Risks to Chinese steel prices now skewed to upside Despite recent bearish newsflow on Chinese steel market sentiment, we are optimistic on the outlook for Chinese steel prices. We believe tighter monetary policy has driven flat steel inventories down 15-20% since March, setting the stage for a return of pricing power in H2. We expect underlying Chinese steel demand to improve in H2 as both industrial production growth and auto production pick up from Q2 softness. European/US steel prices may be bottoming The spread of European steel prices over Chinese prices has now fallen below $100/t, significantly reducing the threat of imports and removing downward pressure on European prices. The broad recovery in underlying steel demand appears solidly entrenched. In addition, key raw material prices remain elevated, while scrap prices in both the US and Europe have risen c.5% in the past month, suggesting further support to steel prices. Sector re-rating likely as H2 pessimism recedes The ongoing resilience of steel prices should allay investor fears of an H2 2011 margin squeeze and earnings slowdown comparable with H2 2010. With inventories relatively low and continued positive momentum in key end markets, we expect the seasonal slowdown in Q3 to be less pronounced in Europe than in previous years. Modest upward momentum in European and US steel prices could serve as a catalyst for sentiment towards the sector and this could lead to a relatively rapid re-rating as investors begin to discount a more stable H2 and a recovery in 2012 and beyond. We believe the current soft patch of economic data will be shortlived and recent share price weakness provides an attractive entry point. MT offers greatest upside; buy now for multi-year cyclical recovery At 5.7x 2012 EBITDA, we believe ArcelorMittal (MT) in particular is undervalued in the context of a continued steel recovery (5.5x is a midcycle multiple). We expect MT's EBITDA to grow at a CAGR of 21% to 2013 and its current share price (down 20% since Feb) offers an attractive entry point ahead of its multi-year march towards normalised earnings. The stock could be one of the biggest beneficiaries of a sector snapback, with c.40% upside in our price target of €32. Upcoming Q3 guidance a potential catalyst for MT The market appears to be pricing in a y/y decrease in like-for-like H2 EBITDA, which we consider highly pessimistic given H2 2010 was characterised by a significant de-stocking. We expect MT's Q3 guidance to be solid in light of a more moderate summer slowdown in volumes, the repricing of legacy auto contracts and continued Mining expansion. We believe the stock could re-rate in the coming month as pessimism towards Q3 guidance and the H2 outlook recedes ahead of Q2 results (27 July).
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