Tenaris S.A. (NYSE:TS ) is a Luxembourg based provider of steel pipe products to the upstream energy companies across the world. Its product offerings are also used in energy gathering, transportation, processing and power generation facilities. Despite OCTG pricing improvement, the input cost escalation issue will keep TS’s growth muted in the next couple of quarters. In the medium-to-long term, Tenaris’s robust strategies will take over the short-term headwind. Tenaris is a sound investment option for investors looking for dividend income.

In 2018 so far, TS’s stock price has gone up 7% and outperformed the VanEck Vectors Oil Services ETF (OIH) which declined by nearly 2% during this period. OIH represents the oilfield equipment & services (or OFS) industry. Before we get into the details, let us understand the business first.

Tenaris’s products are seamless and welded steel casing and tubing, line pipe and various other mechanical and structural steel pipes. TS’s production facilities are located in North and South America, Europe and Asia. Its other products like sucker rods, couplings, pipe threading and finishing facilities produced in Argentina, China, Colombia, Indonesia, Mexico, and Romania. In December 2017, TS started a new greenfield seamless mill in Bay City, Texas. In Q2 2018, North America accounted for 48% of TS’s revenues, followed by South America (20%), Middle East/Africa (17%), Europe (11%), and Asia/Pacific-Oceania (4%) regions.

Let's discuss Tenaris’s strategies across its various geographical locations, and see how it plans to capture the energy market growth.

It is worthwhile to look at what happened in past cycles to gauge what the way forward might be for Tenaris in 2018 and beyond. Demand for OCTG products in the U.S. and Canada plummeted in 2015 and 2016 after the crude oil price crash that started in mid-2014. Sharply declining drilling activity in these regions led to a massive inventory build-up. Sales of OCTG products fell to less than a quarter of the level reached in 2014, according to TS’s 2017 10-K. Since then, drilling activity recovered, as did the crude oil price. In 2017, demand and sales recovered strongly as inventory levels returned to more normal levels. However, the rapid increase in hydrocarbon production in the Permian region is leading to pipeline takeaway capacity constraints, which can dampen the U.S. drilling activity in the coming months. Later, I will discuss other recent developments that can impede North America’s energy production growth in the short-term.

In response to the energy market growth in North America, TS is consolidating its Rig Direct strategy and enhancing its relationship with major customers in the unconventional shale plays. TS is reaping the benefits of the shale market boom. In its Q2 earnings conference call, TS disclosed that two-thirds of its OCTG sales in North America are Rig Direct. In this context, investors may note that TS’s integrated product and service model is called Rig Direct. Under Rig Direct, TS manages the whole supply chain from the mill to the rig for customers under long-term agreements. This helps reduce the overall inventory levels and simplifying operational processes. Oil country tubular goods or OCTG is casing and tubing products combined.

TS’s production ramp-up plans in the U.S. TS is ramping up production in the new Bay City mill. In July, it produced more than 25,000 metric tons of rolling mill as well as finishing and heat treatment lines. Addition of the Bay City mill in December 2017 added a seamless pipe production capacity of approximately 600,000 tons per year. Also, TS is increasing production at its Hickman welded pipe mill and the McCarty premium threading facility. In coming months, TS plans to reopen the pipe processing and finishing facilities at the Conroe mill that was shut down in 2015 in response to the market downturn.

Since 1994, TS has had a business relationship with Pemex, the Mexican state-owned oil company. TS supplies Pemex with Rig Direct. In early 2018, TS renewed its agreement with Pemex for another five-year period. However, since the 2014-16 declines in oil prices, drilling activity in Mexico and demand for TS’s OCTG products have not fully recovered. Also, the full impact of investments from the energy reform process in Mexico has not yet been realized. TS does not anticipate a recovery in the Mexico energy market before 2019.

OCTG price trend: TS’s revenues and margin are closely linked to OCTG’s market price, which effectively determines the realized price for TS. According to a research report, welded pipe price was up 23% until July while seamless pipe prices were up 16% during the same period. Imports accounted for 56% of the demand in May, compared to 68% during May 2017. The decline in imports follows the implementation of quotas in May for Korea, Brazil, and Argentina, which reached the quota limit in June 2018. Analysts expect OCTG pricing to continue to trend upwards into 2H18, reflecting higher raw material cost, the effect of higher import tariff, and the underlying tightness in the U.S. OCTG market.

In Argentina, TS has longstanding business relationships with YPF S.A. (YPF). Here, TS is participating in the on-going development of the Vaca Muerta shale play in Argentina. According to the U.S. EIA, Argentina’s Vaca Muerta makes up about 60% of the country’s 27 Bbbl of technically recoverable shale oil reserves. Since 2010, more than 588 vertical and horizontal shale wells have been drilled and completed in the Vaca Muerta. Such strong activities in this region provide opportunities for TS’s Rig Direct services and technological solution that contribute to reduce drilling cost and improve performance.

In Brazil, TS looks to consolidate its position in recent times. With the development of Brazil’s deepwater pre-salt complex, TS’s product mix has evolved from line pipe for onshore pipeline projects to large diameter conductor and surface casing and line pipe for use in deepwater applications. Consumption of OCTG products in Brazil stabilized in 2017, after falling in each of the three previous years. In 2018, the attractiveness of the deepwater reserves has prompted large oil companies to increase their investments in Brazil. This can lead to increased activity in future years. TS is increasing its supply of surface and conductor casing strengths and connector for offshore, pre-sold to wells for Petrobras (PBR) and other international oil companies in Brazil.

In Colombia, TS has established a long-term relationship with Ecopetrol S.A. TS is currently investing in heat treatment, pipe threading and processing facilities installation in Colombia which enables it to serve more efficiently with its Rig Direct services. The Venezuelan market, however, has been a drag, as with many other energy companies operating in this country as PDVSA delays payments to its suppliers.

In 2018, TS has already delivered an export pipeline into the Zohr field in Egypt. Eni is developing the offshore natural gas project. TS is also preparing to deliver the second pipeline in Q4 2018. TS has received project contract for the expansion projects in Australia and the Middle East. On September 25, TS agreed to acquire nearly 48% share of Saudi Steel Pipe Company (or SSP) for $144 million. SSP produces welded steel pipe and has a manufacturing capacity of 360,000 tons in a year. SSP’s products have an outside diameter range of ½’’ to 20’’, which complements TS’s existing offer in Saudi Arabia. However, government policies may give preferential treatment to regional pipe producers in countries like Saudi Arabia. This can discourage TS’s entry or further investment in such regions. Overall, markets like the Middle East and the North Sea have been improving but any recovery in 2018 will be gradual.

Steel and aluminum are some of the primary raw materials used on the pipes and steel products sold by TS. In March 2018, the U.S. imposed Section 232, which meant a 25% tariff on all steel imports and 10% on all aluminum imports into the U.S. The sanction impacts all carbon products, including pipe, fittings, and flanges. The tariff targeted steel and aluminum imports and related quota measures on countries like South Korea, Canada, Mexico, and EU. Also, a final decision on carbon steel plants anti-dumping has been rendered, increasing cost and lead times. In July, Section 301 tariffs have been put into place which may impact import of certain valves, valve parts and gaskets made in China.

Although import cost may rise significantly for steel products as a result of this tariff, TS is relatively insulated from import-led cost escalation due to its strong manufacturing base in the U.S. As I have already discussed in this article, TS is increasing production at the Hickman welded pipe mill and the McCarty premium threading facility to decrease dependence on import. This will keep TS’s cost of production at a steady level, and minimize cost hikes.

Steel price forecast: In the past year, steel price has increased significantly. From July 2017 to July 2018, the import price index for iron and steel mill products has increased by 19%. On average steel scrap, pig iron, HBI (hot briquetted iron) and DRI (direct-reduced iron or sponge iron) represented ~20% of TS’s steel pipe products’ costs, while steel in the form of billets or coils accounted for 15%, with direct energy accounting for approximately 5% as of December 31, 2017. Typically, the market expects the price of steel in the U.S. to increase in Q3. In Q4, the price may slide, but it is likely to be 40% to 50% higher than European and Asian steel.

What this means for TS is the strategy for TS to increase domestic production will largely negate the import tariff hike, but it does not necessarily reduce TS’s operating cost or improve its margin because steel price in the U.S. will continue to be higher than after-tariff steel import costs.

Tenaris S.A.’s revenues for the first six months of 2018 increased 52.5% over the first half of 2017, while its net income increased by 44% during the same period. The improved results were due to higher sales for OCTG products and line pipe in the U.S., Mexico, Argentina, Colombia, and the Middle East. Also, the average price for TS’s product offerings increased in 2018. The increases were partially offset by lower sales in Canada and lower shipments to East Mediterranean pipelines.

Vallourec SA (OTCPK:VLOWY), which provides tubular solutions for the energy markets and other industrial applications in the U.S. and around the world, saw improved sales and margin in the first half of 2018. Its revenues increased 7.5% year-over-year led by the positive momentum in the energy market. Regarding the Q2 financial result, VLOWY’s management commented,

“The increase in Vallourec's H1 2018 revenue and EBITDA was driven by the positive momentum on the US Oil & Gas market. It allows Vallourec to take advantage of its fully integrated US manufacturing facilities and to pass on as planned significant price increase on OCTG products, coming into force in the third quarter. Oil and Gas International markets also show positive signs of improving activity.”

TS’s management expects Q3 2018 to be “more or less in line or slightly higher” than Q2 2018. Growth in global OCTG demand, following a 40% increase in 2017, will be more modest in 2018 and concentrated in the major markets of the United States, China, Russia, and the Middle East. They will be seasonally weak, because of vacation time in the Northern Hemisphere. Pipeline volume is more likely to improve in Q4 rather than in Q3. In the second half of 2018, TS’s EBITDA is expected to be higher than the EBITDA in the first half of the year. Even is the margin in Q3 does not increase, TS’s management expects higher invoicing in Q3 than in Q2.

TS is a relatively stable dividend payer in the OFS industry. It pays $1.12 dividend annualized. Its forward dividend yield is 3.31%. In the past five years, its dividend has grown nearly 1.7%. During the first half of FY2018, TS’s quarterly dividend was $331 million.

TS’s net debt was negative as of June 30 as a result of cash & cash equivalents balance exceeding total debt. TS’s net debt was negative $422.5 million as of June 30, which was a decline compared to a year ago when its net debt was negative $1.16 billion. Being a net debt-negative company is an attractive feature. When energy price nose-dives, the company’s earnings dip, and servicing of debt becomes difficult. TS is better equipped to survive a downturn compared to many of its OFS industry peers.

TS’s aggregate cash flow from operations was $306 million in the past four quarters until Q2. At this run rate, TS is not likely to fund its 2018 capital expenditure program and dividend from internal cash generation. I have considered the same dividend paid as in FY2017 and assumed the same capex spend in the second half of 2018 as in the first half of the year. So, unless TS can improve its cash flows, it may have to fund a portion of capex and dividend from borrowings from external sources.

TS is involved in a few long-pending litigations and investigations by the regulatory authorities. The Veracel Celulose accident litigation, which is pending since 2007, involves a total claim of $36.6 million. In January 2016, Petroamazonas, an Ecuadorian state-owned oil company, imposed penalties on TS related to a failure in delivery under a pipe supply agreement. The penalties amount to approximately $22.5 million if imposed. The Italian and Swiss authorities are investigating TS’s alleged involvement in improper payments to some officers of Petrobras (PBR). In a similar investigation, the SEC and DOJ are also inquiring into a matter.

Ownership concentration: Paolo Rocca is serving as TS’s Chairman and CEO. Paolo Rocca is also the vice president of San Faustin. As of date, San Faustin beneficially owned 60.45% of TS’s shares. RP STAK controls a significant portion of the voting power of San Faustin. As a result, RP STAK is indirectly able to elect a substantial majority of the members of TS’s board of directors.

For Q3 of 2018, I expect TS’s revenue growth rate to improve compared to Q2. For that, I have considered the value drivers as discussed in this article. I estimate growth to remain steady until Q1 of 2019. Although growth can slow down in the U.S. and Canada in winter, I expect Middle East/Africa and Asia/Pacific-Oceania to push through during this period. I expect North America revenue growth to pick in Q2 2019.

I also expect the adjusted EBITDA margin to remain relatively steady in the next quarter, and decline in Q4 2018 as the input cost escalation erodes margin. However, I expect EBITDA margin to improve in Q2 2019, as OCTG prices improve and adjust to higher costs. Adjusted EBITDA excludes various non-recurring items including impairment charges.

Tenaris is currently trading at an EV-to-adjusted EBITDA multiple of 15.9x. Based on my EBITDA estimates in the next four quarters, TS’s forward EV/EBITDA multiple is 12.3x. This is lower than its EV/EBITDA multiple of 15.0x from FY2012 to FY2017.

TS’s forward EV-to-EBITDA multiple contraction versus its adjusted trailing twelve months EV/EBITDA is less steep than the industry peers’ average multiple compression, as noted in the table above. This is because I expect TS’s EBITDA to improve less sharply compared to the rise in the peers’ average in the next four quarters. This would typically reflect in a lower current EV/EBITDA multiple compared to the peers’ average. TS’s TTM EV/EBITDA multiple is lower than its peers’ (VLOWY, TMST, and X) average of 43.2x. For VLOWY, TMST, and X, I have used sell-side analysts’ estimates provided by Thomson Reuters.

Tenaris S.A. has effective strategies set for different geographic locations to increase sales and deal with the challenges. While the prices of OCTG products are on the rise, cost escalation can weigh on TS’s margin in the near term. To counter the adverse effect of the U.S. tariff on steel, TS is ramping up its domestic production. TS’s balance sheet is strong. However, between dividend payment and short-term debt repayment, its cash flows may be found wanting. TS’s ownership structure is also concentrated. TS’s current trading multiple discount to its past six-year average justifies the risk factors. Tenaris is a sound investment option for investors looking for dividend income, but expect TS to see the full benefits of energy market growth in 2019.

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