 10% 6% 91% 90% 94% 2,945 8% -Figures in US$million 1,150 1,100 1,050 1, % 92% Source: GBM with company data these products. Other Argentina's revenues $1,118 2,642 8% $1,052 2,567 6% 94% Others $$1, Southern Region US$/ton During 2015, the Southern Region accounted for 33% of TX s consolidated revenues. From this percentage, around 30% corresponds to Argentina, as the main customers are located near Siderar s production units; the rest (~3%) comes from customers located in Chile, Bolivia, Paraguay, and Uruguay. TX s customers consist primarily of independent companies and distributors. Products are sold mainly to the agriculture, construction, automotive, tubing, and home appliance sectors. Overall, the Southern Region accounts for 27% of TX s consolidated steel volumes. Production costs. Siderar produces crude steel through the BF method; with this, iron ore and coal are Siderar s main inputs. Iron ore. The main suppliers of iron ore are Vale and Vetria. Products are purchased under long-term contracts, and prices are determined in accordance with market conditions. The company needs 1.3 tons of iron ore to produce one ton of crude steel. Coking coal. Siderar produces its own coke through the distillation of coking coal and petroleum coke; as such, the company buys coking coal from the Australian and US markets under short-term contracts and on the spot market. Regarding petroleum coke, companies such as Axion Energy and YPF provide this input to the company. It takes 0.5 tons of coking coal and petroleum coke to produce one ton of crude steel. Electricity. The San Nicolas and Ensenada facilities are the largest energy consumers among Siderar s units. The San Nicolas unit generates its own electricity through a wholly-owned thermoelectric plant, which has a power capacity of 110 MW. To produce one ton of crude steel, the company requires 0.1 MWH of electricity. Natural gas. This product is mainly used to operate the BF plant, and for the thermoelectric plant in the San Nicolas unit. Gas is supplied through the agreements with Transportadora de Gas del Norte (TGN) and Litoral Gas. The contract with Litoral Gas expires in December this year, while TGN s contract concludes in April The other facilities cover their needs with local distributors. Siderar requires 1.7 MBTU to produce one ton of crude steel. Other inputs. Siderar has oxygen, nitrogen, and argon separation plants, which are managed by ALASA. Currently, the company has contracts with ALASA for the supply of Argentina s CAPEX reached US$188 million in 2015, due to the development of Siderar s San Nicolas unit. Investments were made in the installation of a new profile line and a slitting line in the Haedo unit, which will expand the annual production capacity by approximately 230 Ktons, to 2.3 Mtons. Lastly, investments were also made to further improve environmental and safety conditions. In terms of competition, Ternium is the leader of flat rolled steel products in the Argentinean market, through its subsidiary, Siderar. Brazilian imports are the main competition for TX. The main exporters are CSN, Usiminas, and ArcelorMittal. In the other countries of the region (Paraguay, Uruguay, Chile, and Bolivia), the company maintains a competitive position in flat steel products as well. 22

23 The Southern Region has eight steel processing or production plants in Argentina. One is an integrated flat steelmaking unit (San Nicolas), and four downstream flat steel processing facilities (Canning, Haedo, Florencio Varela, and Ensenada). In addition, TX has six steel service centers; all the units are also located in Argentina. TX produces crude steel under the Blast Furnace technology. Coke, iron ore pellets, lump, and sinter are melted in order to obtain pig iron. After this, scrap and pig iron are molten in the Basic Oxygen Furnace. Furthermore, finished products are obtained through hot and cold rolled methods, among others. GBM estimate utilization rate (volume sales over capacity) 3, Mtons 2.7 Mtons 2.9 Mtons 2,500 Shipments by market in Argentina Automotive13% 2,000 1,500 1,000 98% 87% 88% Agriculture 15% Other Industries 20% Construction 52% Utilization rate Latent Capacity Southern Region steel shipments % 29% 28% % 27% 27% 27% 26% 27% % 24% Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 Steel shipments % of steel shipments -Figures in Mtons Steel revenues in the Southern Region 31% % 34% % 33% 32% % % 30% 31% 30% Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 Steel revenues % of total revenues -Figures in US$billion 40% 38% 36% 34% 32% 30% 28% Southern Region CAPEX % % 43% 41% % 40% % % % 33% 80 31% 29% 40 27% 0 25% CAPEX % of total CAPEX 23

24 Other markets The Manizales Acasa unit, located in Colombia, is the only integrated plant. It produces billets and rebar through its integrated facility based on mini-mill technology. Scrap and electricity are supplied by local producers. Moreover, the two downstream plants are located in the US (Shreveport) and in Guatemala (Villa Nueva). These units process cold and hot rolled coils joined with galvanized products. Regarding TX s service centers, finished steel products are wire, slitted products, tubes, and profiles for the construction industry. In 2015, other markets had an installed finished steel capacity of 900 Ktons. Production Asset Capacity (Ktpy) Product Electric Arc Furnace 190 Crude steel (billets) Billet Continous Caster 190 Crude steel (billets) Hot-rolling Mill (long products) 200 Rebars & Wire rods Hot Dip Galvanizing Line 380 Galvanized products Color-Coating Line 190 Pre-painted products Slitter 310 Service Center Cut to length 190 Service Center Roll forming Line 230 Service Center Profile Line 110 Service Center Tube Line 60 Service Center Wire drawing lines 100 Service Center Wire mesh lines 40 Service Center Rebar processing line 180 Service Center Source: GBM with company data 24

25 Past performance 1,400 1,200 1, ,370 1,239 Source: GBM with company data 1, Other markets steel shipments -Figures in Ktons 1,400 1,200 1, ,251 1, Other markets revenues -Figures in US$ million 1, Figures in US$ Other markets US$/ton Other markets (Colombia, Central America, and the US) represent 11% of Ternium's net sales. In Central America, most of the customers are served through TX International Guatemala's facilities; in the US, customers receive steel products through Ternium International's Houston commercial office, and through the Shreveport plant. In Colombia, Ferrasa s facilities and Ternium International Bogota serve TX' s customers in this country. Lastly, other markets account for 12% of the company's steel shipments. TX uses two sources for the production of finished steel products in Colombia. The first one relies on the EAF (Electric Arc Furnace) method, by melting scrap to produce billets; electricity and scrap are the main inputs in this technology. The other source is based on the purchase of steel products, mainly from Ternium's other subsidiaries and from third parties. In 2015, the company bought 360 Ktons from third parties, representing a 3% YOY decrease. Slab. TX s sales in this market is higher that its steelmaking capacity; thus, the company commonly purchase slabs from other subsidiaries and competitors. Scrap. TX sources all of its steel scrap needs from the local market in Colombia, this is the main input used in Colombia's facilities. The company utilizes 1.1 tons of scrap to produce one ton of crude steel. Electricity. In Colombia, TX purchases energy from ISAGEN under a two-year contract, which expires in December This contract is based on a fixed rate adjusted by the price index (70%). The other 30% is purchased at prevailing prices. TX uses 0.6 MWH to produce one ton of crude steel. Other markets CAPEX stood at US$13 million in This amount was mainly invested in the replacement of equipment, improvements in product quality, and expansions in processing capacity. Regarding others markets competitors, Ferrasa is an important player of long steel in the region, and is the main flat steel processor in Colombia; Acerias Paz del Rio and Gerdau Diaco are TX' s main competitors in this country. In addition, Ternium is a leader of coated steel products in Central America, where the main competition are Chinese import products. 25

26 In other markets, TX has thirteen steel production and processing facilities distributed in the US, Colombia, and Central America (Guatemala, Costa Rica, Nicaragua, Panama, and Honduras). One is an integrated long steel unit (Manizales Acasa), two are downstream flat steel processing plants (Shreveport and Villa Nueva), eleven are service centers, and four are distribution centers. GBM estimate utilization rate (volume sales over capacity) Other markets CAPEX 1,500 1,250 1, Mtons 0.8 Mtons 0.9 Mtons 0.9 Mtons 171% 171% 137% 124% % 21 2% 8 3% % 2.5% 2.0% 1.5% 1.0% 0.5% % Utilization rate CAPEX % of total CAPEX Other markets steel shipments % % % 13% % % % 12% % 12% 11% Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 Steel shipments % of steel shipments -Figures in Mtons 18% 17% 16% 15% 14% 13% 12% 11% 10% Other markets revenues % % % 13% 13% % 12% % 11% 12% 12% Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 Steel revenues % of total revenues -Figures in US$billion 18% 17% 16% 15% 14% 13% 12% 11% 10% 26

27 TX s Ownership The company has one class of shares, with each share having a nominal value of US$1 and with equal economic and voting rights (including the right to vote in general shareholders meetings). It has an authorized share capital of US$3.5 billion; there are currently 2,004,743,442 shares issued and outstanding. TX s annual general shareholders meetings must take place in Luxembourg every first Wednesday of May at 14:30 hrs. The Company s ADS is listed on the NYSE under the ticker TX (each ADS represents ten shares of the Company s share capital) and began trading on February 1, The Bank of New York Mellon acts as the company s depositary; the company s float stands at 24%. 1.80% 9.14% 89.06% Adrián Lajous Martín Berardi Rodrigo Piña 0.04% 24.40% Techint Holding and subsidiaries Tenaris 2.08% 11.46% 62.02% Ternium Directors and Executive Officers Public (Float) Owners Number of shares Techint Holding and subsidiaries 1,243,433,112 Tenaris 229,713,194 Ternium 41,666,666 Directors and Executive Officers 831,560 Public (Float) 489,098,910 TOTAL 2,004,743,442 *Source: Company Data 27

28 TERNIUM s Corporate Structure Techint Group 62.02% Tenaris 11.46% Ternium (treasury shares): 2.08% Float (public): 24.40% TERNIUM 100% 50% 50% 71.2% Ternium - Mexico Las Encinas Peña Colorada Arcelor Mittal 28.7% 12.0% 26.0% 60.9% Siderar - Argentina Float (public) ANSes % 5.0% % 5.0% 23.0% 1 Nippon Steel & Sumitomo Tenaris Other (ordinary 27.7% Usiminas CEU Metal CONFAB shares) 49% Nippon Steel & Tenigal - Mexico 51% Sumitomo Metal Subsidiaries 100% Ferrasa - Colombia Joint operations 100% Ternium - USA Non-consilidated operations 100% Ternium - Uruguay 99.8% Ternium - Guatemala 0.2% 30% 22% 48% Techgen Tecpetrol Tenaris 1: Participation based on ordinary shares distributed (Controling group) 50% 50% Exiros - Netherlands Tenaris *Source: Company Data 28

29 Subsidiaries Ternium-Mexico: Leading flat and long steel manufacturer in Mexico, it produces steel products for the construction and industrial sectors and has an annual finished steel capacity of 7.2 Mtons. Siderar-Argentina: The main integrated manufacturer of flat steel products in the country, with a total annual finished steel production capacity of 2.9 million tons. Ferrasa-Colombia: Ternium owns 100% of Ferrasa, as on April 7,, 2015, it acquired the remaining 46% of Ferrasa. In addition, Ferrasa is the leading distributor and processor of long and flat steel products in Colombia, with a total annual finished steel capacity of 540 Ktons and sales close to 600 Ktons (~70% long products and ~30% tubular and flat products). Consolidated Participation Direct Indirect TOTAL Ternium Mexico 71% 17% 89% Las Encinas 71% 17% 88% Peña Colorada 36% 9% 45% Siderar 61% 61% Tenigal 51% 51% Ferrasa 100% 100% Ternium USA 100% 100% Ternium Guatemala 100% 100% *Source: Company Data Tenigal-Mexico: Manufacturer of hot-dip galvanized steel sheets destined to Mexico s automobile market. The company has an annual finished steel production capacity of 400 Ktons; currently, TX holds 51% of Tenigal, while NSSMC owns 49%. Ternium-Guatemala: This subsidiary operates all of Ternium s steel facilities in El Salvador, Nicaragua, Guatemala, and Costa Rica, with a total annual capacity of 180 Ktons of hot-dip galvanized steel sheets. Ternium International (Uruguay): Comprises companies in Uruguay, the Netherlands, Colombia, and the US, along with offices in Panama and Spain. The headquarters are located in Uruguay. Ternium USA: Operates steel processing activities in the US, which involve the production of galvanized coated sheets, with a total annual capacity of 200 Ktons; thus, its Shreveport unit, is located in Louisiana. Exiros: Ternium owns 50% and Tenaris 50%. The objective of Exiros is to purchase raw materials and other products and services, to have better purchase conditions and prices as Exiros has offices in various countries. Techgen: Joint venture between Ternium (48%), Tecpetrol (30%), and Tenaris (22%). Techgen is a natural gas-fire combined cycle electric power plant in Pesqueria, located in Nuevo Leon, Mexico. Operations will begin in 4Q16 with an estimated CAPEX of US$1.1 billion; in addition, Techgen s power capacity is around 900MW. Furthermore, Tenaris and Ternium entered into a power supply and transportation agreement with Techgen, from which Tenaris will contract 22% and Ternium 78% of the energy produced. 29

30 Other investments: Usiminas: Ternium joined Usiminas control group in January 2012 for a 22.7% stake in Usiminas ON (voting shares). On October 30, 2014, TX bought an additional 10.2% stake in Usiminas ON shares from Previ, paying R$617 million. Furthermore, on April 18, 2016, Ternium subscribed 76.5 million ordinary shares for a total of US$110.9 million. TX and its subsidiaries now own 34.6% of USIMINAS ordinary shares. Overall, TX represents 20.0% of USIMINAS capital. *Source: company data Conflict with Nippon Steel in USIMINAS September 2014 USIMINAS BoD dismissed Julian Eugren (CEO of USIMINAS), along with two other executives, under charges of having broken compliance specifications. All these members were appointed by TERNIUM. After receiving a negative ruling from the CVM (Brazilian Securities Exchange Commission), TERNIUM took the matter to court to appeal the decision, blaming Nippon Steel for breaking the shareholder agreement which requires controlling shareholders to reach a consensus before any such vote is cast. October 2014 The company announced that it completed the acquisition of 51.4 million ordinary (voting) shares of USIMINAS at a price of R$12 per share, for a total of R$616.7 million. Despite the material size of this additional purchase, these shares were not included in the control block, due to the rules of the agreement. April 2015 Shareholders (USIM3) ON (USIM5) PN TOTAL Shares % Shares % Shares % Controling Group % % TT Group % % Nippon Steel Group % % CEU (Usiminas employees) % % Non-controling Group % % % TT Group % % % Nippon Steel Group % % % Others % % % TOTAL ,253.1 * Millon shares Mr. Marcelo Gasparino is elected as new chairman by the minority shareholders, after controlling shareholders could not reach an agreement on the matter. Moreover, the shareholder who proposed Mr. Gasparino, Lirio Parisotto, was also elected as a board member to represent the minority shareholders. TERNIUM challenged the decision to elect Mr. Parisotto, arguing that the company s votes weren t counted correctly, and that the total votes would not have supported the election. A dispute began between the controlling shareholders and the minorities that voted in this election. Later on, Nippon Steel requested the CVM to rule on the 51.4 million share transaction by TERNIUM, arguing that the company exceeded the maximum limit of shares that it could buy. The CVM ruled in favor of Nippon Steel, determining that a tender offer for USIMINAS common stock owned by TERNIUM must be made until the one third maximum ownership rule is satisfied. TERNIUM stated that it would challenge the decision. 30

31 May 2015 Ternium reduced the amount of the USIMINAS Investment to US$521 million. These actions came as a consequence of the conclusion by the SEC relating to the carrying value of the company s investment in USIMINAS. September 2015 Meeting of the controlling shareholders of USIMINAS (TERNIUM and Nippon Steel) announced for October 2015, in an attempt to overcome the various disagreements between these companies. March2016 On March 11, USIMINAS board approved a capital increase of R$1 billion, through the issuance of 200 million new common shares. Nippon Steel made the initial proposal. On the other hand, TERNIUM proposed an alternative capital increase limited to R$563 million, through the issuance of common and preferred shares (100 million of each priced at R$4.35 per common share, and R$1.28 per preferred share). Management and Corporate Governance Board of Directors According to TERNIUM s articles of association, the board of directors consists of a minimum of five members and a maximum of fifteen. In May this year, the company s annual general meeting resolved to reduce the number of board members from nine to eight. Directors Board of Directors Position Seniority Paolo Rocca Chairman and CEO of Tenaris 11 Roberto Bonatti President of San Faustin 11 Carlos Condorelli Director of Tenaris 10 Daniel Novegil Ternium's CEO 11 Gianfelice Rocca Chairman of San Faustin's board 10 Ubaldo Aguirre Directos of Aguirre & Gonzalez 10 Vincent Gilles Decalf Director of Foyer International 0 Adrián Lajous President of Petrometrica 10 *Source: Company data Executive Directors Executive Officers Main Officers Position Seniority Daniel Novegil Chief Executive Officer; Director 21 Pablo Brizzio Chief FinancialOfficer 6 Máximo Vedoya Mexico Area Manager 4 Martín Berardi Siderar Executive Vice President 1 Héctor Obeso International Area Manager 4 Oscar Montero Planning and Operations General 11 Ricardo M. Ali Engineering and Enviornment 1 Rodrigo Piña Human Resources Director 3 Roberto Damidchuc Chief Information Officer 6 Rúben Herrera Quality and Product Director 8 31

32 TERNIUM s PEERS Currently, TX is trading at an enterprise value per ton of US$636 the lowest when compared to regional peers, which are trading at US$1,313 per ton. In addition, in an EV/EBITDA 2017e comparison, TX s shares are trading at a 37% discount over regional peers; in a P/E 2017e comparison, shares are trading at a 9.9x multiple, representing a 35% discount (vs. the whole peer sample). - Figures in US$ million Steel Ktons EV/TON EV/EBITDA P/E P/BV Name Market Cap EV TTM 2016e TTM 2016e 2016e 2017e 2016e 2017e 2016e 2017e NUCOR CORP 15,254 17,401 21,202 23, x 7.2x 18.8x 15.6x 1.9x 1.8x STEEL DYNAMICS INC 6,148 7,611 8,905 9, x 6.2x 12.5x 12.1x 2.0x 1.8x UNITED STATES STEEL CORP 3,046 4,728 15,026 14, x 5.8x n.a 19.1x 1.1x 1.1x AK STEEL HOLDING CORP 1,146 3,496 6,741 6, x 6.3x 16.2x 9.9x n.a n.a ARCELORMITTAL-NY REGISTERED 19,789 33,379 84,400 87, x 5.4x 15.9x 14.0x 0.6x 0.6x North America Peers (Avg.) x 6.2x 15.9x 14.2x 1.4x 1.3x GERDAU SA -SPON ADR 4,872 31,884 16,648 16,712 1,915 1, x 6.6x 67.8x 24.9x 0.6x 0.6x CIA SIDERURGICA NACIONAL SA 4,522 12,891 4,820 4,830 2,674 2, x 10.4x n.a n.a 2.0x 2.2x TERNIUM SA-SPONSORED ADR 4,473 6,235 9,810 9, x 5.1x 8.8x 9.9x 1.0x 1.0x USINAS SIDERURGICAS DE MINAS 2,513 4,482 4,184 3,738 1,071 1, x 11.6x n.a n.a 0.7x 0.7x INDUSTRIAS CH S.A.B.-SER B 2,168 2,179 2,384 2, x 8.4x 19.6x 23.0x 1.3x 1.2x GRUPO SIMEC S.A.-SER B 1,712 1,407 2,103 2, x 6.0x 16.2x 17.7x 1.0x 0.9x Regional Peers (Avg.) 1,313 1, x 8.0x 28.1x 18.9x 1.1x 1.1x NIPPON STEEL & SUMITOMO 18,882 39,724 40,280 40, x 7.3x 19.6x 11.4x 0.7x 0.6x JFE HOLDINGS INC 8,668 21,514 25,970 25, x 6.7x 19.7x 10.5x 0.5x 0.4x Others (Avg.) x 7.0x 19.6x 10.9x 0.6x 0.5x AVERAGE x 7.1x 21.5x 15.3x 1.1x 1.1x Median x 6.6x 17.5x 14.0x 1.0x 0.9x Revenues EBITDA Margin % Name 2016e 2017e 2016e 2017e 2016e 2017e Net Debt Net Debt/EBITDA NUCOR CORP 16,625 17,430 2,206 2,457 13% 14% 2, STEEL DYNAMICS INC 7,707 7,990 1,214 1,232 16% 15% 1, UNITED STATES STEEL CORP 10,427 11, % 8% 2,406 n.a AK STEEL HOLDING CORP 5,975 6, % 9% 2, ARCELORMITTAL-NY REGISTERED 58,215 60,080 6,009 6,428 10% 11% 15,138 n.a North America Peers (Avg.) 11% 12% 3.3x GERDAU SA -SPON ADR 40,700 42,081 4,151 4,749 10% 11% 19, CIA SIDERURGICA NACIONAL SA 5,204 5,428 1,046 1,226 20% 23% 7, TERNIUM SA-SPONSORED ADR 7,160 7,372 1,395 1,258 19% 17% 1, USINAS SIDERURGICAS DE MINAS 2,713 3, % 12% 1,818 n.a INDUSTRIAS CH S.A.B.-SER B 1,662 1, % 14% GRUPO SIMEC S.A.-SER B 1,465 1, % 14% Regional Peers (Avg.) 14% 15% 1.2x NIPPON STEEL & SUMITOMO 44,284 46,720 4,393 5,451 10% 12% 18, JFE HOLDINGS INC 31,453 32,477 2,573 3,219 8% 10% 13, Others (Avg.) 9% 11% 1.5x AVERAGE 12% 13% 2.6x Median 10% 12% 3.7x *Source: GBM with Bloomberg data 32

33 Dividends TERNIUM does not have a formal dividend policy, nor is it obliged to pay a minimum dividend. The amount and payment is determined at the general shareholders meeting. The company s dividend has increased in the last two years, reaching its highest level in 2016, after approving a 0.9 per share dividend, which implied a 4.6% dividend yield. The company did not approve dividend payments back in 2009, due to the financial crisis. Looking forward, we believe the company s dividends are more likely to increase, once the expansionary investments conclude, raising TX s FCF generation. Cost structure and F/X exposure TX s cost structure is directly derived from crude steel production more specifically, from the finished steel production method. Most of the company s COGS comes from the purchase of slabs, which accounts for ~25% of the company s costs; as Mexican operations are no selfsufficient in slab sourcing, requiring third-party purchases at spot prices. Energy costs account for 15% of TX s total cost, while labor represents around 10% on a consolidated basis. TERNIUM s historical dividend payments $0.10 $0.09 $0.08 $0.07 $0.06 $0.05 $0.04 $0.03 $0.02 $0.01 $- $0.05 $ % 2.6% $- $0.08 $0.08 Dividends per share Dividend Yield Source: GBM Research with Company data Costs breakdown $0.07 $ % 3.9% 3.3% 3.9% $0.09 $0.09 $ % 4.6% 4.6% Scrap 10% Zinc 2% Others 5% 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% As mentioned before, Ternium s operations are mainly in Mexico and Argentina, but despite the local presence, the company s revenues are linked to the US dollar, which is the functional currency. In Mexico, the functional currency of the company is the USD; however, in Argentina, the functional currency is the ARS. As such, any variation in the Argentinean peso does affect the company s P&L; mainly through the revaluation of inventories. Moreover, around 65 and 30% of TX s COGS and SG&As are USD denominated. In addition, around 35 % of the company s COGS are linked to local currencies. Iron ore 8% Coking coal 5% Electricity 5% Natural gas 5% Slabs 25% Domestic costs (local currencies) 35% Approved projects and CAPEX Ternium expects to finish 2016, with a total CAPEX of US$400- US$450 million; for 2017, investment should amount ~US$480- US$500 million. Currently, maintenance CAPEX stands at US$350 million. Source: GBM Research with company data Techgen-Power plant structure Regarding TX s projects, Techgen, a power plant in Mexico, will begin operations by 4Q16. The project consists of a combined cycle electric power plant in Pesqueria, with an annual power capacity of 900MW. The total investment stands at US$1.1 billion. Ternium and Tenaris will contract 78 and 22% of Techgen s power capacity. Lastly, energy prices will be based on production costs, plus a premium margin. We estimate, that TX will buy electricity at around US$40-US$50 per MWh. Ternium 78% Techgen Source: GBM Research with company data What s more, Tenigal is a JV between Ternium (51%) and Nippon Steel & Sumitomo Metal (49%). Currently, they have a hot-dip galvanizing plant in Monterrey with a production capacity of 400Ktpy. The new project consists of a new galvanizing line, enabling Tenigal to double automotive galvanized steel production capacity by The estimated CAPEX stands at US$300 million. After completion, capacity in the Pesqueria plant should reach 830Ktons. 900 MW Tenaris 22% 33

34 USIMINAS Market Performer 2017 Price Target USIM3 R$ Price Target USIM5 R$ Price Target USNZY US$1.29 Price - USIM M Price Range - USIM / 4.30 Shares Outstanding (Mill) 1,291 Market Cap (Mill) 8,286 Float 62% Net Debt (Mill) - After Capital Increase 4,346 EV (Mill) 12,632 Operationally, the worst seems to have passed but a notable recovery in Brazil is needed to fully turnaround; especially if controlling block s impasse continues. We are initiating coverage of USIMINAS with a Market Performer rating and 2017 price targets of R$$7.22 (USIM3) and R$4.35 (USIM5). We believe that USIMINAS should be able to implement most of its restructuring program by successfully cutting a significant part of its fixed costs and improving its business strategy. On the other hand, even after the recent capital infusion of R$1 billion, the company still holds a hefty debt situation considering the current EBITDA generation. USIMINAS divestment plan seems limited. Besides the expected divestment of Usiminas Mecanica in the short term, which we do not believe will raise a notable amount (~R$ x), we don t see other non-strategic assets to be sold that could speed-up the deleveraging process TTM 2016e 2017e Revenue 10,186 9,567 9,248 11,265 EBITDA ,047 Net Profit -3,734-2, Free CF EPS P/E EV/EBITDA P/BV * Figures in million of R$ Rodrigo Garcilazo Carreon rgarcilazo@gbms.cl +56 (2) Guillermo Estrada Madrazo gestradam@gbm.com.mx + 52 (55) ext Stalemate between its controlling shareholders still offers many possible outcomes some positive, but most of them negative. In our view, the lack of understanding between the controlling shareholders led to a barren period to take strategic decisions and has resulted in a longer than expected turnover in the company s operations. To make matters worse, there are no clear resolutions. Whereas, the split of the company is not a realistic option at this moment, in our view. USIMINAS s weak operating figures should continue this year. We expect a significant drop in total volumes (-24% YOY), which should surpass our domestic demand expectations of -15%. Export volumes should suffer the most, while the strong reduction in capacity, through the shutdown of the Ipatinga plant, should also affect the equation. Cash flow should stop bleeding this year, due to drastic measures: extreme CAPEX reduction and WK relief. Operating CF should be positive topping R$739 million, but it would only be achieved due to an unprecedented CAPEX reduction (R$350 million vs. R$785 million 2015), and by lower WK needs, which would liberate nearly R$517 million this year. Overall, USIMINAS could be a potential bet over the turnover in the Brazilian domestic outlook beyond 2017 due to its high leverage both financially and operationally, which should benefit from higher sales volumes. However, even considering this potential recovery, we believe the balance of risks does not properly reward its own specific issues especially the emblematic conflict between its controlling shareholders. Glauco Legat gdecastro@gbms.cl +56 (2) EV/EBITDA FWD USIM5 vs. IBOV Index P/BV 34

35 I. Introduction USIMINAS is the biggest producer of flat steel in Brazil, with an annual production capacity of 9.5 million tons. There are two steel mills located in the main industrial regions of the country: Cubatao (SP) and Ipatinga (MG). The vertically integrated company focuses on the domestic market and has a wide ranging portfolio that is divided into four SBUs: Steel: Offers slabs, heavy plates, hot-rolled steel, hot strips, cold-rolled steel, and galvanized products. Usiminas Mecanica: Offers products and services related to metallic structures. Solucoes Usiminas: Ample portfolio of products and services related to the transformation and distribution of flat rolled steel. Mineracao Usiminas (MUSA): Holds mineral assets with potential reserves of 2.6 billion tons. The unit provides iron ore to the steel unit, while also selling excess production to third parties. The business also holds a stake in MRS Logisitica S.A (MRS), a concessionaire that controls and operates railways. Steel Solucoes Usiminas Usiminas Mecanica MUSA Inception - Year Nominal Capacity / Year 9.5 million tons 2 million tons - 12 million tons Industry & Autoparts Distribution Steel Structures Automotive Automotive Shipbuilding and Offshore Electroelectronic Electroelectronic Oil & Gas Main Markets Oil & Gas Pipelines Agricultural Machinery Machinery Civil Construction Equipment Steelmaking Participation Net Revenue (%) 74.2% 15.6% 7.0% 3.2% Source: GBM with company data Background USIMINAS origin dates back to It was founded as a state-owned company in Ipatinga (MG) as part of the Development Plan of President Juscelino Kubitschek. One year later under the Lanari-Horikoshi agreement a minority stake was sold to a consortium of Japanese companies led by Nippon Steel. The first blast furnace was only tuned on in October 1962, when its first plant started operations with a capacity of 500ktpy. However, it was followed by a series of expansion projects over the following years that sought to absorb the strong local demand growth during Brazil s Economic Miracle ( ). USIMINAS remained a state-run company until 1991, when following a period of privatization by the Federal Government the company was sold via a public auction for US$1.7 billion (the company s shares began trading in the same year). In 1994, USIMINAS acquired Companhia Siderurgica Paulista (COSIPA) located in Cubatao (SP) for US$228 million. Another growth cycle was initiated in 1999 via an US$852 million investment plan that resulted in a 1.0 mtpy increase in capacity. More recently ( ), its latest expansion program was implemented, leading to its current annual capacity of 9.5 mtpy. USIMINAS also acquired iron ore mines during this period, resulting in a reserve of 2.6 billion tons of iron ore located in the Serra Azul region (MG). In 2010, Mineracao Usiminas S.A (MUSA) was created in partnership with Sumimoto Corp., leading to several agreements to optimize production and shipping, including an agreement to use the Sudeste Port in Itaguai (RJ). 35

36 II. Investment Thesis We believe that USIMINAS has been improving gradually from the weakest position in the Brazil steel industry. However, the company still has a high net debt outstanding of R$4.5 billion. In addition, the company still faces an emblematic stalemate between the two controlling shareholders since October 2014, which in our view has affected its operating performance as it has led to a barren period to take strategic decisions, delaying the turnaround of the company. On the other hand, it seems that the hard decisions were finally taken such as the temporary shutdown of primary areas of the Cubatao plant, renegotiation of take-or-pay contracts with MRS, and a strong reduction of CAPEX, suggesting that almost all efforts to reduce the cash burn were taken. Coupled with these decisions, which aim to scale the company for a new Brazilian economic reality, USIMINAS has just completed a capital increase of R$1 billion which, although not enough to solve the company s leverage problem, strongly supports its short-term needs. The recent renegotiation of most of USIMINAS debt leaves a good time to reestablish its profitability. Given the recent restructuring process, 92% of its total debt received a significant extension of repayment, which consists of a 3-year grace period for principal and a 7-year period for amortization. On the other hand, we should note that this restructuring also leads to a higher interest rate. Asset sales are limited. We see modest room for significant divestments due to the weak conditions in the domestic economy, which would result in unfavorable market conditions. Moreover, we do not see significant non-core assets that could be sold. Nonetheless, of the crown jewels that could be disposed, USIMINAS Mecanica could raise around (R$406-R$506 million). How to solve the indebtedness issue definitively? New infusion of capital? Our perception after the recent capital increase approved in March 16 is that it is very unlikely for a potential new capital infusion to be approved. It is clear that both controlling shareholders are not on the same page. Nonetheless, even considering the misunderstanding between controlling shareholders; if the company s profitability does not recover significantly over the next ~2 years, it seems that another capital increase would be necessary otherwise the company would have to file for bankruptcy protection in our view. USIMINAS weak operating figures should remain this year, but should post some improvements going forward. We are forecasting a volume drop of 24% YOY for this year, which should surpass our domestic demand expectations of -15%. Export volumes should suffer the most, while the strong reduction of its capacity, through the shutdown of the Ipatinga plant, which should also affect the equation. Nonetheless, cash flow should stop bleeding this year, due to drastic measures: an extreme CAPEX reduction and WK relief. Operating CF should be positive this year at R$739 million, but would be spent almost entirely for the net financial interest expenses, which we forecast at R$415 million. Jumping beyond 2016 an inflection point starting in Our base case scenario is that the Brazilian domestic environment would be better after the recent turnaround in the political macroeconomic policies. USIMINAS could increase its sales volumes. We forecast a 7.9% rise in 2017, coupled with a better operating profitability, which should drive EBITDA to R$1.0 billion still below D&A. Overall, USIMINAS could be a potential bet in the turnover of the Brazilian domestic outlook beyond 2017 due to its high leverage financially and operationally, which should benefit from higher sales volumes. However, even considering this potential recovery, we believe the balance of risks does not properly reward its own specific issues especially the emblematic conflict between its controlling shareholders. 36

37 Investment Thesis Pros and Cons Pros USIMINAS holds a leadership in the flat steel market in Brazil. Potential turnover in Brazil s economy, driven by changes on the political front, could help USIMINAS to recover its profitability via higher volumes and higher dilution of fixed costs. Downsizing actions taken to adapt to the tough reality in Brazil, such as the temporary shutdown of the Cubatao plant and renegotiation of take-or-pay contracts with MRS, should result in better operating performance. Possible disinvestments could marginally help Usiminas Mecanica seems to be the best asset to be sold. Strong reduction in CAPEX would help to preserve cash in the short term. The company s guidance for 2016 is R$350 million (-55% YOY). However, in the medium or long term, that amount seems to be unsustainable. MUSA (mineral unit) could return the cash held in its balance sheet (~R$1.3 billion) to its shareholder USIMINAS (70% interest). Potential hikes on import tariffs which, if approved, could be positive for the sector. Cons Brazilian steel demand could contract further in In our base scenario, we are not foreseeing an inflection point until next year. Brazilian political crisis persists, resulting in the worsening of economic perspectives. This has led to decreases in consumption and investments. Unfavorable global macroeconomic scenario; steel market could remain weak for a longer period. Chinese demand could contract more than expected. Global steel overcapacity could remain high China may not glut its excess capacity. The stalemate between both controlling shareholders TERNIUM and Nippon Steel Corporation could get worse. In an extreme event, the company s assets could be split up to solve the dispute, resulting in a loss of economies of scale and bargaining power with clients. High level of leverage in the short term, even considering the capital increase of R$1 billion. In addition, the recent debt restructuring could result in higher interest rates. Lack of international diversification could not contribute to counterbalance the current weak performance in Brazil. In addition, a recent increase in import duties in the US against Brazilian flat steel could cause a significant decrease in exports volumes for USIMINAS; as that country represented 25% of the total exports during last year. Extraordinary costs to shut down the Cubatao site could still affect 2016 results. Recovering raw material prices especially the increase in iron ore, coal, and electric prices would increase production costs. 37

38 III. Fact Sheet Financials (R$ Mill) 2015 TTM 2016e 2017e 2018e Operating Data 2015 TTM 2016e 2017e 2018e P&L Steels - Sales Volume 4,918 4,184 3,801 4,103 4,481 Revenue 10,186 9,567 9,248 11,265 13,413 Steels - Production Volume 5,007 3,872 3,345 3,905 4,537 Var (%) -13.3% -6.1% -9.2% 21.8% 19.1% Steel Prices (Weighted R$/ton) 1,866 1,847 1,928 2,048 2,204 Gross Profit 174 (215) ,542 Gross Mg. 1.7% -2.2% 3.1% 8.5% 11.5% Iron ore - Sales Volume 3,790 3,206 3,011 3,000 6,000 Operating Profit (3,678) (3,192) (702) (242) 189 Iron ore - Production Volume 3,868 2,790 2,642 3,000 6,000 Operating Mg % -33.4% -7.6% -2.2% 1.4% Valuation 2015 TTM 2016e 2017e 2018e EBITDA 243 (195) 573 1,047 1,491 EPS (2.9) (2.3) (0.5) (0.4) (0.2) Var (%) -86.7% % 135.9% 82.7% 42.5% P/E (2.2) (2.8) (13.9) (16.9) (39.1) EBITDA Mg. 2.4% -2.0% 6.2% 9.3% 11.1% EV/EBITDA 52.8 (65.7) Financial result (1,246) (628) (96) (501) (494) P/B Taxes 1, P/Sales Net Profit (3,734) (2,994) (598) (491) (212) Var (%) % -19.8% -84.0% -17.9% -56.8% Return 2015 TTM 2016e 2017e 2018e Net Mg % -31.3% -6.5% -4.4% -1.6% ROA -13.5% -11.1% -2.2% -1.8% -0.8% Balance Sheet ROE -24.9% -20.4% -4.1% -3.5% -1.5% Cash 2,024 2,713 3,085 3,181 3,092 FCF Yield -7.0% 1.2% 8.9% 6.0% 7.6% Accounts Receivable 1,428 1,233 1,282 1,314 1,495 Inventory 2,748 2,306 2,415 2,807 2,905 Leverage 2015 TTM 2016e 2017e 2018e Fixed Assets 16,166 15,685 15,312 14,373 14,136 Debt/Equity 0.5x 0.5x 0.5x 0.5x 0.5x Total Assets 27,758 26,857 27,179 27,013 27,004 Net Debt/EBITDA 24.1x -23.2x 7.3x 3.9x 2.8x Accounts Payable 1,378 1,331 1,675 1,865 1,927 Interest Coverage 0.2x -0.3x 6.0x 2.1x 3.0x Debt 7,869 7,238 7,238 7,238 7,238 Total Liabilities 12,764 12,147 12,614 12,939 13,003 Turnover (Days of) 2015 TTM 2016e 2017e 2018e Equity 14,994 14,710 14,565 14,074 14,001 Accounts Receivable Inventory FCF Payables EBITDA ,047 1,491 Cash Conversion Working capital (5) (199) (516) CAPEX (783) -477 (350) (350) (350) Liquidity 2015 TTM 2016e 2017e 2018e Income Taxes (32) (31) Current Ratio 1.5x 1.2x 1.2x 1.2x 1.3x Free Cash Flow (577) Quick Ratio 0.7x 0.8x 0.8x 0.8x 0.8x Source: GBM 38

39 IV. Valuation Given the particular debt situation of USIMINAS and its poor generation of free cash flow, a significant portion of the company s value comes from a normalized level of FCF generation valuation approach. Consequently, we are presenting three different valuation approaches, which results vary wildly. We believe a normalized EV/EBITDA approach is more adequate in the current situation, while the salvage value presents a theoretical high value, which we believe is mostly out of reach considering the current situation of the industry and controlling shareholders battle. To reach our price target, we weighted a DCF with 35%, a normalized EV/EBITDA with 55%, while our salvage value weighs only 10%. 2H16e 2017e 2018e 2019e 2020e Perpetuity DCF Net Revenues 5,179 11,265 13,413 15,717 17,209 18,573 Ebitda 462 1,047 1,491 2,111 2,429 2,786 Ebitda Margin. 8.9% 9.3% 11.1% 13.4% 14.1% 15.0% Income Rate Capex ,000 Change in WK WACC Cost of Equity 17.8% Beta 1.30 Rf 11.25% Market Risk Premium 5.00% Cost of Debt (after tax) 15.00% Capital Structure Equity 55% Debt 45% WACC 14.2% Free Cash Flow ,022 1,141 13,348 Discount free cash flow ,963 WACC 14.2% Entreprise Value 12,022 Net Debt 4,346 Minority 1,592 Equity Value 6,083 # Shares 1,291 Perpetuity Capacity 9,500 Utilization rate 85% Sales Volumes 8,075 Average Steel Price R$/ton 2,300 Net Revenues 18,573 Ebitda R$/ton 345 Mg. Ebitda 15% Ebitda R$ million 2,786 Average Steel Price US$/ton 639 EBITDA US$/ton 96 DCF's price p/s 4.71 Source: GBM To obtain the terminal value in our DCF model, we applied an 85% utilization rate. For the long-term steel price, we assumed R$2,300 per ton and estimated an EBITDA margin of 15.0%. We did not plug the statuary corporate tax of 34% into our projections, given some tax benefits and potential negative base that could be used to reduce the effective tax rate during a very long period. Moreover, for the other lines, we assumed a future CAPEX that should be equal to D&A. Lastly; we estimated WK needs that imply almost a quarter of the variation of net revenues. For our growth rate, we assumed a sustainable ROE of 6.6% and a payout ratio of 25%, thus resulting in a nominal growth rate of 5.0%. In our DCF model, we used a WACC discount rate of 14.2%, composed of a cost of equity of 17.8% and after-tax cost of debt of 15.0%, with a weight of 55% for equity and 45% for debt, representing the company s current capital structure. 39

40 Growth Sustanaible ROE 6.6% Payout (%) 25% Growth 5.0% Multiples Analysis Normalized EBITDA 2,786 Normalized EV/EBITDA 6.5 EV 18,108 Present Value EV (2017) 12,159 Net Debt 2017e 4,057 Minority 1,592 Equity Value 2017e 6,509 # shares 1,291 EV/EBITDA price R$ 5.04 Salvage Value Capacity (Ktons) 9,500 US/Ton 750 Value US Mn 7,125 Mecanica EBITDA 20 EV/EBITDA 7.5 Value US Mn 153 Mining (Mtons) 12,000 US/Ton 10 Value US Mn 120 Transformation EBITDA 7 EV/EBITDA 5.0 Value US Mn 33 Net Debt 1,317 Equity Value 6,114 For our multiples analysis, we used a normalized EV/EBITDA multiple of 6.5x; the ratio represents a discount to USIMINAS historical multiples, measured in the period, which was 11.7x. To estimate our EBITDA for perpetuity, we used the same condition set for our DCF perpetuity. In our salvage value approach, we assumed the company is sold in parts; the steel segment is sold at a 50% discount of the current replacement cost in Brazil, which is around US$1,500 per ton of capacity (Gerdau just invested US$1.5 billion for 1 million ton of capacity to compete in the Brazilian flat steel market). The mining division is sold at US$10 per ton of capacity; while the rest of the company is sold at 2017e EV/EBITDA Multiples. We reached a notable high value compared to other valuation methods and markets prices. This situation points that current FCF generation capabilities of flat steel capacity is considerably low in the current economic environment of the country, and also suggests the potential value that could be unlocked if a correct and sustainable turnaround strategy is implemented in the company; a situation, that needs an harmonious controlling block in our view. We are initiating coverage of USIMINAS ordinary shares (ONs, USIM3) with a Market Performer rating and 2017 price target of R$7.22 per share (implying an 16% downside). USIM3 is trading at a 110% premium to the preferred shares (USIM5), for which we set a price target of R$4.35 per share (implying a 7% upside). In our view, the huge spread ratio between stock classes is based on the current legal dispute between the controlling shareholders. Moreover, some minority shareholders still claim that when TERNIUM joined the control block (in 2012), there was an actual change of control; thus, TERNIUM should have launched a tender offer. This case remains in courts. In our view, it is hard to recommend investing in USIMINAS ordinary shares based solely on the possible tag along or potential takeover battle: Ternium vs. Nippon. Thereby, we reach a price target of R$7.22 per ON, assuming a more conservative premium of control of 66% over PN (average premium last 5 years). Premium Common Shares Vs. Preferred Shares USIM3 (Premium 66%) R$ 7.22 Valor Equity ON (R$ million) 5,363 Equity Value Forecasted (R$ million) 7,727 USIM5 R$ 4.35 Valor Equity PN (R$ million) 2,381 # Shares 1,291 Salvage Value p/s USD 4.74 Salvage Value p/s BRL Source: GBM Source: GBM 40

41 V. USIMINAS operations Steel Unit USIMINAS steel production and processing facilities are only located in Brazil. Currently, the company has a production capacity of 9.5 million tons of finished steel products, divided among two steel mills, located in the main industrial regions of the country: Cubatao (SP) and Ipatinga (MG). The whole capacity corresponds to flat products. In addition, the company has a 70% stake in UNIGAL, which galvanizes its products. Galvanized Steel Mill Slabs Heavy Plates Hot Coils Cold Coils EG HDG Ipatinga 5,000 1,000 3,600 2, ,050 Cubatao 4,500 1,000 4,400 1, ,500 2,000 8,000 3, ,050 Source: GBM with company data USIMINAS is an integrated company; thus, the main raw materials used in the production of steel are coal, limestone, dolomite and iron ore, which is partially supplied by MUSA. Other important components in COGS are electric energy and natural gas; although the company does not have energy assets, USIMINAS established a long-term contract with CEMIG and Santo Antonio to supply energy for its Ipatinga and Cubatao plants until December 2019 financial conditions of the agreement were not disclosed. As the company has considerably reduced its production (temporary shutdown of Cubatao), which in turn led to lower energy demand, USIMINAS started to resell its exceeding energy supply on the spot market. This strategy proved profitable for some time, as spot prices were higher during 2014 and most of 2015; however, during this year, this resale has generated continuous losses (R$85.3 million). Another important aspect of its operations is related to the logistics side, where the company signed long-term contracts with two railway companies: VLI and MRS Logistica S.A. In the latter, USIMINAS also holds an 11% stake. In addition to serving the external market, the company has two ports: Cubatao Terminal (SP), and Praia Mole Terminal (ES). These ports serve the export production from the mills located in Cubatao and Ipatinga. COGS Breakdown - Steel Demand by Sector - Steel Breakdown Export Market Source: GBM with company data Source: GBM with company data Source: GBM with company data 41

42 Mining MUSA USIMINAS mining business unit started in 2008, through the acquisition of mineral assets consisting in a reserve of 2.6 billion tons of iron ore and 5 mtpy of installed production capacity located in the Serra Azul (MG). USIMINAS holds a majority stake of 70% in (MUSA); the remaining interest belongs to a consortium of Japanese companies, led by Sumitomo Corporation, which had paid R$2.6 billion for this stake in At the time of its creation, MUSA had scheduled investments of R$1.5 billion to achieve in the first phase a nominal capacity of 12 million tons by the end of Under the strategic business plan, most of the production would be directed to USIMINAS, and the excess production could be sold to third parties, including the foreign markets. In addition, by enjoying the good performance during the first years, MUSA approved the "Compactos project, which could increase the nominal production capacity to 29 million tons. To perform this second phase, the company budgeted a CAPEX of around US$1.0-US$1.5 billion. However, before the company started to implement the new brownfield project, the commodity s price collapsed; thus, the project was discarded. Net Revenues & EBITDA margin MUSA Figures in million of R$ Source: GBM with company data Production & Sales Volume MUSA Figures in thousand tons Moreover, as a consequence of the drop in iron ore prices, USIMINAS had to recognize a write-off of R$2.2 billion during The amount was recorded based on a DCF test with the following main assumptions: i) Nominal rate of 11.9% per year (BRL), ii) Brazilian inflation of 4.5% per year, and iii) Iron ore prices of US$57-US$74/ton. Currently, production is considerably lower than its nominal capacity; consequently, the company reached a compensation agreement with MRS, where both parties agreed to revoke the take-or-pay agreement regarding the use of MRS s logistic railway. Under the agreement, MUSA absorbed the liability to pay ten annual installments of R$31.5 million as financial compensation (R$163 million present value). Source: GBM with company data Iron ore price 62% (USD per ton) 42

43 Steel Processing Solucoes Usiminas: Solucoes Usiminas is the biggest service center of flat steel in Brazil, with 9 industrial units, distributed in the states of Rio Grande do Sul, Sao Paulo, Minas Gerais, Espirito Santo, and Pernambuco. These units have a combined nominal capacity to process more than 2 million tons of steel per year. Net Revenues & EBITDA margin Solucoes Usiminas Figures in millions of R$ The steel service center focuses on two main activities: i) transform flat steel into coil and thick plates into regular or figured sheets, cylinders, blanks, and tubes; and ii) store and distribute the products supplied by the steel production unit. Although the unit is important in terms of net revenues, it has always delivered small or even negative margins, as most of the revenues are related to the distribution of steel (small clients not economically viable to buy directly from the steel unit), rather than value-added processes. However, even considering the historically weak performance of the unit, it is strategically important to the whole group by ensuring the sales volumes and keeping the alternative channel to distribute its products, eliminating intermediaries. Capital Goods Usiminas Mecanica: Usiminas Mecanica offers products and services in the capital goods industry, specifically: metal structures and bridges, industrial equipment, industrial assemblies, blanks, and stamping and railway wagons. Source: GBM with company data Net Revenues & EBITDA margin Usiminas Mecanica Figures in million of R$ The production process starts with the technical specification and drawings of the final good; then, the items are assembled. Currently, the unit has the capacity of casting 25,000 tons per year. 2,000 tons for large dimensions and another 23,000 tons for smaller parts. According to the last data released by the company, despite the macro situation, which drags down investments in capital goods, the unit currently has a backlog of R$400 million, which could be executed in the next years (~1-2 years). Usiminas Mecanica s positive path compared to the other business units has drawn attention, as it is the most valuable asset to be sold in the company s disinvestment plan. However, USIMINAS Mecanica has been offered to third parties for a while; furthermore, the company announced that it hired a financial advisor to execute this task. Source: GBM with company data Usiminas Mecanica Backlog Client Description Anglo American Electromechanical assembly for Mineração Barro Alto Brasfels Manufacturing and assembly of shipyard Petrobras Supply of furnaces, platforms, towers and bell mouths Petrobras Supply and assembly of storage tanks Vale Disassembly and assembly of Furnace for Mineração Onca-Puma Vale Manufacturing and assembly of structures for Mina Caue Vale Electromechanical assembly for Mineração em Canaa dos Carajas 43

44 USIMINAS - Past performance In 2015, the company posted a relevant deterioration of its financial numbers, dragged down by Brazilian domestic demand (-13.1% YOY); however, the steel unit (~74% of revenues), recorded an even sharper drop (-21.4%YOY), partially compensated by export sales, which increased (+36.7% YOY). All in all, USIMINAS total sales volumes decreased (-11.2% YOY), reaching 4.9 million tons. Added to this weak performance of its main unit, last year MUSA, which since its inception, used to be the second most relevant unit measured in terms of revenues and EBITDA generation, turned out to be a cash burning unit. This is a consequence of the plunge in iron ore prices, which led the unit to barely keep its operations working. Sales volumes dropped 37.5% YOY and forced the company to record a huge impairment of R$2.2 billion during the year. In this scenario of much lower capacity utilization, MUSA and MRS reached an agreement, where both parties agreed to revoke the take-or-pay contract regarding the use of MRS logistics railway. Consolidated Net Revenues Figures in millions of R$ Net Revenues - Breakdown per segment Figures in million tons Source: GBM with company data EBITDA BREAKDOWN Figures in millions of R$ EBITDA - R$ million Jun TTM Steel 1, ,151 1, Goods Capital Mining Processing (+/-) Adjustments ,670 1, ,773 1, EBITDA Margin % 20.0% 11.0% 5.5% 14.1% 16.0% 3.0% -1.8% Source: GBM with IaBr data Furthermore, last year, the other business units followed a similar trend and posted equally weak results. Solucoes Usiminas the processing unit kept working with a negative EBITDA margin (-1%). The only exception was USIMINAS Mecanica Capital goods which posted better results, mainly because this unit had a sound backlog contracted in previous years, and executed a relevant part of it. This translated into higher revenues (+9.4% YOY) and expansion of its profitability. 44

45 SG&A expenses posted a better trend, decreasing 12% YOY. The reduction was due to the reduction in labor force, third-party expenses, and reversal of provisions for bonuses. In addition, the company implemented some non-recurring measures, such as the reduction of working days of its administrative employees at its headquarters during three months (July-September) results include a long list of non-recurring items, such as the already mentioned impairment of R$2.2 billion in mining, which joined the impairment of R$400 million in the steel unit, in addition to the renegotiation of take-or-pay contracts with MRS (R$163 million, equivalent to the NPV of ten installments of R$31.5 million), provisional expenses related to the shutdown of Cubatao (R$94 million), and finally, also losses on energy resale (R$65.4 million). F/X impacted heavily on bottom line and net financial results due to the strong depreciation of the BRL against the USD F/X losses reached R$1.1 billion, partially offset by a hedge, which contributed R$240.4 million. On the other hand, F/X boosted external sales (+36.7% YOY). This strong allocation of sales volumes smoothed the decrease of consolidated volumes. Nonetheless, this better external environment is unlikely to continue in the future, as the main destination of the company s exports the US imposed high tariffs against Brazilian steel at the end of last year. Free cash flow Figures in millions of R$ Free cash flow Ebitda 2,670 1, ,829 1, (-) Income tax (-) Capex -3,200-2,490-1, , (+/-) WC -1, , FCFF -2,271-1,235 1, Financial result (-) Financial Expenses (+) Financial Income (+/- ) FX ,072.1 (+/- ) Swap - Hedge Financial result ,246 Source: GBM with company data Net debt / EBITDA Figures in millions of R$/units USIMINAS finished a cycle of investments where, in the last six years, it invested around R$10.2 billion. This movement pressured the company s balance sheet, which converted into its main issue. Focus on the disinvestment plan. So far, the company didn t implement a substantial disinvestment plan. In our view, a possible disinvestment plan is a good driver to enhance its balance sheet. But, we see small room for significant divestments, due to the weak conditions of the economy, which would translate into unfavorable market conditions. One valuable asset that could be the sold is USIMINAS Mecanica. The company has in fact already hired a financial advisor to seek buyers or strategic partners. Using a multiple valuation approach, we reach a negligible amount (R$406-R$506 million) to reduce the company s heavy debt burden. Source: GBM with company data Estimated Valuation USIMINAS Mecanica Figures in millions of R$ EV/ EBITDA EBITDA 2016e - R$ million Source: GBM with company data 45

46 USIMINAS Debt profile: To date, USIMINAS debt stood at R$7.2 billion by the end of June 2016, where most of the debt is still characterized by long-term maturity. R$ - million Thereafter Total Current Debt 1, ,618 Non-current Debt - 1,710 1,871 1, ,619 TOTAL 1,618 1,710 1,871 1, ,237 Source: GBM with company data USIMINAS s debt by currency USIMINAS s debt by maturity (%) Source: GBM with company data Source: GBM with company data Notably, USIMINAS fully consolidates its subsidiary MUSA (70% stake), removing the cash belonging to third parties (30%). We would reach a higher majority net debt indicator as MUSA currently holds ~R$1.3 billion in cash so USIMINAS adjusted debt is R$910 million. Furthermore, we would like to highlight the quasi-debt of R$163 million (present value), derived from the recent agreement between MRS and MUSA, where both companies agreed to revoke the take-or-pay agreement signed by MUSA. Under the new agreement, MUSA agreed to pay ten annual installments of R$31.5 million as financial compensation. USIMINAS recorded this liability as a non-current liability in its consolidated financial statements. 46

47 Capital Increase On March 11, USIMINAS board approved a capital increase of R$1 billion, through the issuance of 200 million new common shares. Nippon Steel made the initial proposal. On the other hand, TERNIUM proposed an alternative capital increase limited to R$563 million, through the issuance of common and preferred shares (100 million of each priced at R$4.35 per common share, and R$1.28 per preferred share). In the end, Nippon s proposal dominated, but the three members appointed by TERNIUM voted against it. The capital increase of R$1 billion was only approved and ratified by an extraordinary meeting held on April 18. The following legal steps regarding the capital increase process were completed in July 2016, when the company subscribed the whole amount offered. Notably, both controlling shareholders subscribed their respective stake in the issuance. Debt Restructure In addition, and linked to its successful capital increase, USIMINAS recently obtained a favorable and important step in its debt restructure with its main creditors, which hold approximately 92% of USIMINAS gross debt. Under the agreement, creditors granted a 3-year grace period for principal and a 7-year period for amortization. The company did not disclose the amortization scheduled or the financial cost of the operations. In our view, the debt renegotiation is certainly very important, and will give USIMINAS enough time to alleviate its balance sheet. On other hand, despite the rather long period already received from the pool of banks, it is quite certain that the new agreement should come with higher interest rates. The remaining debt (~10%) is held mainly by international bonds holders (US$180 million maturing in 2018); under our view we believe that USIMINAS will also try to negotiates new terms with the bondholders. Original schedule -2Q 16 R$ - million Thereafter Total Gross Debt 1,618 1,710 1,871 1, ,237 Expected new schedule - Debt* R$ - million Thereafter Total Gross Debt ,758 7,237 Source: GBM with company data *Assumptions We assumed under the new debt schedule that only the international bonds (US$180 million F/X rate of 3.20 BRL/USD) maturing in 2018 will be kept untouched. The remaining debt will be rescheduled according to the company s press release 3 years grace period (starting in 2019). In addition, as the company didn t disclose the amortization period of the new debt, we also assumed a uniform amortization divided into the remaining 7 years of the contract. 47

48 Controller Agreements Since the privatization of the company at the end of 1991, which was the first company to be offered in the Brazilian Federal Privatization Program, the company has always had an important free float. After the privatization, the main shareholders by voting shares were: Nippon Steel, Financial Institutions mainly Bradesco, Vale, Previ, Usiminas Pension Fund, and Valia Vale Pension Fund, and others. The first Shareholder Agreement was signed in The main names remained the same except for the inclusion of Votorantim Participacoes, Camargo Correa, Fap Empreendimentos, and De Castro Loureiro Eng. Ind. Ltda. Under this first agreement, despite the quite numbers of different economic groups in the block, the main players in the agreement were Nippon and the V/C group formed by Votoratim Participacoes and Camargo Correa. The valid period was set for 15 years (until 2013). However, a second agreement was signed in 2004, with only some small changes related to some updates of the stakes and the extension of the agreement for an additional period of 10 years, until However, at the end of 2011, TERNIUM bought the Votorantim and Camargo Correa stakes in the control block with a substantial premium over market prices. Through this acquisition, TERNIUM became an important shareholder in the company, and joined the control block with Nippon. Notably, the purchase of shares by TERNIUM was not technically classified as a change of control despite the various complaints coming from minority shareholders; thus, tag along rights were not triggered. In light of this event, a new shareholder agreement was necessary, and was indeed established in mid-2012 between Nippon and TERNIUM. Under the new shareholders agreement, the control would be evenly divided among the two groups, including the same number of board members (3 from each side) and key management (1 executive director for each side), while the appointment of the CEO would require a consensus from both parties. Moreover, the new agreement stated that all kinds of strategic decisions should be taken by both sides through a unanimous resolution. Nonetheless, an informal agreement was defined between the two parties, whereby for the first two years, TERNIUM would appoint the CEO, and Nippon Steel would appoint the Chairman of the board. So, in the first round of nominations, TERNIUM appointed Julian Eguren for the position of CEO, and Nippon appointed Paulo Penido as the Chairman of the board. Nippon Steel vs. TERNIUM Dispute At the end of September 2014, the Board of Directors approved a resolution to force the removal of the company s CEO Julian Eguren and two executives related to TERNIUM. The resolution was ratified by Chairman Paulo Penido, after an internal and external audit indicated compliance issues regarding benefits non authorized and paid under Julio Eguren s management. TERNIUM argued that Nippon Steel violated the shareholder agreement as, under the agreement, a unanimous agreement was necessary to decide on the subject removal of key executives. Therefore, TERNIUM started a legal dispute against the board s decision. So far, the process has received two negative rulings from the first Courts, but the company is waiting for further decisions from higher instance Courts. Meanwhile, in November 2014, TERNIUM bought an additional stake in Usiminas, by buying common shares from Previ Pension Fund, again paying a substantial premium (82%) over market prices. The number of shares bought was 51.4 million (equivalent to ~10% of the total common outstanding shares) at a price of R$12 per share, resulting in an additional investment of R$616.8 million. Despite the material size of this additional purchase, these shares were not included in the control block, due to the rules of the agreement. 48

49 Possible Outcomes - Nippon Steel vs. TERNIUM Dispute Almost two years have passed since the dispute started, and it seems to be getting more hostile day by day. In our view, the worst point is that, so far, the parties haven t reached any common ground company management, capital increase proposal, and recently, the dismissal of the CEO. So far, the only formal act, or at least the only one released to the market, was the informal negotiation by both parties in October 2015 in Chicago, where the top leaders from both sides discussed the possible outcomes to solve the problem yet, they have not made any progress. We see four possible scenarios, although these could also have several variations, each. TERNIUM and Nippon solve the dispute together. In this scenario, which we see as the best option, both sides agree to come together, accept the mutual misunderstandings, and move on to reestablish USIMINAS control under a new controlling agreement. Although this scenario led to positive aspects for all participants, we consider this scenario rather unlikely, as the negotiations outside of the courts seem not to be moving forward, even after two years have passed. One side moves out of the society. As TERNIUM and Nippon cannot reach a solution, one player could leave the society and sell its stake to the other side. Yet, looking forward, this scenario also seems difficult to imagine, based on the following aspects: i) TERNIUM buys Nippon s stake. TERNIUM joined the society paying a high premium to access the control block. However, after the legal dispute started, TERNIUM assumed a more aggressive position to defend its investment; more specifically, the acquisition of Previs stake in USIMINAS. Thus, we do not expect that TERNIUM would resign easily to this strategic investment; in addition, although TERNIUM didn t agree to the format and amount of the capital increase, TERNIUM agreed to put in new money, in order to avoid its stake being diluted. ii) Nippon buys TERNIUM s stake. Nippon showed recently a more aggressive appetite to put new money into the company, whereby Nippon s proposal was significantly higher than TERNIUM s; moreover, Nippon also pledged the commitment to make the whole capital increase if third parties didn t follow. So, we might expect that NIPPON could also offer to buy TERNIUM s shares. Court battle dispute goes ahead. Since the two parties took legal actions to defend their interests and so far haven t reached a friendly agreement, we can imagine that at least the legal dispute will go forward. As the legal dispute leaves the decision to a third party, the possible outcomes in this scenario are more difficult to define, as the action depends on legal interpretations. We see this scenario as negative, due to its uncertainty, and we assume that the final decision will not be reached in the short term, in our view affecting USIMINAS strategy and operations for a while. USIMINAS splits up. In our last scenario, both sides failed to reach an agreement, resulting in a split-up of USIMINAS assets. This scenario involves the division of the two steel mills, whereby Nippon is more likely to retain the Ipatinga plant, while TERNIUM would more likely control the Cubatao Plant. We see that this scenario is not optimal as the firm might face loss of synergies, bargaining power, financial costs to execute, etc. Moreover, if withdrawals rights are implemented in this transaction, the upside for minorities is considerable (book value at BRL$12.45 per share), a situation that would put additional pressure on the company s balance sheet. Thus, we believe that in this scenario, an asset swap would be more likely. Summary Scenarios - Potential Impacts USIMINAS TERNIUM TERNIUM and Nippon, solve the dispute together + + One side move out of the society. + + Court Battle dispute go ahead. - - USIMINAS is split-up. - - Source: GBM 49

50 USIMINAS premium ordinary shares vs. preferred shares Another issue remains pending in courts: some minority shareholders claim that when TERNIUM joined the control block (2011), there was a change of control; thus, according to Brazilian law, the company should launch a tender offer. One of the main minority shareholders in USIMINAS is the company s main competitor, CSN which, by December 2015, owned 20.69% of PN shares and 14.13% of ON shares in USIMINAS. CSN sued TERNIUM based on Brazilian corporate law, stating that if a controlling shareholder buys more than 1/3 of the free float of a share class, the group would be obliged to: i) realize a tender offer for all shares on the market tag along (80%); or ii) sell the number of shares that exceed 1/3 of free float. After CSN entered the legal proceeding, USIMINAS ordinary shares (ON) have increased sharply, despite the drop of preferred shares (PN), resulting in a wide spread between the two classes (currently ~238%). Thus, the ON performance better reflects the potential that a high control premium could trigger. Another point that may have contributed to the high premium is the potential hostile takeover battle involving TERNIUM and Nippon where both players could be natural buyers for the ordinary shares. One example of this interest was the acquisition of Previ s stake for R$12.00 per ON share, when the market price for USIM3 was R$6.59. So far, the legal dispute has been in favor of TERNIUM, as the case has already been judged in the first instance (September 2013). Nonetheless, the final decision is still pending, as CSN appealed to a superior court. In our model, we reach a price target of R$6.50 per ON, assuming a more conservative control premium of 66% over PN (average premium for the last 5 years), although we can imagine that a higher premium could be feasible. USIMINAS shares performance Common Shares (USIM3) vs. Preferred Shares (USIM5) Source: GBM with Bloomberg data 50

51 Ownership Structure USIMINAS has three types of stocks listed on BMF&Bovespa. Two are preferred shares, USIM5 and USIM6, but the latter class is totally insignificant, representing less than 0.01% of the total shares. The outstanding shares total 1,291,252,109. Common shares (USIM3) amount to 743,355,922 and hold voting rights, while preferred shares (547,818,424) have specific rights guaranteed under the company s corporate bylaws and Brazilian corporate law, including dividends. The latter are 10% higher than those of the common shares, and have preemptive rights on the reimbursement of capital in the case of liquidation. USIMINAS is listed in the level 1 corporate governance segment of BMF&Bovespa, which translates into a tag-along clause for minority parties who hold common shares; the clause ensures 80% of the amount received by controlling shareholders. Management In terms of executive management, the company faced important changes over recent periods. The main alteration was the recent dismissal of the CEO, whereby executive Romel de Souza left the company on May 25, and the shareholders, through a general meeting held on the same day, appointed internal executive Sergio Leite, who previously served as Vice-President responsible for the Commercial area of the company. Even on this decision both controlling shareholders were not on the same page. On this issue, TERNIUM voted in favor of replacement, arguing that under Romel de Sousa, the company posted poor results and didn t implement an adequate turnaround. On the other hand, the Nippon group defended the maintenance of the executive, and took legal measures to defend its position. On October 5, the Minas Gerais State Court granted the request of Nippon Steel to invalidate the CEO appointment made at the company s May 2016 board meeting. According to the court s decision, the former CEO Romel Erwin was reinstated. Another recent change in the executive base was the substitution of the Corporate Vice President. Mr. Takahiro Mori took over the position, which was previously held by Nobuhiko Takamatsu. Lastly, the company nominated Mr. Ascanio Merrighi to replace Sergio Leite as Vice President of the Commercial area. Executive Romel Erwin* Ronald Secklmann Ascanio Merrighi Takahiro Mori Tulio Chipoletti Position CEO CFO and IR Officer Commercial VP Corporate Planning VP Industrial VP *reappointed after court decision Source: GBM with company data 51

52 USIMINAS Timeline USIMINAS was founded as a stateowned company Under the Lanari- Horikoshi agreement a minority stake was sold to a consortium of Japanese companies led by Nippon Steel The first blast furnace was only tuned on in October 1962, with a initial capacity of 500k tons of steel per year. The company is privatized for US$1.7 billion USIMINAS acquired Companhia Siderurgica Paulista (COSIPA) located in Cubatao (SP) for US$228 million. A growth cycle was initiated in 1999 via a US$852 million investment plan that resulted in a 1.0 million ton per year increase in capacity In 2010, Mineracao Usiminas S.A (MUSA) was created in partnership with Sumimoto Corp., leading to several agreements to optimize production and shipping. TX joined in the block control, bought stakes from Votorantim and Camargo Correa with substantial premium over markets prices. Source: GBM with company data 52

53 Organizational Structure Source: GBM with company data 53

54 Board of Directors Elias de Matos Brito (nominated by Ternium) Chairman. Guilherme Poggiali Almeida (nominated by TERNIUM) Oscar Montero Martinez (nominated by Ternium). Mr. Montero has been General Director of Planning & Operations at Ternium S.A. since Mr. Montero previously served as Planning and Supply Chain Director for Ternium. He started his career with the Techint Group in 1984 as a commercial analyst for Propulsora Siderurgica. Since then, he has held several positions within Propulsora and Siderar. Mr. Martinez has served as Strategic Planning Director of Sidor since Fumihiko Wada (nominated by Nippon Steel). Graduated in Business Administration from the University of Keio in Japan. Mr. Wada is a Corporate Consultant for Nippon Steel and Nippon Usiminas Co. Ltd., as well as President and CEO of Nippon Usiminas Co. Ltda. Paulo Penido Pinto Marques (nominated by Nippon Steel). Graduated in Electrical Engineering from the Federal University of Minas Gerais (UFMG). Mr. Apellido has acted as the CFO and IR and IT Director for USIMINAS, CFO and IR Director of Companhia Siderurgica Nacional (CSN), Chairman of the Board for Transnordestina Logistica, Chairman of the Board for Ita Energetica, a board member of MRS Logistica S.A., a board member of Rio Negro Comercio e Industria de Aco S.A., a board member of Usiparts Sistemas Automotivos S.A. and CFO and IR Director of Embraer. Yoichi Furuta (nominated by Nippon Steel). Gesner Jose Oliveira Filho (nominated by CSN). Ricardo Antônio Weiss (nominated by CSN). Graduated in Civil Engineering from the Sao Paulo University Polytechnic School and has postgraduate studies in Business Administration from CEAG FGV. He completed the Advanced Management Program from Harvard Business School. He is currently a founding partner and Managing Director of W Consultoria e Participações, an independent advisor for Usiminas, Log-In Logistica Intermodal, and Coteminas. He is also FIESP Supreme Economic Council member. Rita Rebelo Horta de Assis Fonseca (nominated by USIMINAS pension fund). She holds an Executive MBA in Finance from IBMEC, a specialization in Financial Administration from the Dom Cabral Foundation, and a degree in Economic Sciences from PUC/MG. Rita has experience as a planning superintendent, an investment analysis superintendent, an economic-financial analyst, and a cost and budget analyst at USIMINAS. Luiz Carlos de Miranda Faria (nominated by USIMINAS employees). Francisco Augusto da Costa e Silva (nominated by BTG Pactual). 54

55 GERDAU Market Outperformer 2017 Price Target GGBR3 R$ Price Target GGBR4 R$ Price Target GGB US US$3.82 Price - GGBR M Price Range - GGBR / Shares Outstanding (Mill) 1,720 Market Cap (Mill) 16,513 Float 60% Net Debt (Mill) 15,797 EV (Mill) 32, TTM 2016e 2017e Revenue 43,581 42,708 39,811 41,112 EBITDA ,333 3,944 4,553 Net Profit -4,596-5, Free CF 3,128 5,014 3,430 2,765 EPS P/E , EV/EBITDA P/BV GERDAU: Leading position in the long steel market across the Americas. We are initiating coverage of GERDAU with a Market Outperformer rating and a 2017 price target of R$9.65 (GGBR3) and R$12.85 (GGBR4). We believe that GERDAU is better positioned among its Brazilian peers, due to its important regional diversification especially in North America, which currently compensates a weak domestic market. In addition, GERDAU has a solid balance sheet and resilient cash flow generation. GERDAU delivered a sound positive cash flow generation of R$5.0 billion, during the last twelve months. GERDAU s management successfully implemented a sound working capital plan, which translated into a reduction of R$2.9 billion in WK needs. Moreover, we should highlight the tight control of costs, which resulted in a 5% drop in SG&A expenses, a notable achievement considering the high inflationary environment in Brazil. Together, we believe these items reflect that the company is well managed. GERDAU holds a global leadership position in long steel and specialty steels, providing a wide range of products, from steel billets to special steels with automotive applications. In addition, we believe that GERDAU has a higher flexibility and operating advantage, due to its mix between mini-mill and integrated plants could be an inflection point for the Brazilian unit, resulting in the first growth in sales volumes since 2013, when Brazilian steel s apparent consumption reached its peak. * Figures in million of R$ Rodrigo Garcilazo Carreon rgarcilazo@gbms.cl +56 (2) Guillermo Estrada Madrazo gestradam@gbm.com.mx + 52 (55) ext Margin strategy could derive in disinvestment (Southern America & Special Steel), a situation that could enhance the balance sheet, and improve margins. This upside risk is not priced in our view. Downside risk GERDAU becoming involved in the Operacao Zelotes, where the company is being accused of paying bribes to members of CARF (Administrative Co uncil of Tax Appeals) to rule in favor of the company on two legal appeals which, according to Federal prosecutors, could result in a tax evasion of up to R$3.6 billion. Overall, our balance of risk still justifies our positive stance on the stock; our perception is that the company keeps the attractiveness in terms of valuation 7.1x EV/EBITDA 2017e vs.8.0x historical average (last 10 years). In addition, we think GERDAU could benefit from its divestment plan, which could be a good driver to enhance its balance sheet. Glauco Legat gdecastro@gbms.cl +56 (2) EV/EBITDA FWD GGBR4 vs. IBOV Index P/BV 55

56 I. Introduction GERDAU is the largest steel producer in Latin America with an annual production capacity of 25.3 mtpy, divided into 46 plants. The company has a vertical operation, from the supply of iron ore and scrap to steel transformation. The company s focus is the production of the long rolled and special steels, which are mainly used in civil construction and manufacturing companies, respectively. The company differs on some points from its main Brazilian peers due to the following aspects: i) it carries a geographic diversification, with relevant operations outside Brazil, such as North America and Latin America; ii) the use of mini mills mainly, which use scrap for production; and iii) family management and control. Source: GBM with company data Background Brazil North America Special Steels South America Inception - Year Nominal Capacity / Year 9.2 million tons 10.5 million tons 3.1 million tons 2.4 million tons Civil Construction Infrastructure Automotive Civil Construction Infrastructure Civil Construction Industry & Autoparts Infrastructure Main Markets Industry & Autoparts Industry & Autoparts Oil & Gas Shipbuilding Machinery Machinery Machinery Agricultural Oil & Gas Industry & Autoparts Participation Net Revenue (%) 29.0% 38.8% 19.9% 12.3% Participation EBITDA (%) 35.4% 34.6% 18.1% 11.9% Participation Shipments (%) 36.8% 35.6% 15.0% 12.7% GERDAU s inception dates back to 1901 when German immigrant Johannes Heinrich Kaspar Gerdau, commonly known as João Gerdau, and his son Hugo Gerdau bought Ponta de Paris Nail Factory, located in the city of Porto Alegre (RS). Later, in 1914, Hugo Gerdau took control of the company, and nineteen years later, the Nail Factory was expanded through the construction of another plant in Passo Fundo (RS). In 1939, Hugo Gerdau died and management of the company passed into the hands of two executives, until 1946, when one of Hugo's sons-in-law, Curt Johannpeter, assumed the management of the company. Mr. Johannpeter was previously a finance executive at a subsidiary of Deutsche Bank, resulting in a relevant background in finance. At the end of 1947, the Nail Factory now known as Metalurgica Gerdau S.A. became a listed company, and one year later, steel production was implemented in the group through the acquisition of steelmaker Riograndense. Over the years, GERDAU grew in pace with Brazil s economic growth, through the industrialization process. Thus, seeking to benefit from this economic momentum, the company executed a series of acquisitions, which consolidated its position in the domestic market. In 1969, Aconorte steel located in Pernanambuco was bought; in the 80s, GERDAU emerged as an international company after the acquisition of the Laisa plant located in Uruguay. The years from 1984 to 1990 were crucial for the company as important acquisitions were made. During the Federal Government s privatization program, GERDAU acquired the Barão de Cocais steel mill, and later, Usiba. In 1992, GERDAU acquired AZA in Chile, and Acos Finos Piratini in Brazil. In 1999, GERDAU entered into the US market through the acquisition of Ameristeel, and in the same year, GERDAU S.A. began trading on the NYSE. During the 2000s, the company took another cycle of acquisitions: Gerdau Acominas (2001), its largest mill, steel companies Diaco, and North Star were acquired in Colombia and the United States, respectively; in 2004, Sidelpar Company (2005); and in 2006, Siderperu (Peru), Sheffield Steel, Callaway Building Products in the US, and GSB in Spain. Parallel to these acquisitions, GERDAU underwent a vertical integration process, where it acquired iron ore mining rights from Grupo Votorantim in Minas Gerais in Another vertical acquisition was the purchase of Cleary Holdings in 2008, which holds minerals rights on coke and coal in Colombia. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 56

57 II. Investment Thesis We are initiating coverage of GERDAU with a Market Outperformer rating and a 2017 price target of R$9.65 (GGBR3) and R$12.85 (GGBR4). We believe that GERDAU is better positioned among its Brazilian peers, due to its important regional diversification especially in North America which compensates for the currently weak domestic market. In addition, GERDAU has a solid balance sheet and more resilient cash flow generation. GERDAU has an important geographic diversification in 13 countries. We should highlight the relevant position held in the North America division, which currently contributes significantly to the group s revenues (38.8%). This relevant diversification outside Brazil is an important mitigating factor for the group, which could access different markets, posting smoother and lower volatility in its numbers. Also, we see that this operational diversification adds more flexibility and operating advantages compared to its main competitors, where GERDAU could align its production in the more efficient plants, depending on market conditions. GERDAU holds an important share in the special steel segment, which corresponds to a higher valued added product. GERDAU currently holds a nominal capacity of 3.1 million tons, divided among its operations in Brazil, North America, and India. Furthermore, GERDAU aims to focus on higher value added products. This trend could be seen in the last two agreements released: i) the JV signed with Sumitomo Corporation, which aims to supply parts for wind turbine towers; and ii) the technical cooperation agreement with JFE for the production of heavy plates in its Brazil unit. Nonetheless, regarding the negative aspects, GERDAU faces a lawsuit regarding possible tax irregularities, which are being investigated by the Operacao Zelotes. Under the investigation, GERDAU is being accused of paying bribes to members of CARF (Administrative Council of Tax Appeals) to rule in favor of the company on two legal appeals which, according to the Federal prosecutors, could result in tax evasion worth up to R$3.6 billion. GERDAU defended its position and reiterated its innocence; in addition, the company has declared that it fulfilled all the legal requirements by justice, and has disclosed all the tax liability appeals in its financial statements. In our view, this potential liability could materially affect the company s numbers, although we believe that this legal dispute will take a long time to be solved and seems to us impossible to quantify potential impacts, if any. Overall, we see GERDAU s balance of risks in a favorable position where, despite the weak macro scenario and some specific issues that GERDAU might have to face in the future, we see the stock attractively valued vs. its historical values 7.1x EV/EBITDA 2017e vs. 8.0x historical average (last 10 years). In addition, we think GERDAU could benefit from its divestment plan, which could become a good driver to enhance its balance sheet. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 57

58 Investment Thesis Pros and Cons Pros Attractive valuation metrics compared to the main players in the world. Due to the high exposure of its international operations, GERDAU should be more compared to international players than to its domestic peers. GERDAU holds a relevant global leadership position in the long steel and special steels sectors, with a wide range of products. Geographic diversification counterpointing the weak performance of the Brazilian unit. In addition, operations abroad result in higher operating flexibility. Moreover, although the company is focused on the mini-mill concept, GERDAU has an important blast furnace capacity Ouro Branco plant. Potential turnaround in Brazil s economy, driven by changes on the political front. Possible disinvestment plan could enhance the balance sheet, or even use the amount to pay extraordinary dividends. Potential higher steel prices in the local market. Brazil s lack of infrastructure and housing deficit could be a long-term positive call for GERDAU. Cons Brazil steel demand to contract again in In our base scenario, we forecast an inflection point in Brazilian political crisis persists, resulting in the worsening of economic outlooks, which has led to decreases in consumption and investments. Unfavorable global macroeconomic scenario; steel market remains weak for a longer period. China s demand could contract more. In addition, a potential worsening in US activity may reverse the positive results presented by GERDAU North America division. Global steel overcapacity remains China does not glut its excess capacity. Zelotes Investigation Although the company strongly defends itself from the bribe accusations and tax evasion charges made by the Public Prosecutors, a future potential liability could surpass the initial suggested amount of R$3.6 billion. Recovering raw material prices especially the increase in scrap and electricity prices would increase production costs. Source: GBM GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 58

59 III. Fact Sheet Financials (R$ Mill) 2015 TTM 2016e 2017e 2018e Operating Data 2015 TTM 2016e 2017e 2018e P&L Steels - Sales Volume 16,970 16,648 16,061 16,712 17,302 Revenue 43,581 42,708 39,811 41,112 43,797 Steels - Production Volume 16,861 16,549 16,745 17,420 17,630 Var (%) 2.4% -2.0% -8.7% 3.3% 6.5% Steel Prices (Weighted R$/ton) 2,568 2,565 2,479 2,460 2,531 Gross Profit 4,291 3,893 3,684 4,213 5,573 Gross Mg. 9.8% 9.1% 9.3% 10.2% 12.7% Brasil 6,456 6,383 6,091 6,297 6,636 Operating Profit (3,216) (3,630) 1,393 2,039 3,281 North America 6,233 6,263 6,131 6,207 6,331 Operating Mg. -7.4% -8.5% 3.5% 5.0% 7.5% South America 2,222 2,170 2,114 2,188 2,254 EBITDA 4,389 4,333 3,944 4,553 5,794 Special Steels 2,621 2,452 2,115 2,021 2,081 Var (%) -14.4% -1.3% -10.1% 15.5% 27.3% Valuation 2015 TTM 2016e 2017e 2018e EBITDA Mg. 10.1% 10.1% 9.9% 11.1% 13.2% EPS (2.7) (2.9) (0.0) Financial result (2,879) (1,757) (843) (1,661) (1,558) P/E (3.6) (3.3) (1,572.6) Taxes 1, (561) (286) (903) EV/EBITDA Net Profit (4,596) (5,035) (11) P/B Var (%) % 9.6% -99.8% % 780.8% P/Sales Net Mg % -11.8% 0.0% 0.2% 1.9% Balance Sheet Return 2015 TTM 2016e 2017e 2018e Cash 6,919 4,877 4,655 5,759 6,125 ROA -6.6% -8.6% 0.0% 0.2% 1.4% Accounts Receivable 5,042 4,043 4,663 4,788 4,818 ROE -14.4% -18.1% 0.0% 0.3% 2.9% Inventory 8,781 6,764 7,092 6,992 6,958 FCF Yield 18.9% 30.4% 20.8% 16.7% 18.7% Fixed Assets 41,137 34,890 34,485 33,571 33,391 Total Assets 70,095 58,234 58,595 58,716 58,838 Accounts Payable 3,630 2,757 3,287 3,311 3,340 Leverage 2015 TTM 2016e 2017e 2018e Debt 26,461 20,674 20,674 20,674 20,674 Debt/Equity 0.8x 0.7x 0.7x 0.7x 0.7x Total Liabilities 38,124 30,473 30,828 30,434 30,363 Net Debt/EBITDA 4.5x 3.6x 4.1x 3.3x 2.5x Equity 31,970 27,761 27,768 28,282 28,475 Interest Coverage 1.5x 2.5x 4.7x 2.7x 3.7x FCF EBITDA 4,389 4,333 3,944 4,553 5,794 Turnover (Days of) 2015 TTM 2016e 2017e 2018e Working capital 1,701 2,900 1,317 3 (515) Accounts Receivable CAPEX (2,325) (1,875) (1,700) (1,600) (1,800) Inventory Taxes (637) (344) (130) (191) (386) Payables Free Cash Flow 3,128 5,014 3,430 2,765 3,094 Cash Conversion Cash cost/ Ton - R$ 2,315 2,332 2,249 2,208 2,209 Liquidity 2015 TTM 2016e 2017e 2018e EBITDA / Ton - R$ Current Ratio 0.3x 0.3x 0.3x 0.3x 0.3x EV/Ton - R$ 1,904 1,941 2,012 1,933 1,867 Quick Ratio 1.7x 1.7x 1.7x 1.8x 1.9x Source: GBM GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 59

60 Financial Summary by division Source: GBM estimates -Figures in Ktons and R$million GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 60

61 IV. Valuation To estimate the price target, we used a discounted free cash flow (DCF) and a multiple approach in order to compare the company s performance to its peers. We are considering weights of 33% for the DCF, 33% for the EV/EBITDA 2017 multiple approach and 33% for the normalized/exit multiple approach. 2H16e 2017e 2018e 2019e 2020e Perpetuity DCF Net Revenues 19,478 41,112 43,797 46,814 50,040 54,600 Ebitda 2,017 4,553 5,794 6,544 7,493 8,190 Ebitda Margin. 10.4% 11.1% 13.2% 14.0% 15.0% 15.0% Income Rate ,474 Capex 847 1,600 1,800 2,200 2,700 2,700 Change in WK ,399 1,092 Perpetuity Capacity 26,000 Utilization rate 75.0% Sales Volumes 19,500 Average Steel Price R$/ton 2,800 Net Revenues 54,600 Ebitda R$/ton 420 Mg. Ebitda 15.00% Ebitda R$ million 8,190 Free Cash Flow 1,045 2,765 3,094 3,164 2,614 2,924 Discount free cash flow 1,175 2,765 2,752 2,505 1,841 24,588 WACC 12.4% Entreprise Value 35,626 Net Debt 15,797 Minority 257 WACC Cost of Equity CAPM 17.5% Beta 1.25 Rf 11.25% Market Risk Premium 5.00% Cost of Debt 13.00% Capital Structure Equity 50% Debt 50% WACC 13.0% Equity Value 19,571 # Shares 1,720 DCF's price 11.4 Growth Sustanaible ROE 6.0% Payout (%) 33% Growth 4.0% Source: GBM To obtain the terminal value under our DCF model, we applied a 75% utilization rate. For the long-term steel price, we assumed R$2,800 per ton, thus resulting in an estimated EBITDA margin of 15.0%. We did not plug the statutory corporate tax of 34% into our projections, given some tax benefits and potential negative base that could be used to reduce the effective tax rate over a long period. Moreover, for the other lines, we assumed a future CAPEX that should be close to D&A. Lastly, we estimated WK needs that imply 25% of the variation of net revenues For our growth rate, we assumed a sustainable ROE of 6.0% and a payout ratio of 33%, thus resulting in a nominal growth rate of 4.0%. In our DCF model, we use a WACC of 13.0%, composed of a cost of equity of 17.5% and after-tax cost of debt of 13.0%, where we use a weight of 50% for equity and 50% for debt, representing the company s current capital structure. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 61

62 For our multiples analysis, we used first an EV/EBITDA target of 7.0x on our 2017e EBITDA. Our multiple ratio applied is lower than GERDAU s historical average of 8.6x measured between , on our 2017e EBITDA. In our view, the lower multiple is justified by the company s lower profitability compared to the historical period. In addition, we used a second multiple approach where we used a normalized EV/EBITDA of 7.0x on our normalized EBITDA consistent with the perpetuity in our DCF approach. EV/EBITDA Normalized Multiple Analysis EBITDA Normalized 8,190 EBITDA 2017e 4,553 EV/EBITDA Normalized 7.00 Target 7.00 EV 57,330 EV 31,874 Present Value EV (2017) 39,690 Net debt 2017e 14,915 Net debt 2017e 14,915 Minority 257 Minority 257 Market Cap 16,701 Equity Value 24,518 # shares 1,720 # shares 1,720 EV/EBITDA price R$ EV/EBITDA price R$ 9.71 Source: GBM We are initiating coverage of GERDAU s ordinary shares (ONs, GGBR3) with a Market Outperformer rating and a 2017 price target of R$9.65 per share (implying a 26% upside). GGBR3 is trading at a significant discount of 28% to the preferred shares (GGBR4), which we have also rated as Market Outperformer with a price target of R$12.85 per share (implying a 21% upside). In our view, the significant spread between the two stock classes is mainly backed by the lack of liquidity of GGBR3: ONs trade R$1.5 million per day (last 30 days ADTV), while the PN share volumes total R$123 million (last 30 days ADTV). We believe, that this gap between the two share classes volumes comes from the great difference in the free float of the ONs class 24% vs. 74% of the PNs. In terms of dividends, both classes have the same rights; however, in terms of tag along only the common share has an 80% of tag along right in case of change of control GERDAU SA is listed at level I in terms of Corporate Governance BMF&Bovespa. Thus, under our valuation model, we reach a price target for ON assuming a discount of 25% over PN (average discount of the last 5 years: ~30%). GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 62

63 V. GERDAU Operations GERDAU currently has 46 steel mills in four regional business divisions; the company has a nominal capacity of 25.3 million tons per year of crude steel. The largest part of this capacity is located in North America (10.5 million tons), followed by Brazil (9.2 million tons), special steel (3.1 million), and South America (2.4 million). Business Divison - Breakdown (2015) Business Unit Installed capacity (ktons) Utilization rate % of total revenues % of steel shipments North America 10, % 38.8% 35.6% Brazil 9, % 29.1% 36.8% Special Steel 3, % 19.9% 14.9% South America 2, % 12.2% 12.7% 25, % Source: GBM with company data GERDAU s main products are long rolled products (rebar, merchant bars, wire rod and profiles), which are used mainly in the construction and manufacturing industries. In addition, the company produces galvanized wire, wire mesh, nails, clamps, and fences. Despite being almost totally focused on long steel, GERDAU also has a hot rolling coil mill with a capacity of 800ktpy in Ouro Branco (MG). Moreover, GERDAU resells flat steel products from other producers, to which the company adds value at its flat steel service centers. Moreover, seeking to increase its participation in flat products at the end of 2013, the company decided to produce heavy plates, at the Ouro Branco plant located in Brazil. So far, production has not started, yet it should begin this year (3Q16), adding 1.1 million tons of capacity. Last, but no less important, GERDAU has a relevant special steel production. The company manufactures engineering steel (SBQ), stainless steel, rolling mill rolls, and engineering steel pieces, mainly serving the auto industry. GERDAU concentrates its production on the mini-mill concept, where the mills are equipped with electric arc furnaces (EAF) that can melt scrap; these plants in general have a small nominal capacity (~500-1,000 ktons) and are designed to meet the local market s needs. This strategy was implemented in Brazil and the US, due to the large geographic distances of these countries and thus, high freight costs. GERDAU s mini-mills main input is scrap and a mix of pig iron, depending on market and technical conditions. Despite this mini-mill nature, GERDAU has a significant integrated mill capacity, located in Brazil, in the Ouro Branco plant, the largest of the group, with a nominal capacity of 4.5 million tons. Integrated plants produce steel by the direct reduction of iron-ore in its blast furnace. The main inputs for these mills are (i) petroleum coke, which is domestically provided, (ii) coal imported from Colombia, USA and Canada; (iii) ferroalloys purchased mainly from local suppliers; and (iv) iron ore, which is sourced both from large mining companies and internal supply. Another important component in production costs is energy, as steel production is an energy-intensive process, especially at mini-mill plants which demand roughly 500kw to produce 1 ton of steel. GERDAU s own hydroelectric plants supply roughly 40% of the total energy demand. However, this strategy is only present in Brazil, where the company has two power generation hydroelectric plants: i) Dona Francisca Energetica DFESA (125 MW), where the company owns 51%; and ii) Cacu and Barra dos Coqueiro (155 MW), where GERDAU has total control. In addition, GERDAU has the possibility of building another plant Cachoeirinha and Sao Joao complex with an expected nominal capacity of 105 MW; however, the project is currently stopped due to environmental issues. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 63

64 Brazilian Unit The Brazilian business unit has a nominal capacity of 9.2 million tons of finished steel products, divided into 12 steel mills distributed in the main industrial regions of Brazil. However, GERDAU has a larger production concentration based in the Ouro Branco (MG) plant, which is actually the largest plant of the group with a capacity of 4.5 million tons of crude steel; the plant operates using blast furnace technology. Due to this large plant, Brazil concentrates the demand for coal, coke, and iron ore. These raw materials are partially supplied internally by subsidiaries of the group. This upstream strategy was implemented during the commodity boom, seeking to reduce exposure to the cycles. Because of this integrated system, the Brazilian unit has historically presented the group s highest profitability margin. GERDAU is the largest Brazilian long steel producer with a 49.6% market share, according to IaBr (Brazilian Steel Institute). Net Revenues & EBITDA Margin Figures in millions of R$ Source: GBM with company data Production & Sales Volume Figures in thousand tons However, despite its leadership in long steel, the unit was affected by the tough macro scenario in Brazil. During 2015, sales volumes decreased 1.9%, reaching 6.5 million tons. On a positive note, GERDAU s sales fell considerably less than the domestic long steel demand (-14.4%). The sound advance in exports compared to 2014 was due to a more favorable exchange rate during 2015, and also to the group s greater operating flexibility, which allows it to distribute its production among its regional businesses. Lower average realized price per ton R$2,010 vs. R$2,250 in 2014 also affected in the equation. On the other hand, COGS dropped at a slower pace than steel prices, compromising the unit s gross profitability. Lower utilization rate capacity which, at the end of the year, was 69 vs. 72% in 2014, also resulted in a lower fixed cost dilution, compounded with extraordinary costs related to production stoppages, which amounted to R$229.8 million in Source: GBM with company data Utilization Rate Figures in million tons Going forward, we expect a recovery on its Brazilian operations, supported by a recovery of the domestic market after We believe that even a small recovery in the economic front could result in a higher steel consumption multiplier Apparent domestic demand is 29% below its peak ( ) vs. GDP which is only 0.92% below in the same period. Thus, GERDAU s capacity utilization rate should recover, which is an important aspect in order to dilute fixed costs. In addition, a better macro perspective could translate into higher price premiums (vs. external markets) in the local market. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 64

65 North American Unit The North America business unit has a nominal capacity of 10.5 million tons of finished steel products, divided among 16 steels mills distributed in the main industrial regions of the US and Canada. However, GERDAU has a large concentration in the US, predominantly on the east coast, the southeast, and the Midwest of the country. Net Revenues & EBITDA Margin Figures in millions of R$ The high presence in the country derived from the acquisition of Ameristeel in 1999, and then again in 2002 with the merger with the Canadian company, Co-Steel. After combining both operations, this transformed the North American unit into the largest division in terms of nominal capacity for GERDAU, surpassing Brazil. The region produces exclusively on electric arc furnaces mini mills, where the main raw material inputs are scrap and electricity. However, compared to the Brazilian unit, GERDAU s North American unit is not vertically integrated in energy. Source: GBM with company data Production & Sales Volume Figures in thousand tons During last year, the unit had a different trend from the other units of the group, keeping its recovering trend since However, despite this better performance in terms of profitability, some negative points were also present in 2015, where we can highlight the lower sales volumes (- 4.1%). Volumes were mainly pressured by the imported material in the region, despite the solid demand from nonresidential construction. Notwithstanding this bad performance in terms of volumes, the better operating performance resulted from higher realized prices, which actually transformed the unit into the largest contributor for the group. Coupled with these higher prices, COGs increased at a slower pace than sales prices lower scrap prices contributed largely to this effect, and costcutting efforts also helped. According to estimates made by WSA, US steel demand should increase 3.2% in 2016 and 2.7% in 2017, supported by a robust housing sector and the automotive sector. However, GERDAU should post a slight contraction this year in terms of volumes due to a higher penetration of imports and by GERDAU s strategy to favor margins vs. volumes, which could led to a lower market share. Source: GBM with company data Utilization rate Figures in million tons Going forward, we find several possible triggers for the unit; where the main point for us, is a rebound in the infrastructure sector. Regardless of the winner of the upcoming election in November in the US; the new President is expected to launch a sound budget in the sector. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 65

66 South America - Unit This business has a nominal capacity of 2.4 million tons of finished steel products, divided into 14 steel mills, distributed predominantly in Chile, Colombia, and Peru, which contribute around 80% of the unit s shipments. The rest of the volumes come from Venezuela, Uruguay, and Argentina; the latter has a project to build a new plant with a nominal capacity of 650 ktpy, which should start the production at the 4Q16. South American economies in general expanded at varying rates last year, resulting in different apparent steel consumption in the region. As for the main countries for GERDAU, the highest expansion of apparent demand according to Alacero (Latin American Association of Steel) was Chile (+10%), followed by Argentina (+5%) and then by Colombia (+3%), on the opposite side, Peru contracted 9%. Despite the drop in terms of sales volumes last year (-2.4% YOY), net revenues increased 8% YOY, mainly because of F/X movements against the BRL. Net Revenues & EBITDA margin Figures in millions of R$ Source: GBM with company data Production & Sales Volume Figures in thousand tons Pressure from imported goods in the region is strong. According to Alacero, total import volumes represent 36% of the apparent demand of the region, mostly coming from China. Despite this poor performance in terms of volumes, the better operating performance was the result of higher realized prices (R$2,634 vs. R$2,435 per ton), coupled with a relevant reduction of SG&As (-19% YOY). Thus, EBITDA margin expanded from 9.1 to 13.9%. Going forward, GERDAU should see an increase in Argentina s market share, due to its incremental capacity in the country. Coupled with a better macroeconomic prospect for this country, this should result in positive results. We expect a better performance in the region; we could highlight the expected recovery on Argentina s numbers. In this country, the company should start its brand new plant (650ktpy), which should translate into a higher market share in the country; and secondly, as the macroeconomic environment improves, volumes should increase too. Notably market s consensus expects Argentina s GDP to grow 3% next year. Multiplier should top 2.0x Lastly, we should note that region has a relevant correlation with Brazil s economic activity, the largest economy in the region. This country is a relevant trading partner of other countries in the region, especially Argentina which steel and auto sectors are deeply correlated (roughly 75% of auto exports goes to Brazil). Thus, an envisioned recovery in Brazil, should also to translate into better numbers. Source: GBM with company data Utilization rate Figures in million tons Source: GBM with company data GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 66

67 Special Steels - Unit The special steel business unit has a nominal capacity of 3.1 million tons, divided into 7 steels mills distributed in the main industrial regions of the US, Brazil, and India. This capacity already considers the exclusion of Sidenor s 1 million ton capacity, which on May 20, GERDAU divested for 155 million, plus an additional 45 million, depending on future performance. Last year, the unit was strongly affected by the relevant concentration and depression of the Brazilian automotive sector, main end-user of special steels, and also by poor performance in Spain. Along a different path, North American sales posted a more favorable performance, due to the recovery of the automotive sector there which, on the other hand, was also affected by lower sales to the oil & gas sector. India performed better, actually seeming to keep the positive trajectory going forward as, according to World Steel Association, it should post a significant increase in apparent demand +5.4% YOY in 2016e and +3.1% YOY in 2017e. Overall, despite the mixed trend delivered among its main market regions, the relevant importance and significant contraction of the Brazilian market dictated the overall performance of the unit. Shipments contracted 9.4% in 2015 compared to Net Revenues & EBITDA margin Figures in million of R$ Source: GBM with company data Production & Sales Volume Figures in thousand tons On the other hand, positive F/X and some measures to optimize production, which resulted in a reduction of inventories and some SG&A cuts, were not enough to support EBITDA margin, which decreased 100 bps to 9.6%. Future performance of special steel remains unclear, mainly due to uncertainty in the Brazilian auto sector. Despite this negative outlook in the unit s main market, the sales of special steels destined to North America and India could partially offset this weak performance. Source: GBM with company data Utilization rate Figures in million tons GERDAU s performance in the division remains pressured, mainly by the uncertainty surrounding the Brazilian auto sector, which is still posting weak figures. Moreover, the oil & gas sector is still suffering low oil prices; a situation that significantly impact investments and maintenance in the sector. Moreover, we should recall that volumes should see a strong drop starting in 3Q16, due to the sale of Spain s operations, which represented roughly to 1/3 of the volumes. Nonetheless, despite lower volumes, GERDAU s management expects that the profitability in the division should recover; in this respect, the pain s operations were pressuring with nearly 200 bps the consolidated margin. Source: GBM with company data GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 67

68 GERDAU - Past performance In 2015, GERDAU s main figures were affected by the challenging global macro environment, especially in the Brazil market. However, due to its important regional diversification, the company was in a better position when compared to its mains Brazilian competitors. Consolidated Net Revenues Figures in millions of R$ Net Revenues - Breakdown per regional business Figures in million tons Source: GBM with company data Source: GBM with company data During this tough scenario, GERDAU reduced production and implemented a tight control on SG&As, which dropped 5.4% YOY a notable result compared to the high inflation seen in Brazil (10.67%) last year. The reduction in consolidated production was -6.5%, mainly coming from the weaker Brazilian demand caused by the slowdown in the automotive, construction, and manufacturing industries, main end-user segments for special steels and long rolled steel. The reduction in production led to an adjustment in inventory levels. This wise measure helped GERDAU to unlock a significant working capital amount R$1.7 billion, where this component strongly supported the company s FCF generation. Sales Volumes & Production GERDAU Consolidated Figures in million tons Utilization rate - GERDAU Consolidated Figures in million tons Source: GBM with company data Source: GBM with company data GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 68

69 GERDAU - Past performance COGS Breakdown Steel (2015) Despite all the control measures and reduction of discretionary expenses, COGS posted a 10.6% YOY increase however, if the F/X is excluded, the costs in US$/ton would have posted a -15.2% YOY drop. This reduction shows the relevant management actions; nonetheless, production costs could have presented better figures, if production levels hadn t fallen so much, as they caused a much lower dilution of fixed costs labor, maintenance, and depreciation together represent 40.3% of the total COGS. On the other hand, average realized prices did not grow at the same pace as COGS; consolidated realized prices were R$2,568 per ton (or US$777 per ton) vs. R$2,381 (or US$950 per ton) during 2014, which contributed to the reduction in gross profitability. Source: GBM with company data The North American unit turned out to be the largest contributor in terms of net revenues for the group, corresponding to 38.8% of total revenues. Despite this position, the North American unit posted a contraction of 4.1% YOY in sales volumes, reaching 6.2 million tons of steel. Nonetheless, the strong devaluation of the Real against the USD resulted in a higher value when measured in BRL. However, even excluding the F/X effect, the unit posted sound operating numbers, measured by a significant recovery in gross profit and EBITDA margin +230 and +280 bps, respectively. EBITDA breakdown Figures in millions of R$ EBITDA Jun/16 TTM Brazil 2,220 2,394 2,979 2,815 1,656 1,306 North America 1, ,619 1,678 Special steels 1,158 1, South America (-) Adjustments ,651 4,176 4,784 4,829 4,389 4,333 Mg. EBITDA 12.8% 10.7% 11.7% 11.2% 9.8% 9.9% Nonetheless, despite the sound improvement in the North American unit, the leadership in terms of EBITDA generation still comes from the Brazilian unit. Brazilian EBITDA contribution fell to 12.8% in 2015 (vs. 19% in 2014); the contraction was mainly explained by the decrease in the unit s average realized price of R$2,010/ton in 2015 vs. R$2,250/ton in Moreover, during 2015, the company decided to rearrange two business units, as the iron ore segment was included in the Brazilian business unit, while the Mexican operations become part of the North America business unit. GERDAU announced the acquisition of minority interests equity in some companies of the group. These acquisitions were made for a total of R$2.0 billion. Source: GBM with company data Free cash flow Figures in millions of R$ Free cash flow Jun/16 TTM EBITDA 4,651 4,176 4,784 4,829 4,389 4,333 (-) Income tax (-) CAPEX -1,961-3,128-2,657-2,267-2,325-1,875 (+/-) WC ,551 1, ,701 2,900 FCFF 1, ,932 1,323 3,128 5,014 Source: GBM with company data GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 69

70 GERDAU s debt profile: GERDAU s debt stood at R$20.7 billion at the end of June Most of the debt has a long-term maturity. Most of the debt is denominated in USD (79%), BRL (17%), and other currencies (4%). Thus, considering this high exposure to foreign debt, which is mainly distributed between international bonds (60%) and bank loans (40%), the weighted average interest rate stands at 7.4%, which is relatively lower compared to Brazilian companies. In addition to its lower financial cost vs. its peers, we see that GERDAU has access to a large numbers of financial institutions in the markets where it operates. Currently, GERDAU holds a revolving credit line of US$700 million available for withdrawal in the next 12 months. R$ - million Thereafter Total Current Debt 1, ,959 Non-current Debt - 3,126 1, ,262 10,288 18,715 TOTAL 1,959 3,126 1, ,262 10,288 20,674 Source: GBM with company data GERDAU s debt by currency GERDAU s debt by maturity (%) Source: GBM with company data Source: GBM with company data GERDAU held a net debt/ebitda (TTM) ratio of 3.6x at the end of June 2016, which in itself is a high level compared to the company s historical levels. Although at first glance the number seems to raise an alert, the debt structure mitigates some of the risks, as the debt concentration is heavily focused on the long term (especially after 2018), and financed with a low interest cost. We forecast that GERDAU will reach the peak of its leverage during 1Q17 (3.8x). Thereafter, the ratio will gradually drop. Moreover, foreseeing a higher leverage in the next periods, management took two actions to mitigate the situation: I) it obtained a waiver over its debt covenants; and ii) management started an asset divestment plan. These measures have already borne some fruits. The company recently announced (May 20) the sale of its international operations in Spain, through the sale of its subsidiary Sidenor. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 70

71 Zelotes question: How much could be the loss, if any? On February 24, the company was formally informed that it is being investigated under the Zelotes operation that the Brazilian Federal Police and Public Prosecutors are carrying out. Under the operation, local authorities are studying a potential fraudulent decision taken by CARF (Administrative Council of Tax Appeals) through the payment of bribes to rule in favor of some related companies who appealed to the council. Under the accusation charged against GERDAU there are two legal appeals that the company has made and were previously accepted by CARF the first judgment appeal dates back to 2012 (R$1.3 billion), and the second judgment dates back to 2014 (R$1.9 billion). The origin of this legal dispute was the discussion of the deductibility of goodwill against corporate taxes; in turn, the origin of this goodwill dates back to 2004/2005, when the group implemented a series of corporate restructures among its subsidiaries. GERDAU has defended its position and has reiterated its innocence; in addition, the company declared that it has met all the legal requirements by disclosing all the tax liability appeals in its financial statements. Moreover, due to its confidence in the merit of the tax dispute, the company has not made any provision regarding the subject. In our view, this potential liability could materially affect the company s numbers, although we believe that this legal dispute will take a long-time to be solved, and we find it impossible to quantify potential impacts, if any. Moreover, as seen in similar case, the company could enter into an off-court agreement to repay these taxes, under a very long payment schedule. Nonetheless, assuming that GERDAU will have to pay the whole amount claimed by the authorities R$3.6 billion. Under this theoretical exercise, we discounted this amount from our forecasted Equity Value at the end of 2017; which is R$21.5 billion. Consequently, this potential claim could reduce by 17.8% our target prices, resulting into alternative prices of R$7.94 for GGBR3 and R$10.57 for GGBR4. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 71

72 Ownership structure GERDAU is one of the oldest companies listed in the BMF&Bovespa. Its inception dates back to 1947, when the company was listed on the Porto Alegre Stock Exchange. After many corporate restructures since its inception, the company has a structure where the holding company, Metalurgica Gerdau, which is also a public company, controls GERDAU with 65% of the voting capital shares. Both listed companies have common (ON) and preferred shares (PN). Common shares have voting rights, while preferred shares have specific rights assured under the company s bylaw, including a preference in the reimbursement of capital in case of liquidation. Both GERDAU SA and Metalurgica Gerdau SA are listed at level I in terms of Corporate Governance BMF&Bovespa. In addition, GERDAU is listed in ADR program level II and Latibex Spain. The final indirect control over the group is held by the founding family, Gerdau. Nowadays, the family is in the third generation, led by the current CEO/Chairman, Andre Gerdau, who took over the position from his father, Jorge Gerdau, who still carries the image of the group in the media. GERDAU and Metalurgica Gerdau do not have any shareholder agreements established; thus, as mentioned before, the final control over both companies is in the hands of the Gerdau Family. Management Although the family has control and carries some weight in management, the top management mainly comprises executives from the market, and only a few names in the family have key positions in the company. In terms of corporate governance, under its bylaws, the Board of Directors shall be comprised of three to eleven members, with a mandate of one year, and reelection permitted. The currently body has six members, all of whom are appointed by the controlling group. Although the Board of Directors is the last instance of decision, GERDAU has implemented an Advisory Council since March Under this new committee, which includes Jorge Gerdau Johannpeter, Klaus Gerdau Johannpeter, and Frederico Gerdau Johannpeter second family generation the company complemented the decision-making and transmits management experiences acquired over the decades to new generations. Executive André Bier Gerdau Johannpeter Claudio Johannpeter Peter John Campo Guilherme C. Gerdau Johannpeter Manoel Vitor de Mendonca Filho Francisco Deppermann Fortes Harley Lorentz Scardoelli Position CEO Vice-President (Brazil unit) Vice-President (North America unit) Vice-President (Special Steels unit) Vice-President (South America unit) Vice-President (Administrative, TI, HR e etc..) Vice-President (Treasury, Accounting and IR) Source: GBM with company data GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 72

73 Board of Directors Claudio Johannpeter Chairman. Bachelor s in Metallurgical Engineering by the University of Rio Grande do Sul. Abroad, he took several courses, such as Executive Development at Penn State, Advanced Management Program at Harvaard, and Operations Management at University of London. Mr. Claudio Johannpeter, has worked in Gerdau since Andre Bier Gerdau Johannpeter CEO/Board member. Bachelor s in Business Administration by Pontifica Universidade Catolico do Rio Grande do Sul. He also took General Business Administration at Toronto University, and Marketing at Ashridge and Advanced Management Program at Wharton School. He has worked in Gerdau since Richard Chagas Gerdau Johannpeter. Bachelor s in Law by the Federal University of Rio Grande do Sul, and MBA at Stanford Graduate School of Business. He has worked Gerdau since Affonso Celso Pastore. Graduated in Economics at the University of Sao Paulo, where he also took a PhD in the same field. He is currently Professor at Fundacao Getulio Vargas and independent consultant. He worked as Finance Secretary of the state of Sao Paulo and Chairman of Brazil s Central Bank. Expedito Luiz. Bachelor s in Law by the Federal University of Rio Grande do Sul, Master in Law by Columbia Law School. He works in Gerdau since Fernando Fontes Iunes. Graduated in Civil Engineering by Mack University and obtained the title of MS and PhD from the University of London (UK). Advisory Council Jorge Gerdau Johannpeter. President. He holds a degree in law from the Federal University of Rio Grande do Sul. He started his career as apprentice in 1954 and became the CEO in He has served on the board of directors since Germano Hugo Gerdau Johannpeter. He holds a degree in business administration from Getulio Vargas Foundation. Mr. Germano has served as board member since 1973, and in 2002, became the Vice Chairman of the board. Klaus Gerdau Johannpeter. He holds a degree in civil engineering from the Federal University of Rio Grande do Sul. Mr. Klaus has served as board member since 1973, he also served as board member of company Seiva SA Florestas e Indústrias. Frederico Carlos Gerdau Johannpeter. He holds a degree in business administration from the Pontifica Universidade Federal do Rio Grande do Sul and a master s degree in business, finance, costs, and investments from the University of Cologne, Germany. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 73

74 GERDAU s Timeline GERDAU was founded by Hugo Gerdau with the Pontas de Paris Nail Factory in Porto Alegre. Curt Johannpeter, sonin-law of Hugo, takes the helm of the company and oversees a decisive phase of business expansion. Steel production begins in Porto Alegre, using the conception of the mini-mill The second Riograndense steel production unit starts operations in Sapucaia do Sul GERDAU start sto produce steel in the Northeast and Southeast regions of Brazil. Innternationalization began with local production in Uruguay. The '80s also marked a significant expansion of operations in Brazil, mainly through GERDAU entered into the US market, through the Ameristeel acquisition; in the same year, Gerdau S.A. become publicly traded on the NYSE GERDAU bought mining rights from Grupo Votorantim located in Minas Gerais ans starts its own iron ore Source: GBM with company data GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 74

75 Organizational Structure Source: GBM Research with Company reference form version 5 GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 75

76 What s steel Steel is a metal that results from the alloy of iron and carbon, containing, on average, around 98% of iron (Fe) and up to 2% of Carbon (C), although sometimes other minerals such as molybdenum, manganese, and zinc are added to improve its qualities. There are many kinds of steel, though for this thesis, we will divide them into two large categories: flat steel and long steel. Many cultures have produced steel, but a British inventor (Henry Bessemer) formerly used the first technique to produce steel back in the 1850s. There are more than 3,500 different grades of steel with many different physical, chemical, and environmental properties. It is estimated that 75% of modern steel was developed in the past twenty years. Steel is completely recyclable, as its properties remain unchanged as time goes by. The steel industry is the second biggest industry in the world, after oil and gas, with an estimated global turnover of US$900 billion; in addition, the housing and construction sector is the largest consumer of steel nowadays, using ~50% of the steel produced. The automotive sector accounts for 13% of the steel industry, mainly due to modern cars, which are built with new steels that are stronger, but 35% lighter than in the past. Thus, steel is the material of choice because of its strength, ductility, and versatility; the steel industry invests over 80 million Euros in research projects for the automotive sector, in order to meet customer demand. Car composition Global steel uses Mechanical machinery 16% Construction 50% Metal Products 10% 1,620 Mtons steel produced in 2015 Automotive 13% Other transport 5% Electrical equipment 4% Domestic appliances 2% Source: GBM Research with data from WSA Steel vs. Aluminum in the auto industry Source: GBM Research with data from WSA 208 Kg is the world s average steel use per capita in It has increased from 140 Kg in Source: GBM Research with data from WSA GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 76

77 How steel is made Main production methods: Blast Furnace: In this method, iron ore is placed along with coke and additives in the top of a large structure (around 25 meters long). Underneath, blasts of heated air are introduced into the furnace which, when mixed with coke, create the necessary heat to melt iron ore and release the oxygen in this mineral during the process. Afterwards, the molten steel is accumulated at the bottom of the furnace to be processed further. Lastly, by using the continuous casting methods, it is turned into slabs. Electric Arc Furnace: First, the furnace is heated with the aid of electricity. After it reaches a certain temperature, scrap is poured through an open compartment in the top, along with some other ingredients, such as ferroalloys, ores, and other fluxes. Finally, this method turns into billets and thin slabs. Blast Furnace Process Electric Arc Process Iron ore, coke and additives are introduced into a large structure 1 2 Hot air and coke make iron ore to melt and lose oxygen Scrap is placed into a furnace, previously heated with electricity 1 Scrap is 2 mixed with ferroalloys, ores and some other fluxes The steel remains at the bottom of the furnace and it is processed 3 Steel is obtained, in some cases, in less than two hours 3 Source: GBM Research with data from WSA Source: GBM Research with data from WSA The process to produce steel consists in three basic stages: reduction, refining, and lamination. The basic difference between integrated mills and mini-mills is based on the reduction phase, and on the inputs used. An integrated mill uses iron ore, coal, and coke to produce pig iron and then steel. Semi-integrated mill operates the two final stages, and starts production with pig iron or metallic scrap. Raw materials have an important role in the steelmaking process, the main inputs used in the process are iron ore, coal, coke, and scrap. BOF Cost Breakdown (Inputs) Iron Ore 38.7% Coke 21.3% Scrap 10.2% Oxigen 1.3% Fluxes and Ferroalloys 9.3% Others 13.6% Energy 2.3% Labour 3.3% Source: Steel On The Net, GBM Research EAF Cost Breakdown (Inputs) Scrap 76.3% Fluxes and Ferroalloys 5.3% Electrodes 1.8% Other Costs 6.3% Energy 7.7% Labour 2.6% Source: Steel On The Net, GBM Research GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 77

78 Global steel supply Top 15 steel-producing countries in 2015 Figures in Mtons Source: GBM Research with data from WSA Global crude steel production Figures in Mtons Source: GBM Research with data from WSA Global crude steel production decreased 2.8% YOY in The slowdown was mainly driven by a slight contraction coming from China (-2.3% YOY), as the country is the main driver of global production worldwide; China remains the largest steel producer accounting for ~49% of the world s production or (804 Mtons 2015). In the last ten years, China has turned into the world s major power in the steel industry, boosting both demand and production. During this period, the global steel production presented a CAGR of 3.5%, while China achieved a striking CAGR of 8.5% ( ). Looking ahead, China will continue to drive the world s steel production. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 78

79 Crude steel production per main countries 2015 World total: 1.62 billion tons 2.2% 6.3% 10.2% 5.8% 12.6% 6.8% 6.5% 49.6% Source: GBM Research with data from WSA Others EU (28) Other Europe CIS NAFTA China Japan Other Asia Others Comprise: Africa: 0.8%% Middle East: 1.8% Central & South America: 2.8 % Australia and New Zeland:. 0.4% According to the World Steel Association, China s output decreased 2.3% in 2015 compared to While the rest of the world s production decreased 2.8% in WSA expects China s production to remain flat for 2016, while the rest of the world s production should post mild contractions between 1 and 2%. We are more conservative regarding China s growth, as it has entered into a slower phase of steel demand, pressuring the country s supply; thus, in the first seven months of 2016, Chinese crude steel production has decreased 0.5% YOY, affecting the world s production (-1.2%) As such, we expect a slight 1.5% contraction in the world s steel production in 2016, while for , we estimate an expansion of 1% per year, delivering a 3.8% CAGR from 2012 to All in all, crude steel production worldwide should reach 1.66 billion tons in 2018, and by 2050, steel use is projected to increase 1.5 times higher than present levels, in order to meet the needs of the world s population. The steel industry currently operates with a capacity utilization rate of 69%, which highlights the global oversupply an industry concern since Looking forward, the industry is likely to remain in structural surplus. We believe capacity utilization will remain close to current levels, preventing a rebound in prices; for this year and 2017, we estimate a capacity utilization of 70%. Crude steel production development and capacity Figures in billion tons % 82% 72% 77% Source: GBM Research with data from WSA 80% 76% 77% 74% 69% Crude steel production capacity World including China World production (excluding China) China's production Crude steel production utilization 90% 85% 80% 75% 70% 65% GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 79

80 Global steel demand Apparent finished steel consumption growth World and China World total: 1.5 billion tons Finished steel consumption per region World total: 1.5 billion tons 30% 25% 20% 15% 10% 5% 0% -5% -10% 9.6% 8.6% 10.9% 6.7% 6.9% 0.2% 23.5% -6.3% 13.9% 6.5% 9.2% 7.9% 3.0% 1.9% 11.4% 6.2% 1.0% -3.0% -3.4% -5.4% -0.9% 0.4% -4.0% -2.9% e 2017e World China 3.3% 10.2% 9% 3% 2.6% 16.2% 3.5% 44.8% EU CIS NAFTA Central and South A. Africa China Middle East Asia (w/o China) Others Comprise: Australia and New Zeland:. 0.5% Source: GBM Research with data from WSA Source: GBM Research with data from WSA The steel industry presented sharp growth for several years. Now, it faces a new normal of low growth was the first year with negative demand growth since For two consecutive years, China has been delivering YOY contractions in its apparent steel consumption; a depressed real estate market, coupled with a slower than expected progress on infrastructure projects, caused a sharp slowdown in the construction sector, leading to 3.4 and 5.4% YOY contractions in China s apparent demand in Moreover, we forecast a contraction of 4 and 3% for China s demand for 2016e and 2017e. Furthermore, developed economies performed below potential (-4% YOY) during 2015; however, this trend is likely to be reversed in 2016 and 2017, delivering a slight 1.5% YOY increase. All in all, the outlook for 2016 and 2017 remains complicated and we maintain a neutral view. The WSA forecasts a 0.8% YOY drop in 2016; nonetheless, this trend should be reversed by 2017, with a 0.4% YOY increase, leading demand to reach 1,494 Mtons by then. Global crude steel consumption worldwide Figures in billion tons Regional short range outlook (Apparent steel use of finished products) Figures in Mtons Source: GBM Research with data from Bloomberg and WSA Region 2015 YOY% 2016e YOY% 2017e YOY% Other Europe % % % Africa % % % Central/South Ameri % % % CIS % % % Middle East % % % NAFTA % % % European Union % % % Asia and Oceania % % % World 1, % 1, % 1, % Source: GBM Research with data from WSA GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 80

81 Regional Trade Regions with deficit vs. regions with surplus (crude steel) Figures in Mtons Source: GBM Research with data from WSA In 2015, global demand for finished steel, decreased 3% vs. 2014, amounting to 1,500 Mtons. China s apparent demand was mainly behind this effect, as consumption came to Mtons (-5.4% YOY). In 2014, the steel market delivered a 7.27 Mton surplus, mainly due to Asia, which delivered 66.3 Mtons of extra crude steel production. Chinese steel production represents ~70% of the Asian continent, and around 49% of the global market for steel. In 2014, China posted a surplus of 82 Mtons, while Japan also reported a double-digit figure of 37 Mtons; in addition, Ukraine, Russia, and the other CIS countries presented a surplus of 43 Mtons in the same year. Moreover, the European Union presented a surplus of 6.2 Mtons, mainly due to higher production from Germany (the largest steel-producing nation in the EU). Regarding the United States, we saw a strong 10% YOY contraction in apparent steel use during In the previous year, the US posted a deficit of 33 Mtons, accounting for ~69% of North America s steel deficit (48.4 Mtons). Lastly, Mexico s deficit stood a 6.6 Mtons in the same year; since 2000, Mexico has presented a deficit in its steel trade balance. What s more, South America also posted a deficit of 5.6 Mtons. Brazil s surplus (5.4 Mtons) wasn t enough to offset the deficit coming from Peru, Venezuela, Colombia, and Argentina, among others. Moving on to Africa and the Middle East, both regions presented a deficit of 25 and 27 Mtons, respectively. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 81

82 China s steel situation China s apparent consumption YOY% China s steel demand: breakdown % 60% 40% 20% 0% -20% -40% -60% -80% Finished Steel demand Finished Steel production Finished Steel imports Finished Steel exports Source: GBM Research with data from Bloomberg Source: GBM Research with data from Bloomberg So far this year, Chinese steel exports have accumulated a 9% increase in the first seven-months of the year; on the other hand, steel imports have decreased 3% YOY, resulting in a 4.2% contraction in China s apparent demand. In addition, the world s largest steel consumer has experienced lower steel production (-2.5% YOY), mainly due to a lower than expected economic growth, coupled with a strong surplus in the steel market. Chinese figures 1H16 Furthermore, one third of China s steel output is used for infrastructure, so a sharp fall in investment will cut steel use. The construction industry accounts for 74% of the country s total steel consumption; this division only represented 63% of China s steel demand back in It is clear how China Source: GBM Research with data from Bloomberg is suffering from excess steel capacity, and the government is working to remove it; the real estate and the infrastructure industries alone represent the same amount of steel used by Russia, India, Japan, the US, and Korea. Chinese steel demand vs. other countries demand 2014 Figures in Mtons Real State 95 Infrastructure 298 Others Source: GBM Research with data from CRU 125 Export Chinese steel consumption 700Mt Countries demand Korea Russia India Japan US Per Capita consumption in China Source: GBM Research with data from CRU > 360 kg > 220 kg, <360 kg < 220 kg GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 82

83 World cost curve for liquid steel (by plant) Figures in Mtons Operating cash cost (US$/ton) Cumulative production (Mtons) Q e Crude steel price Source: GBM Research with data from Wood Mackenzie World cost curve for finished steel (by plant) Figures in Mtons Operating cash cost (US$/ton) 1, Cumulative production (Mtons) Q e Crude steel price Source: GBM Research with data from Wood Mackenzie The world cost curve has flattened substantially since the peak cost period in 2011, primarily due to a weakening of raw material prices. A flattering cost curve also promotes increased competition and delays in production; these factors have pushed down the top end of the cost curve. The position of the marginal producer can rapidly change, due to changes in cost of capital, efficiency in operations, and currency movements; hence, the liquid steel cost curve has adjusted downwards 22% from 2014 to 2015, while in the last six months we have seen an adjustment of -8.5%. Cost inflation has been higher in emerging markets, while steel producers from the CIS (Commonwealth of Independent States) occupy the bottom of the cost curve, because of their integrated mining operations. Despite a decline in costs, steel producers from Japan and South Korea remain in difficult positions; China has managed to decrease its production costs. Furthermore, North America s BOF costs have increased considerably in 1H16. Most of the European and Chinese companies are positioned at the end of the cost curve; in addition, BOF steel costs are 14 and 17% lower compared to North America and China. We must note that EAF and BOF steel costs vary in each country, due to raw material prices, energy prices, labor, and currencies. BOF Steel Costs Figures in US$/tons Europe North America China Source: GBM Research with data from Bloomberg EAF Steel Costs Figures in US$/tons Europe North America Source: GBM Research with data from Bloomberg GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 83

84 World operating cash cost curve (2016) Operating Cash Cost (US$/ton) Operating Cash Cost (US$/ton) Operating Cash Cost (US$/ton) Operating Cash Cost (US$/ton) Cumulative production Mtons Crude Mexico Argentina Brazil Cumulative production Mtons Finished Mexico Argentina Brazil Cumulative production Mtons Semi-Finished Mexico Argentina Brazil Cumulative production Mtons Hot-Rolled Coil Mexico Argentina Brazil HRC US$/ton (US) Source: GBM Research with data from Wood Mackenzie GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures Crude Steel Finished Steel Semi-Finished Steel Hot-rolled Coil Cash Cost Distribution Cash Cost (US$/ton) Percentile US$0 - US$255 55% US$255 - US$290 25% US$290 - US$396 20% Brazil has a clear advantage in crude steel, with a cash cost of US$/ton, standing below the 45% percentile among all of the countries in the curve. The total weighted average cost per ton stands at US$260, which is mainly influenced by China, given its low ~US$238 cash cost. Cash Cost Distribution Cash Cost (US$/ton) Percentile US$0 - US$325 50% US$325 - US$385 30% US$385 - US$460 20% For finished steel, Mexico is positioned as the third country with the lowest cost of production (US$309), standing behind China and Russia. In addition, Mexico comes in as part of the lower 47% percentile. The weighted average cost in this segment stands at US$335 per ton. Furthermore, around 50% of the world s finished steel is produced below a cash cost of US$325. Cash Cost Distribution Cash Cost (US$/ton) Percentile US$0 - US$276 50% US$276 - US$310 30% US$310 - US$415 20% Regarding semi-finished steel, China remains positioned as the second most profitable country, with a US$252 cash cost. The world s weighted average stands at US$415 per ton. Argentina is located in the 81% percentile, driven by a US$315 cost. Interestingly, 50% of the world s semifinished steel is produced below US$276; Mexico and Brazil are below this figure. Cash Cost Distribution Cash Cost (US$/ton) Percentile US$0 - US$336 60% US$336 - US$395 20% US$395 - US$460 20% Lastly, hot-rolled coil weighted average cost is around US$335 per ton. Surprisingly, Mexico is positioned in the second place, with a US$285 production cost; Brazil is positioned below. Moreover, Argentina is positioned in the 76% percentile and 15% above the world s average cost. 84

85 Brazilian Steel Industry Brazil s steel industry has 29 mills 14 integrated and 15 semi-integrated with an installed capacity of 48.5 million tons of crude steel per year, through 11 business groups: Aperam, ArcellorMittal Brasil, CSN, GERDAU, SINOBRAS, Thyssenkrupp CSA, USIMINAS, VSB Tubos, Vallourec, Villares Metals, and Votorantim. Brazil s steelmakers - Geographic distribution These companies have a strong concentration in the Southwest region where the production is more focused on flat than long steel. The major producers in terms of volumes are integrated mills, which represent 38.5 million tons of installed capacity, compared to a 10 million tons capacity of semi-integrated mini-mills. High presence of integrated mills is justified by iron ore availability in the country. Brazilian steel production totaled 33.2 million tons last year, representing a 2.1% YOY decrease, with a utilization rate of 68%. The sector has been operating at a slow pace and has presented a drop in production in the last 4 years. Production peaked at 35.2 million tons in Despite the slower pace in production, Brazil retains the 9 th position in terms of global production. The domestic market is mainly served by local steel production. Notably, since 2005, Brazil has presented a positive trade balance for steel. This positive balance seems to support the current domestic contraction, shifting partially from domestic to external markets. The Brazil Steel Institute (IABr) estimates a crude steel production drop of 6.8% for this year, reaching 31.0 million tons. Ranking-largest producers of crude steel 2015 Source: GBM Research with data from IABr Brazil crude steel production & installed capacity Figures in Mtons Brazil breakdown finished steel production Figures in Mtons Source: GBM Research with data from IABr Source: GBM Research with data from IABr GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 85

86 Brazilian demand Apparent steel consumption (national production + net imports +/- inventories) peaked in 2013 at 26.4 million tons. During that year, Brazil s GDP rose 2.7% YOY. Brazil s apparent consumption is highly concentrated in four end-user segments: Civil Construction (37%), Automotive (22%), Capital Goods (20%), and Domestic Appliances (6%). Brazil s apparent consumption Figures in Mtons The tough domestic macro scenario since 2013 severely affected by the fog environment low business and individuals confidence dragged down the results of these four end-user segments. Consequently, domestic steel demand dropped 6.8% YOY in 2014 and 13.1% YOY in However, on a positive note, this year could be the bottom of the cycle, as we are foreseeing an inflection point in Our optimistic view for next year is based on a soft comparison base, coupled with an economic turnaround in Brazil, Despite this plunge, the outlook remains very challenging and will probably persist this way in the current year as apparent demand has dropped 14.3% TTM, at the end of July. Notably, apparent steel consumption is accumulating a drop of more than 30% over the historical peak reached in According, to the Brazil Steel Institute (IABr), domestic apparent consumption may decrease 14.4% YOY in 2016, reaching just 18.2 million tons mainly driven by political changes that could trigger a relevant recovery in business confidence. In light of this, the steel sector could be widely leveraged on this potential recovery. A small recovery on the economic front could result in a much higher steel consumption during the first years of that recovery one example: Apparent domestic demand has dropped 29% since its peak ( ) vs % GDP in the same period. Source: GBM Research with data from IABr Brazil s demand by end sector Source: GBM Research with data from IABr Brazil steel use per capita vs. GDP capita For the long-term outlook, we expect a good recovery in terms of volumes across the industry, based on better economic performance and low steel per capita usage in Brazil. Source: GBM Research with data from WSA GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 86

87 Civil construction The sector represents 37% of the total demand, and is the major consumer of long steel wires, bars, truss frame, and nails. Brazil s civil construction presents a cyclical trend linked to main macroeconomic variables: credit, unemployment rate, wage growth, consumer confidence, and the growth of new families. Thus, following all the good macroeconomic conditions in the past years, civil construction presented a strong growth pace during However, due to the worsening of the macro outlook, the sector was heavily impacted, resulting in weak conditions for new housing starts. According to SECOVI-SP, the launches of new houses posted a drop of 31% at end of 2015 in the Region of Sao Paulo; moreover, the results are still indicating weak numbers, where the latest data (June) suggests that launches have dropped 17% YOY in the last twelve months. Another subdivision in the civil construction segment is infrastructure, which seems to be even in a worse situation. The industry has been highly affected by the political scandal Lava Jato, which linked big names in the sector and forced the public sector to reduce new contracts. Lava Jato s investigation has been underway since March 2014, and is still releasing new relevant facts day-by-day. In our view, the poor performance in the sector should continue in the short term, especially this year. Nonetheless, our perception is that the sector could present better results beyond 2017 soft base and recovery of confidence in the sector. In addition, for the medium/long term, it seems to us that this sector has a better outlook some old opportunities still exist on paper. House Deficit: According to IPEA (Institute of Applied Economic Research) Brazil has a deficit of 5 million houses. House units launched-sao Paulo Region Figures in thousand units Source: GBM Research with data from SECOVI-SP Brazil s construction survey (FGV) Figures in units Cement sales (TTM) Figures in Mtons Lack of investment in infrastructure: Brazil suffers from the historical lack of infrastructure, which affects all the sectors of the economy. Currently the ratio of Construction to Total GDP, stood at 5.4%. Source: GBM Research with data from FGV (IBRE) Source: GBM Research with data from SNIC GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 87

88 Automotive sector The sector is an important end-user of steel. Producing one vehicle (light), on average, requires a consumption of 700 kilos of steel, according to World Steel Statistics. Thus, at the end of 2015, the automotive sector represents the second largest sector in steel consumption in Brazil, with 22.2% of the total (mainly flat steel). Given this high interdependence, the peak of the sector matched the peak of steel demand in The automotive sector has had a robust growth pattern in the last years from 2005 to 2013 where the vehicle production increased at a 5.5% CAGR. However, this trend was reversed in 2014, when the production fell 15.1% YOY and exports plunged 39.2% YOY; in 2015, production again dropped 23.5% YOY. In addition to the macro situation, the sector has an even higher risk factor, explained by the fact that vehicles are durable goods and require a high amount of capital to purchase. According to Brazil's National Association of Automotive Vehicle Manufacturers (Anfavea), 63% of vehicle sales are made with some financial help. However, high delinquency rates, driven by high leverage and by increasing unemployment rates, led Brazilian banks to shrink credit volumes considerably, affecting the sector. Brazil Total production of vehicles Figures in thousand units Brazil Total registration of new vehicles Figures in thousand units Source: GBM Research with data from ANFAVEA Source: GBM Research with data from ANFAVEA The outlook remains tough for this year. Up to July, the number of vehicles produced has dropped 12.9% TTM compared to the numbers of 2015, and registration of new vehicles has decreased 21.2%. According to ANFAVEA estimates, production may decrease 5.5% YOY in 2016, reaching 2.3 million units, and the sales of new vehicles could contract 19% YOY. Given this disappointing outlook, our perception is still bearish in the short term, despite the sector s already low levels. The sector could present better results (recovery pattern), but the economic environment weighs against it. However, in our view, a potential turnaround could be achieved by higher exports, which already posted a recovery last year (+16.1% YOY) and keep increasing (+11.0% TTM July 2016). On the other hand, the recent revaluation of the BRL could partially offset this situation. Lastly, another positive trigger could be the recovery of Argentina Brazil s largest historical partner, which currently correspond to roughly of 76% of the total vehicles exports. The capital goods & home appliances segment is highly correlated to gross fixed investment, which continues on a downtrend in Brazil. In 4Q15, gross fixed investments disappointed for the seventh consecutive quarter, falling by a sharp 18.5% YOY the worst performance in 19 years. Thus, investments dropped 14.1% YOY in 2015, also marking the sharpest fall on record. Along the same vein, home appliances follow the same poor trend ( 8.7% YOY). GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 88

89 Brazil Vehicles inventories Figures in thousand units Brazil Vehicles imports volumes Figures in thousand units Source: GBM Research with data from ANFAVEA Source: GBM Research with data from ANFAVEA Brazil National fleet & per capita Figures in thousand units Brazil Total production of vehicles Figures in units Source: GBM Research with data from ANFAVEA Source: GBM Research with data from ANFAVEA GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 89

90 FX & Trade Balance Brazil s domestic market is mostly served by the local steel production, whereby 55% of total steel production is destined to the domestic market. Since 2005, Brazil has presented a positive steel trade balance; in 2015, Brazil exports totaled 13.7 million tons (+40.3% YOY), while imports reached 3.2 million tons (-19.3% YOY). Imports versus exports Figures in Mtons The latest updates (July 2016) published by IABr are also indicating that the positive trade balance remains, despite the high volatility and sound recovery in BRL. Exports showed an increase of 2.8% YTD, while imports showed a contraction of 46.3% YTD. Despite the lower levels of steel imports, imports penetration translates into 9.4% of apparent consumption. Imports share remains close to the average of 11.7%, recorded in the last 12 years. Under this rationale, coupled with the tough outlook for Source: GBM Research with data from IABr it, the Brazilian steelmaking sector has historically pressured the Federal Government for a hike in tariffs over Brazil s top export countries 2015 imported steel. Most of the imports come from China (38%). Currently, import duties on steel stand between 10 and 14%, depending on the steel products. The sector claims an additional increase of 2-4%. We assume no changes coming from this side in the short term, keeping in mind that the drop in imports and the rise in exports have been driven by the strong devaluation of the BRL over the last 2 years. We believe that the most likely scenario is that tariffs will not be raised in Brazil; however, we might see some positive implications for domestic steelmakers if any action of this kind is taken. The rationale would be that despite the current low penetration, the action could trigger a potential increase in domestic steel prices, recovering some of the profitability for the industry. Source: GBM Research with data from IABr Brazil top import countries 2015 On the other hand, the recent antidumping charges against Brazilian imports in the US, which increased its tariffs to 7.2%, could partially affect a recovery in the area. Source: GBM Research with data from IABr GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 90

91 Domestic vs. import parity Despite the low levels of steel imports, direct imports play an important role in the Brazilian steel market, especially as a driver of local prices. Domestic pricing is based on the cost to import steel plus a premium or a discount, which includes all the direct and indirect costs freights, insurance costs, internal transportation, storage costs, and interest rates measured as costs of opportunity. A stronger BRL jeopardizes steel producers, as imported steel becomes more attractive. To avoid losing market share, local players might match the same international prices which, in consequence, reduce their profitability or may even result in a loss. Historically, the premium or discount of imports vs. Brazilian domestic prices followed the same correlation as the apparent domestic demand; when Brazilian steel demand is growing, the premium charged by Brazilian steelmakers tends to increase, due to the more favorable situation. However, this rationale could be shortly violated due to some arbitration proceedings. We must mention that some niche products with high added value (for example, cold rolled sheets and galvanized sheets) maintain historically higher premiums. In addition, imports in general are more focused on flat steel than long steel, due to the difficultly in shipping long steel products, and also, to several different specifications depending on the markets. On a separate note, imported steel to be used in Brazilian civil construction must be certified by a Brazilian association ABNT. Overall, the weak performance in the domestic environment, coupled with the low level of utilization at the main steel mills in Brazil, would likely cause premiums to remain in the low single-digit range. Lastly, another external factor that may pressure prices is related to global competition which, according to WSA (World Steel Association), is currently operating with an overcapacity of 700 million tons mainly in China. Estimates of domestic premium/discount in Brazil - Figures in US$ International HRC export price (FOB) 350 Ocean Freight (from Europe) 35 HRC C&F Brazil port 385 Insurance (0,5%) 2 CIF Price 387 Import tax (12%) 46 Port Expenses 15 Working Capital 22 AFRMM Tax 10 Domestic Freight 25 Others (Letter of credit exports, storage) 15 (1) Price for imported HRC in Brazil 520 FX - BRL/USD 3.20 (1) Delivered Product - HRC price (R$/ton) 1,665 (2) Domestic Reference Steel Price (R$/ton) 1,750 Premium 5% Source: GBM Research with data from IABr Sensitivity analysis-import parity BRL/USD FOB Price - HRC (China) USD/ton # % 27% 21% 16% 11% 7% % 19% 13% 8% 4% 0% % 11% 6% 2% -3% -7% % 5% 0% -4% -8% -12% % -1% -6% -10% -13% -17% Source: GBM Research Brazil s import penetration over apparent demand Figures in Mtons Source: GBM Research with data from IABr GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 91

92 GBM Takeaways Brazil steel sector Our GBM Economic Team thinks that Brazil is suffering its sharpest contraction in more than twenty years, and that it seems that the economic plunge will continue this year (-3.3% YOY GBM 2016e). In this context of no recovery in sight for 2016, the more probable scenario suggests that all the end users of steel will drag down steel apparent demand again, in line with IABr s forecast of -14.4% YOY. However, this is not a new story; the contraction in demand seems to be determined by market expectations. Despite this disappointing outlook in the short term, we have a more positive view for beyond 2017, as we believe that the economy is stabilizing; the last indicators show that the bottom of the cycle could be reached this year. Thereby, we foresee that the steel sector could be widely supported by this potential recovery; a small recovery on the economic front could result in a higher steel consumption multiplier apparent domestic steel demand is 29% below its peak ( ) vs. GDP, which is only 0.92% below in the same period. Coupled with this high beta of the sector, we should recall that the international market seems to be working in a better shape than in the last months steel prices have posted a sound recovery in HRC China-USD (+59%), indicating that the worst may have passed, although there is high uncertainty regarding the sustainability of these new prices. In addition to these indicators, we see some potential domestic triggers. Brazil s political crisis seems to be in the final stages: Brazil s situation is definitely not an easy GDP has contracted for nine consecutive quarters, fiscal deficit remains at record levels, while inflation remains above Central Bank s target. However, things seem to be improving, during the first months of the new government, it appears determined to restore the public accounts and to pave the way for economic recovery. Starting with its economic team; key names were taken positively by the market, especially Henrique Meirelles and Ilan Goldfajn as the new Finance Minister and BCB Governor, respectively. Lastly and even more important, the new administration has also showed commitment to execute some structural reforms, such as Public Pension reforms and Federal expenditure s ceiling budget. In addition, the government is also mulling other reforms, such as scrapping sovereign wealth funds, greater participation of private companies in the oil & gas sector, and higher infrastructure concessions. If successfully carried out, these measures will help Brazil regain competitiveness in the medium to long term. The sector s is strong leverage play- financially and operationally. o The current low level of capacity utilization could be substantially increased by a potential recovery in the domestic market, which would result in a higher dilution of fixed costs. A high degree of operating leverage could help to recover the sector s profitability. As steelmakers carry a relevant balance sheet leverage, lower rates could lead to a welcome lower debt service. For example: GERDAU holds R$23.7 billion in debt and USIMINAS holds R$7.4 billion; both companies hold most of this as post-fixed debt. If we reduce the weighted average financial cost by 1%, it would decrease financial expenses by R$237 million and by R$74 million, respectively. Overall, rising steel prices and a potential shift in the domestic economy have led us to be moderately optimistic. We do see upside for the sector, but of course, there are still downside risks, mainly coming from abroad (China). However, an early recovery could be seen as soon as next year, considering the recent increase in confidence levels (consumer and business), as well as a slower drop in industrial output lately. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 92

93 Brazil Industrial Production & Capacity Utilization Figures in thousand units Brazil Industrial Survey (FGV) Figures in thousand units Source: GBM Research with data from IBGE Source: GBM Research with data from FGV Brazil FOCUS Survey Figures in thousand units Brazil CDS 5-year performance Figures in basis points Source: GBM Research with Central Bank of Brazil Source: GBM Research with data from Bloomberg GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 93

94 Mexico Industry-Steel Demand: Expecting a positive outlook in Mexico s steel consumption The importance of the steel industry in Mexico s economy The steel industry has an important role in Mexico; steel develops new economic strategies in different sectors of the country s economy. it is mainly used in the automotive, construction, household appliances, packaging, oil, machinery, and equipment sectors, among others, becoming a basic input for Mexico. Source: GBM Research with data from INEGI & CANACERO Apparent steel consumption in Mexico (finished steel) Figures in thousand tons In 2015, the steel sector accounted for 1.9% of Mexico s GDP, with a cyclical behavior. In addition, the steel industry contributed 6.3% of the Industrial GDP; in terms of revenues, it is worth ~P$345 billion, representing 11.1% of Mexico s Manufacturing GDP. This industry contributes 720 thousand direct and indirect jobs, representing about 0.6% of the total manufacturing industry. Steel demand showed a gradual recovery from 2009, reaching 24.2 Mtons in The ratio between the Mexican GDP and domestic steel demand is 2.0x. GBM s economic team forecasts a GDP increase of 2.1% for 2016 and of 2.2% That said, Mexico s steel demand should grow 3.3 and 4.7% in 2016/2017, respectively. All in all, we believe consumption in the country should be propelled by the construction and automotive industries, which account for more than 65% of the country s demand. Source: GBM Research with data from WSA Apparent steel consumption per capita in Mexico Figures in Kg Moreover, the World Steel Association (WSA) expects Mexico to remain positioned as the largest steel consumer of finished steel in Latin America. As such, domestic apparent consumption should increase (+3.4% YOYe) to 25 Mtons by the end of the year. Mexico is the ninth largest steel consumer worldwide, while accounting for 2% of the world s total steel demand. Lastly, for 2017, Mexico s steel demand should reach 26.2 Mtons (+4.7% vs. 2016), representing a 4.6% CAGR from 2005 to 2017e. Source: GBM Research with data from WSA GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 94

95 Steel consumption in Mexico by industry Steel demand in Mexico Source: GBM Research with data from INEGI Construction spending in Mexico Apparent steel use in Mexico increased 6% YOY to 24.2 Mtons in 2015, mainly driven by a broad expansion of the industrial sector and an improvement in the construction sector during the year. Construction is the most important sector for steel demand, accounting for ~45%. Construction steel is used in buildings and houses, where structural sections make up 25% of the steel use, while reinforcing bars and sheet products account for 44 and 31%, respectively. Focusing on parking lots, bridges, train stations, and airports, about 60% of steel use in these projects comes from rebar, while the rest are steel products, such as plates and sections. Mexico s construction industry presented a strong recovery after the financial crisis of Recently, construction GDP has slowed down posting a slight 1% (Jan-May) increase (vs. +3.6% in 2015). All in all, we believe this trend should change in 2H16 and in the coming years, driven by the P$26 billion investment in the communications and transportation sector. In addition, the construction of the NAICM airport will require a P$170 billion in CAPEX. Transportation and auto production account for 20% of Mexico s steel use. More than half of a car is made of steel. 34% is used on the body structure, such as doors, panels. and trunk closures, 23% goes to the drive train for the engine, and the rest (12%) is used for the creation of the suspension. Steel used per vehicle is 900Kg, on average. In addition, steel makes up 20 to 25% of high speed trains. Last year, 1.3 million vehicles were sold by Mexico (+19% YOY). By June 2016, 722 thousand vehicles had been sold (+18.3% YOY). Mexico has strong fundamentals to keep increasing vehicle sales at a 5.2% CAGR in the period, as we believe vehicle financing has room to grow. Tools & Machinery covers a wide range of Mexico s steel use, accounting for 21.8%. Source: GBM Research Did you know that Torre Reforma, is the tallest building in Mexico. Torre Reforma used 12 Ktons only for its construction skeleton. More than 50% of all steel goes into buildings and infrastructure. In addition, steel is 100% recyclable. The global recovery rate is 85%. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 95

96 Auto production, the catalyst of growth. Mexico s estimated vehicle production Figures in thousands of units 6,000 5,000 4,000 3,000 2,000 1,000-4,700 4,900 4,000 4,300 3,400 3,500 3,220 2,885 2,933 2,260 2, e 2017e 2018e 2019e 2020e Source: GBM Research with data from AMIA s and Business Monitor Mexico is the world s fourth largest exporter of vehicles (ahead of countries like China, Russia, India, and Brazil), and the fifth largest exporter of auto parts in the world. Mexico s vehicle production in 2015 reached 3.4 million units (+6.3% YOY). This figure should increase (+2.9% YOY) to 3.5 million units in 2016; AMIA expects 4.9 million units by 2020, implying an 8% CAGR from 2010 to Currently, Mexico is a leader in the automotive industry, being the largest vehicle producer in Latin America. In addition, it is positioned as the seventh largest auto producer around the world, and is expected to become the fifth by The country s strategic geographic location is a key driver for the auto industry; this is why 23 of the most important OEMs have set up in the country. With this, around 48 models of light trucks and cars are produced in Mexico keeps delivering strong figures Figures in automotive units We should note that Mexico is on the way to become the main auto exporter to the US, surpassing Canada and Japan. Currently, 81% of the vehicles produced in Mexico are exported, the US is the main destination, accounting for 66% of the total vehicles produced in Mexico; Canada represents 9%, and the LatAm region 12%. Mexico s total vehicle exports reached 2.6 million units in 2014 (+12.2% YOY). In 2015, this record was again surpassed as exports grew 4.4% to 2.8 million units. In Source: GBM Research with data from AMIA s and Business Monitor addition, exports have presented an 8.8% CAGR since Looking forward, we think this trend will continue in the coming years. Mexico has several competitive advantages, which will support future growth in this sector. Lastly, taking a look at the US auto industry, this sector had an incredible year in 2015 (+5.7% YOY). Unit sales have been recovering since 2009, presenting a 5-year CAGR of 10%. Mexican auto production (exports vs. domestic mkt) Figures in thousands of units of light vehicles 3,500 3,000 2,500 2,000 1,500 1, , , , , ,355 Source: GBM Research with data from AMIA and ANPACT ,642 2, Exports Domestic Mexican exports of light vehicles Share by country Source: GBM Research with data from AMIA GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 96

97 Supply: Installed capacity & utilization rate in Mexico Figures in million tons % % 79% % 64% Used capacity Latent capacity % of used capacity Source: GBM Research with data from CANACERO and WSA Mexico s crude steel production vs. apparent consumption Figures in million tons 76% % 79% % % 62% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% According to CANACERO (the National Chamber of the Iron and Steel Industry), the installed capacity in the country stands at 29.2 Mtpy. Last year, Mexico was using only ~62% of its installed capacity (-4% YOY), below the levels of 2009 (64%). That said, there remain 11 Mtons of latent capacity to be used; the main catalyst for this to change depends on lower steel imports. Mexico is positioned as the thirteenth largest crude steel producer worldwide. The country faced an arduous year in 2009, when steel production dropped 18% YOY to 14.1 Mtons; after this, Mexico s steel production improved significantly, posting an average increase of 4% each year. In 2015, the national steel market slowed down, crude steel production fell (3.7% YOY) to 18.2 Mtons, following a 3% contraction worldwide. We can conclude that Mexico s steel output is being affected by higher steel imports, which increased 10.2% YOY, and they now account for 47.3% of the country s steel demand, taking a toll on domestic production. Source: GBM Research with data from CANACERO and WSA 75% of Mexico s total steel production is destined to the domestic market. Since 2000, Mexico has presented a deficit in its steel trade balance. In 2015, Mexican steel exports totaled 4.3 Mtons (-26% YOY), while imports reached a record high due to higher volumes coming from China, South Korea, and Japan, totaling 13.7 Mtons (+10.4% YOY). At the end, Mexico posted a 9.4 Mtons of deficit (the worst performance registered since 2000). To sum up, demand in the country is not the problem, as domestic demand is growing above the rest of the world; hence, Mexico s steel consumption is absorbed by imports, which account for more than 35% of domestic demand; leading to a 42% steel deficit. The answer to solve this problem is antidumping measures. Mexico s steel Trade Balance Figures in thousand tons 7,000 4,000 1,000-2,000-5,000-8,000-11,000-14,000 All in all, we forecast a recovery in the coming years. We expect 1.5 and 2.6% YOY increases for 2017 and 2018, respectively; 2016 should remain relatively flat vs ,000 4,000 1,000-2,000-5,000-8,000-11,000-14,000 Steel exports (volumes) Stel imports (volumes) Net imports (Deficit) Source: GBM Research with data from CANACERO and WSA GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 97

98 Local Producers: Arcelor Mittal, AHMSA, Ternium, and Deacero are the biggest steel producers in Mexico in terms of volumes. Considering these five companies, they represent ~80% of Mexico s total steel production. These companies have maintained their market share position since 2007, having changed only slightly since then. Currently, higher imports from China, among other countries, are affecting local producers market share; however, they are working on the implementation of antidumping duties with the Ministry of Economy. Steel production by different companies (Market share) Steel projects on the way Nucor (50%) and JFE Steel (50%) will build a plant in central Mexico. The plant is expected to cost US$270 million with a capacity of 400Ktpy of galvanized sheet steel. Operations will begin in 2H19. Ternium will develop a second hot-dip galvanizing line in Tenigal with a production capacity of 430 Ktons, starting operations in Total investment stands at US$300 million. ICH/SIEMC should start its expansion projects in Tlaxcala, adding 500 Ktons by the end of Source: GBM Estimates Most of the steel mills are located in Northern Mexico, as steel companies find positive synergies in this location. In addition, 29% of Mexico s steel production Source: GBM Research with data from SE comes from Coahuila, while Michoacan, Nuevo Leon, and Guanajuato account for 18, 16, and 11%, respectively, mainly due to more steel facilities in these states. We estimate an increase of 1.3 Mtons in Mexico s steel capacity by 2019, driven by the construction of three new facilities; we do not rule out the entry of more projects, given the positive growth in Mexico s construction and auto industry. Mexico s steel mill distribution by Federal Entity and company Steel production per Federal Entity Guanajuato 11% Veracruz 7% San Luis Potosi Puebla 6% 4% Nuevo León 16% Michoacán 18% Coahuila 29% Estado de Mexico 3% Tlaxcala Jalisco 2% 2% Baja California Norte 2% Source: GBM Research with data from SE and companies Source: GBM Research with data from CANACERO GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 98

99 Net Imports (Duties) In general, Mexico s tariff policy is based on chapter 72 and 73 of the TIGIE (General Tax Act of Imports and Exports). Mexico s steel industry is open to international trade with more than one hundred countries with virtually zero tariffs since 2012, when the Ministry of Economy changed the tariff regulation, in order to increase the trade exchange with other countries. This resulted in a negative effect, as steel imports have increased 40% in the last four years. Simple average tariff on steel imports in Mexico Nowadays, Mexico is facing several problems regarding steel imports. The main issue lies in 16.0% 15.5% temporary imports, as a significant amount of 14.0% steel enters the country without being reexported once again. This regime is used to avoid 12.0% 11.2% 13.6% import tariffs and technical requirements applied 10.0% to permanent imports. Thereby, Mexican steel 8.3% 8.4% mills asked the Ministry of Economy (SE in 8.0% 8.3% Spanish) to implement antidumping duties on 6.0% 5.6% imports, particularly those coming from China and India. 4.0% 3.4% 2.9% 2.0% 1.4% 1.4% 1.4% In response, the SE deployed several measures and will tighten control of temporary imports for 0.0% export products, requiring bail bonds to ensure that the product is re-exported. Moreover, a Simple average tariff on steel imports range of steel products will be treated as Source: GBM Research with data from WTO and the Ministry of Economy sensitive goods, whose import permits involve more requirements (86 new tariffs added to this category). Likewise, the Ministry of Economy extended the variety of steel products that require an automatic notification to enter the country; lastly, a committee was created by the Ministry of Finance (SAT), SE, and CANACERO to have greater control over steel imports. Mexico s tariff profile Furthermore, Mexico has the endorsement of the World Trade Organization (WTA) to impose a 34.3% tariff on imports, without breaking the international trade rules. Currently, imports from the metals and minerals where steel is included have an average tariff of 2.8%. Recently, SE imposed compensatory duties of 66% on Chinese cold-rolled steel imports, and preliminary tariffs on hot-rolled coil imports from China, Germany, and France were established at 72, 25.4, and 12.4%, respectively; in addition, it is evaluating duties on wire rod imports from China. We believe that SE will release more antidumping duties on steel imports this year; we have seen positive results as rolled steel imports coming from China have dropped 63% Source: GBM Research with data from WTO YOY (January-May) to 225 Ktons (vs. 608 Ktons). Interestingly, in 2015 Mexico was ranked second regarding steel imports coming from China, overall all the LatAm countries; now, Mexico has fallen four positions. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 99

100 Prices: External influences Rolled steel imports from China into LatAm Figures in thousand tons % % % % % % % % % % % 100 8% 8% 8% 148 6% 50 5% 0 3% Brazil Central Chile Mexico Peru Colombia Ecuador America January-May 2015 January-May 2016 China's participation by country Steel imports are a key risk influence to steel prices. Emerging markets (-2.7% YOY), especially China (-5.4% YOY), are experiencing a slowdown in domestic steel. On the other hand, Mexico s consumption is growing at a good pace; however, demand is covered by unfair practices, pressuring domestic prices. In 2015, NAFTA absorbed 4% of China s steel export volumes. Currently, Mexico accounts for 8% of rolled steel imports coming from China into LatAm (lower compared to the 12% of 2015), below Chile, Peru, Brazil, and Central America (Honduras, Panama, and Belize, among others). Source: GBM Research with data from ALACERO-WTA-GTIS Average steel price of Chinese exports to LatAm Figures in US$/Ton Average flat steel price of Chinese exports to LatAm Figures in US$/Ton Source: GBM Research with data from ALACERO-WTA-GTIS Source: GBM Research with data from ALACERO-WTA-GTIS Mexico s steel prices are influenced by unfair imports. In the first half of 2016, China s steel export prices to Mexico averaged US$636 per ton, below local steel prices; surprisingly, this figure is slightly above last year s level (+2% YOY) driven by higher flat steel prices (+8.8% YOY), which account for ~70% of Mexico s total steel imports. Looking forward, we believe that with the implementation of the anti-dumping duties on steel imports, domestic producers will begin to gain ground, but more importantly, prices should begin to recover on the back of less unfair imports. In 1H16, we began to see this effect. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 100

101 Argentina Industry-Steel Steel production & utilization rate Figures in thousand tons Crude steel production Capacity utilization rate % Source: GBM Research with data from INDEX Argentina crude & finished steel production Figures in million tons % 80% 70% 60% 50% 40% 30% 20% 10% 0% 50% 40% 30% 20% 10% 0% -10% -20% Supply. Steel capacity stands at 7.2 Mtons; in 2015, the utilization rate was around 72%. Consequently, there are approximately 1.8Mtons of latent capacity. So far this year, the steel utilization rate has decreased sharply, averaging ~60% (vs. 69% in 2015) from January to June. In the first quarter of 2016, utilization dropped to levels of 58%; however, during the last two months, we have seen a slight recovery to levels of ~63%. Looking forward, we believe the country will maintain a utilization level of around 65% for the rest of the year, meaning a monthly crude steel production of around 375Ktons. In 2015, Argentina produced 5.03 Mtons of crude steel (-8.4% YOY) and 4.57 Mtons of finished steel (- 9% YOY). Steel production in the country slowed down, reaching production levels that were not seen since 2012.This effect was mainly driven by a strong 18% YOY contraction in the pipe segment, affecting long steel volumes (-19% YOY). Currently, Argentina supplies 0.4% of the world s total crude steel production (1.62 billion tons); in addition, Argentina is positioned as the twentyeighth largest crude steel producer worldwide, and the third largest producer in LatAm % Crude steel production Finished steel YOY% Finished YOY% Crude Source: GBM Research with data from Acero Argentino and WSA Argentina s steel Trade Balance Figures in thousand tons 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, (500) (1,000) 5,089 4,785 3,637 3,203 4,925 4, ,334 5,350 4,966 5,156 5,034 4,946 5,073 5, Trade Balance Production Apparent consumption Source: GBM Research with data from Acero Argentino and WSA 5,280 4,612 China exported Mtons of steel in From this amount, 9.4 Mtons (8.5%) were exported to LatAm; Argentina received 182 Ktons (+304% YOY) accounting for 2% of China s total steel exports to Latin America. Furthermore, Argentina s imports increased 36.7% YOY to 1.1 Mtons (the highest figure registered since 1998), and China was mostly behind this negative effect accounting for 17% (vs. 5.7% in 2014) of the country net imports. What s more, around 18% of Argentina s total production is destined to exports. Interestingly, in 2015, the country s steel demand rose 5% YOY to 5.28 Mtons, while domestic production decreased 8% YOY to 4.6 Mtons. That said, Argentina posted a deficit of 668 Ktons; this amount was not seen since So far this year, Argentina s steel imports have delivered positive results, declining 27% YOY. China is mostly behind this effect, as the country s exports to LatAm dropped 35% YOY. During the last five years, Argentinean exports have represented ~18% of the country s total steel production. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 101

102 Imports (Taxes) Import taxes on steel products Product Import Tax Argentina 1 Heavy Plates 12% Semifinished 8% 2 Coiled Plates 12% Long products 12% 3 Hot-rolled sheets 12% Flat products 12-14% 4 Hot-rolled coils 12% Pipes 14-16% 5 Cold-rolled sheets 12% 6 Cold-rolled coils 12% 7 Tinplate 12% 8 Galvanized sheets 12% 9 Sheets coated 12% 10 Pre-painted sheets 12% 11 Other sheets 12% 12 Stainless steel 14% 13 Bars 14% 14 Reinforcing bars 12% 15 Wire rod 14% 16 Tubes and pipes 16% Source: GBM Research with data from INDEC and WITS On average, Argentina has an import tax duty of 12%. Comparing Argentina to other countries taxes, such as the US, Japan, China, Mexico, and Colombia, the country has high import duties. Argentina entered into the Treaty of Asuncion with Brazil, Uruguay, and Paraguay, creating the Common Market of the South, or Mercosur. Since January 1, 2000, zero tariffs apply to steel products traded among them. Applicable steel tariffs to Mercosur member countries from nonmember countries currently range between 2 and 16%. However, every six months, Mercosur members may exempt from tariffs a limited number of products imported from non-member countries. Antidumping measures have been used in the past to prevent unfair competition that directly affects the steel industry in Argentina. After several subsequent revisions of such cases, there are currently no measures in place. Argentinean producers and upcoming projects The Argentinean steel industry represents 8% of LatAm s total production and is controlled by six companies, with a total finished steel production of 5.03 Mtons (2.02 Mtons of long steel and 2.6Mtons of flat steel). Currently, the largest steel company in Argentina is Ternium. The Siderar plant allows Ternium to maintain a ~95% market share in the country. Moreover, the main steel producers are: Siderar (TX), Sicerca (Tenaris), Acindar, Sipar (Gerdau), Acerbrag, and Aceros Zapala. Moreover, Argentina s steel industry will soon complete some relevant investments, which will lead to an increase of 650k tons in its nominal capacity, and will raise its rolling capacity by 800k tons. These investments comprise three projects from the principal players in the country: Sipar (GERDAU), Acindar (ArcellorMittal), and Siderar (Ternium). Argentina s steel production and market share (TXleader) Figures in thousand tons 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, TX's finished steel market share TX's cold rolled market share Source: GBM Research with data from Ternium - Siderar and Acero Argentino Starting from the most relevant, we should highlight the Sipar expansion project, where the company is building a new melt shop, slated to start up by the end of The new plant will be located in the city of Peres, and will have annual installed production capacity of 650k tons. The project is budgeted at US$140 million. The second project relates to the expansion of Acindar (ArcellorMittal), which was completed in the first quarter of this year and is still currently under ramp-up. It comprises a new rolling mill in the Santa Fe province, with an annual capacity of 400k tons per year of rebar, which will be destined to the civil construction market. The project was budgeted at US$100 million. 5,377 93% 4,952 91% 5,144 5,022 4,572 98% 98% 98% 98% 98% 96% 95% 94% 1,468 1,419 1,512 1,398 1, Arg. Finished Steel production Arg. Cold Rolled production 100% 99% 98% 97% 96% 95% 94% 93% 92% 91% 90% GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 102

103 Apparent Steel Demand Argentina s apparent steel demand, like many other macroeconomic variables in the country, has presented a high volatility in recent periods; sharp decreases ( and ), and then periods with robust growth ( ). In our view, this reinforces the fact that Argentina s growth over the last periods followed an unsustainable path, which resulted in the well-known imbalances in the economy. Despite this unfavorable scenario, we should note that Argentina s apparent steel consumption has advanced at a CAGR of 3.8% over the last 15 years, and has historically outperformed the general expansion of Argentina s economy, implying multiples of 2x to 3x. Argentina Macro variables Source: GBM Research with data from Acero, ADEFA, AFCP, and INDEC. Argentina s apparent demand peaked in 2015, when the apparent consumption reached 5.7 million tons; during that year, Argentina s GDP posted an increase of 2.4% YOY. Argentina s apparent consumption is highly concentrated in the three main end-user segments: Civil Construction (44%), Automotive and Metallurgical chain (40%), and Capital Goods (12%), Together, these three end segments represent 96% of total consumption. Despite this peak, reached last year, the outlook for this year has being very challenging, as shown in the last report from July 2016, where the numbers indicated an accumulated drop of 6.0% TTM. According to estimates from the Argentinean Steel Chamber (Acero) the domestic apparent consumption may decrease 17.0% YOY in 2016, reaching 4.3 million tons. The decrease so far endorsed the higher elasticity compared to the GDP which, according to our estimates, should decrease ~1% this year. Argentina, like many other underdeveloped countries, presented lower apparent steel demand per capita which, according to the World Steel Association, at the end of 2015 reached kilos per inhabitant, versus the World Average of 208 kilos per inhabitant. We believe this suggests that for the medium and long term, Argentina has a better outlook, based on the natural emergent ascension and on the increase of its low intensity of steel per habitant. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 103

104 Automotive sector This sector had a robust growth pattern in the last periods from 2005 until 2011 where the production of vehicles has historically outperformed Argentina s economy and increased with a compounding rate of 12.6% per year. During 2011, the sector achieved its peak, reaching 830 thousand units produced. However, this trend was reversed in 2012, when production tumbled 7.8% YOY, strongly influenced by exports drop (-18.4% YOY). For the next periods, the industry kept its negative performance, except for the subsequent year, when production advanced 3.5%; but then, during 2014 and 2015, production suffered another sharp decrease, where the output was 22 and 14.7% lower, respectively. These erratic patterns in the Argentinean automotive sector seem to be influenced by its weak exports performance, which is an important driver for Argentinean production, as it historically represents 57% of its total national production. During 2014 and 215, export volumes decreased 17.4% and 32.9%, respectively. Argentina Total production of vehicles (units) Figures in thousand units Argentina Total export volumes (units) Figures in thousand units Source: GBM Research with data from ADEFA Source: GBM Research with data from AFCP This negative performance coming from exports is strongly supported by the economic difficulties of its largest partner Brazil, which represents about 75% of the total Argentinean exports. The neighbor country has been suffering from lower vehicle sales volumes year after year since 2012, and as shown in the last report from July 2016, is still suffering an unprecedented decrease, where the accumulated sales of new vehicles points to a drop of 21.2%. Currently, Argentina s production seems to continue on rocky road, as seen in the last report from July 2016, where the number of vehicles produced indicates a further decrease of 8% TTM compared to 2015 numbers while, in the same period, exports volumes have decreased 20%. According to estimates from ADEFA, production may decrease 5.1% YOY in 2016, totaling 500 thousand units. On the other hand, Argentina s automotive market is following a different trend, where domestic sales are growing at 3.7% TTM. Estimates for the whole year by ACARA (which represents dealers) expect 3.5% growth in sales, reaching a total volume of 650k tons. Given this mixed outlook, our perception is that the Argentinean automotive sector has a poor outlook as, despite the already low level posted over the last two years, the sector is still worsening. Nonetheless, in our opinion, the sector as well as the entire Argentinean economy could easily post better results starting next year, driven by the recently implemented economic reforms. In addition, we should highlight that there are two factors that could positively impact the sector: namely, the recovery of the country s main and irreplaceable partner (Brazil), and the reduction of imports penetration in the market, which is currently around 52% of the total new vehicle sales. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 104

105 Argentina Construction sector According to ACERO, this sector represented 44% of the total apparent demand by the end of It is the largest consumer of long steel (wire, bars, truss frame, and nails). The sector has been presented as a countercyclical segment vs. Argentina s general economic performance in recent periods. It was supported by a high inflationary environment, which helped to boost the sector, as investors historically see it as a good and safe investment in periods of stress. To illustrate this, the ratio of Construction GDP to Total GDP in 2002, according to a report by the Center for Production Studies (CEP), was at a record low level of 3.5%. Since then, the construction sector accelerated its growth for several consecutive years; consequently, at the end of last year, the ratio reached 5.6%. Argentina Monthly house sales in Buenos Aires Figures in units Argentina Cement production volumes Figures in thousand tons Source: GBM Research with data from CABA Source: GBM Research with data from ANFAVEA In addition, to reinforce the positive outlook for the sector, despite the general macroeconomic condition of this year, which seems to be interpreted as a transitory year, Argentina s home sales keep improving compared to the last two years. According to CABA, home sales increased 11% during 2015 in the city of Buenos Aires. In addition, the results are still pointing to good figures; the latest data (June) shows that the unit launches accrued over the last twelve months have advanced 6% YOY. In our view, civil construction could present solid results beyond 2017, based on higher confidence levels, and macroeconomic variables, that directly influenced the sector: credit volumes of financing, low unemployment rates, wage remuneration growth, consumer confidence, and the growth of new families. In addition, we should highlight other medium- and long-term opportunities that might also help to develop the sector, hamely: some old opportunities which exist on paper and could be partially executed. Housing Deficit: According to the country s official statistics agency, INDEC, Argentina has a housing deficit of 2 million units. Lack of investment in infrastructure: Argentina suffers from the historical lack of infrastructure, which affects all the sectors of the economy. GBM Grupo Bursatil Mexicano, S.A. de C.V., Casa de Bolsa ( GBM ), and its affiliates, may carry out and seek to do business with companies covered in its research reports. Investors should not consider this report as a single factor in making their investment decisions. These materials do not constitute an offer to buy or sell any security or participate in any trading strategy. Please refer to the last page of this report for Important Disclosures. 105