Thoughts and Analysis from Tenaris’s Investor Day

Tenaris S.A. (TS) is one of the world’s leading manufacturers of seamless and welded steel casing and tubing, otherwise known as “oil country tubular goods.” Its products are used mostly in oil & gas drilling operations.

The company was incorporated in Luxembourg in 2001. It is controlled by San Faustin, an Italian investment firm founded in 1948. That same year, San Faustin formed Siderca, the predecessor of Tenaris, which is now the sole producer of seamless tubular products based in Argentina. San Faustin currently owns 60.45% of Tenaris. Four of ten Tenaris Board members are also on San Faustin’s Board, including Paolo Rocca, Tenaris’s Chairman and CEO; Roberto Bonatti, the President of San Faustin; Gianfelice Rocca, the Chairman of San Faustin who is also the brother of Paolo Rocca; and Alberto Valsecchi, formerly a Chief Operating Officer of Tenaris.

San Faustin also has a similar majority ownership position in Ternium, S.A. (TX), which was also incorporated in Luxembourg. Ternium is the leading steel producer in Latin America, with production centers in Mexico, Guatemala, Columbia and also the United States. Tenaris owns 11.46% of Ternium’s outstanding shares.

The American Depositary Shares (ADSs) of both Tenaris and Ternium trade on the NYSE under the symbols TS and TX, respectively. Each Tenaris ADS is equivalent to two regular Tenaris shares. Here is a recent stock chart for Tenaris (courtesy of

Tenaris Weekly Stock Price Chart 161102

Over the years, Tenaris has built leading market positions in tubular goods in Argentina, Mexico and the United States. It also has significant operations in the Middle East, Europe and Asia. In recent years, the company has become a leading producer of seamless pipes and casings that are used in high pressure and high temperature applications, such as unconventional onshore and deepwater drilling operations. It also manufactures premium joints and couplings to complement its casing and tubing products.

In an effort to further differentiate its product offering, Tenaris has recently launched its RigDirect service, which offers just-in-time delivery of its products combined with technical consulting and field services to ensure that its customers use its products effectively and safely.

Like other oilfield services companies, Tenaris has suffered a steep decline in sales and profits over the past two years as a result of the sharp drop in drilling activity brought on by the plunge in oil prices. The steep decline in demand for pipe has also heightened global competition. Korean pipe manufacturers, for example, have been sanctioned for dumping pipe on to the U.S. and Canadian markets.

Tenaris’s net sales fell by 31% to $7.1 billion in 2015 and by an additional 42% to $2.4 billion for the six months ended June 30, 2016. Unit volumes fell 28% to 2.6 million tons in 2015 and by 32% to about 1.0 million tons in the 2016 first half. Average prices fell 6% to $2,447 per ton in 2015 and by 17% to $2,143 in 2016. Thus, while the volume decline has been fairly steady and steep, the drop in pricing has accelerated so far in 2016; but there have been signs of a turnaround in recent months.

The decline in sales has taken a toll on Tenaris’s profitability. Its net income declined from $1.2 billion ($1.96 per ADS) in 2014 to a loss of $74 million (‑$0.14 per ADS) in 2015. Excluding a non-tax deductible impairment charge of $400 million in 2015, the company would have reported net income of $176 million ($0.30 per ADS) in 2015. For the first half of 2016, net income declined to $19 million from $326 million in 2015.

Throughout this difficult period, Tenaris financed its operations and funded an ambitious capital spending program without increasing debt. In fact, its net cash position (i.e. cash minus debt) doubled from $900 million in 2013 to $1.8 billion in 2015 and held at just under $1.8 billion at mid-year 2016.

The company has been able to build and hold its net cash position primarily by reducing its working capital requirements. Over the 18 months ended June 30, 2016, Tenaris has recaptured $1.8 billion in cash from working capital. That combined with an additional $1.1 billion in cash from operating activities has more than covered $1.9 billion in investing activities (mostly capital expenditures) and $0.9 billion in dividend payments.

Despite the industry downturn, Tenaris has continued to invest heavily in its core business to enhance its competitive position. Its most significant investment recently has been its first seamless pipe manufacturing facility in the U.S. at Bay City, Matagorda County, Texas. This state-of-the-art mill with finishing and heat treatment lines will have an annual capacity of 600,000 tons and a logistics center that will facilitate just-in-time deliveries of tubular products, sucker rods and accessories. This new $1.8 billion plant is expected to become operational in 2017.


Tenaris Bay City Construction Site as of March 21, 2016

Tenaris has also invested in a joint venture called Techgen, which is building a 900 MW natural gas-fired power plant which will supply electricity to Ternium’s and Tenaris’s operations in Mexico. Along with its initial investment for a 22% stake in Techgen, the company has guaranteed its proportionate share of Techgen’s bank debt and natural gas forward purchase contracts.

Tenaris’s performance has also been bolstered by its geographic diversity. Even though the price of oil has fallen everywhere, natural gas prices still vary from region to region because of supply and demand constraints and the so far limited impact of LNG shipments. Thus, the company’s business in Latin America, especially in Argentina, has held up better than other regions because the country continues to face a natural gas supply shortage. (The hydrocarbon resource at Argentina’s Vaca Muerta region, which is still largely undeveloped, is estimated to be half as large as the unconventional resources of the U.S.) Tenaris is also benefiting from Saudi Arabia’s efforts to double its natural gas production by 2026. While drilling activity in Mexico is down nearly 90% since 2012, energy reform will raise drilling activity there in the years ahead. Thus, Tenaris is positioned to benefit from the oil & gas development in many parts of the world.

Although the company has been able to conduct its operations and meet its capital spending requirements without incurring debt, it is currently not generating enough in earnings to cover its $0.90 annual dividend (per ADS), nor are earnings expected to cover the dividend until 2018 (at the earliest). On a rolling 12-month basis, the company has posted a loss of $0.67 per ADS. Consensus estimates anticipate earnings of $0.13 per ADS for 2016 and $0.46 for 2017.

While its ability to reduce working capital has allowed it to both fund capital requirements and pay the dividend, management thinks that it is unlikely that it will be able to continue to pull more cash out of working capital going forward. In fact, it is more likely that Tenaris will have to invest in working capital as sales rebound.

With the improvement in both the price of oil and the modest pick-up in drilling activity, Tenaris expects that its sales will improve with each successive quarter. By year, the company anticipates that worldwide demand for OCTG products, which fell 37% in 2015, will fall another 25% in 2016; but then rebound 24% in 2017, with most of the increase coming from the U.S. and Canada. The company’s net sales should therefore follow a similar pattern.

Despite the expected bounce back in net sales, Tenaris says that profit margins will be slower to improve, due to competition and other factors. Consensus estimates for 2016 and 2017 imply profit margins that are implicitly lower than 2015 (excluding the net cost of impairments), but not that much lower. So it would not be surprising to see the trajectory of profit improvement come in below current forecasts.

With a slow rebound in profits and the likelihood that investment in working capital will increase, Tenaris probably will have to decide whether to fund the dividend out of its investment holdings or pare it back. At its recent analyst day, CEO Paolo Rocca was noncommittal on this issue, saying that the Board would consider the dividend at the end of the year.

With its 60% equity stake, San Faustin receives about $320 million annually from the dividend, so any decision to cut the dividend will undoubtedly be considered carefully by the Board. From my perspective, Mr. Rocca’s desire to wait rather than vow to preserve the dividend at all costs gives me greater hope that management and the Board are looking after both the company’s and shareholders’ long-term interests.

In this case, with a total annual cost of about $530 million, Tenaris could in theory cover the dividend for more than three years (assuming breakeven operating and investing cash flows) before it would swing into a net debt position. However, with the realization that growth will require investment in working capital and with the still significant uncertainties that envelope the global oil & gas market, including increasingly tough competitive conditions from state-supported producers in China, Korea and Russia, for example, the company is right to want to protect its balance sheet to ensure that it can meet any challenge that arises.

Under the assumption that Tenaris cannot squeeze more cash out of working capital, my projections indicate that the company would have to use its investment reserves to cover the $177 million cost of the dividend in the fourth quarter. The company could also burn through $1 billion of cash, if sales rebound by as much as 25% in 2017 and profitability is slow to improve. Consequently, I think that there is a 30%-40% chance that the dividend gets trimmed sometime during 2017.

Despite that risk, I believe that existing Tenaris investors who can afford to weather the potential volatility should continue to hold their shares because the company is taking the appropriate steps to protect and enhance its competitive position. New investors, however, face a choice of investing now and accepting the risk of a dividend cut or waiting to get a lower price, but also risking that the dividend may not be cut and so losing the opportunity to buy before the share price recovers.

At the current price of $27.50, Tenaris’s shares trade at very high forward multiples (in excess of 100 times projected 2016 earnings and about 60 times projected 2017 earnings) and a dividend yield of 3.3%. This is not, in my view, a bargain price that discounts the risk of a future dividend cut. Accordingly, I have decided to wait for a more attractive entry point before buying Tenaris’s shares.

November 2, 2016

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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