23 September 2013 Europe/France&Italy Equity Research Steel Tubular view Research Analysts SECTOR REVIEW Michael Shillaker 44 20 7888 1344 [email protected] Change is in the pipeline James Hanford 44 20 7883 1551 [email protected] Figure 1: Vallourec and Tenaris capex (€m) and free cash flow yield (%) 1400 12% James Gurry 10% 44 20 7883 7083 1200 [email protected] 8% Liam Fitzpatrick 1000 6% 44 20 7883 8350 4% [email protected] 800 2% Specialist Sales: James Brady 600 44 20 7888 4267 0% [email protected] 400 -2% -4% 200 -6% 0 -8% 2010 2011 2012 2013E 2014E 2015E VLLP Capex TENR Capex VLLP FCF yield TENR FCF yield Source: Company data, Credit Suisse estimates ■ Vallourec (O/P, €56) vs. Tenaris (U/P, €15) in a wider sector context. In this report, we present our view on the outlook for the tubular sector and discuss, in particular, the Vallourec versus Tenaris investment case. We reiterate our preference for Vallourec over Tenaris, based on the changes that are occurring in the tubular space and which we think are likely to continue. Tenaris is regarded as high quality by the market, rightly in our view, but it has significantly outperformed the sector and Vallourec, in particular, as a result and we believe the stock is fully priced. In contrast, Vallourec has seen a difficult two years, with delays in key ramp-ups and stagnation in the industrial segment to which it is still significantly exposed. With the key mills now turning profitable, we expect a marked increase in EBITDA even without a material cycle recovery. Vallourec is significantly cutting capex, which should, we believe, make it one of the best cash-flow generators within basic resources. If management delivers on its capex guidance, which we think it will, there is potentially scope for a material re-rating by the market. Tenaris, by contrast, is significantly increasing capex, with a resulting deterioration in FCF yield relative to Vallourec. ■ Structure: We discuss the investment case in detail, addressing the following issues: (1) the medium- and long-term outlook for the Oil Country Tubular Goods (OCTG) market in key geographies and implications for Vallourec and Tenaris; (2) capacity additions and FCF profiles; (3) growth potential from key clients and contracts; (4) comparison of cost positions; (5) implications of the OCTG trade case; (6) fair value estimates; and (7) analyses of ratios and relative share price performance. DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION® Client-Driven Solutions, Insights, and Access 23 September 2013 Key charts Figure 2: Vallourec FCF yield (%) and capex (€m) Figure 3: Tenaris FCF yield (%) and capex (€m) 1,000 10% 1,400 12% 900 8% 1,200 10% 800 6% 700 4% 1,000 8% 600 2% 800 500 0% 6% 400 -2% 600 4% 300 -4% 400 200 -6% 200 2% 100 -8% - -10% 0 0% 2010 2011 2012 2013E 2014E 2015E 2010 2011 2012 2013E 2014E 2015E VLLP Capex VLLP FCF yield TENR Capex TENR FCF yield Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates Figure 4: Vallourec oil and gas as % of total sales Figure 5: US natural gas conventional and unconventional production (Bcf/d) 70% 45 40 65% 35 60% 30 55% 25 50% 20 45% 15 10 40% 5 35% 0 2002 2004 2006 2008 2010 2012 2014E 30% Q1 Q2 Q3Q4Q1 Q2 Q3 Q4Q1 Q2 Q3 Q4Q1Q2 Q3 Q4Q1 Q2Q3 Q4 Q1Q2 Conventional Unconventional 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11 12 12 12 12 13 13 Source: Company data Source: EIA, Bentek Energy, Credit Suisse estimates Figure 6: Vallourec share price vs. WTI Figure 7: Tenaris share price vs. WTI 160 160 25 140 140 20 120 120 100 15 100 80 80 60 10 60 40 5 40 20 20 0 0 Jul-06 Jul-13 Oct-04 Apr-08 Oct-11 Jan-03 Jun-09 Jan-10 Mar-04 Feb-07 Mar-11 Aug-03 Dec-05 Sep-07 Nov-08 Aug-10 Dec-12 May-05 May-12 Jan-09 Jan-13 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-10 Jan-11 Jan-12 WTI oil price Vallourec WTI oil price Tenaris Source: Thomson Reuters Source: Thomson Reuters Tubular view 2 23 September 2013 Table of contents Executive summary 4 Our investment case 5 Tenaris: A solid but fairly valued company 6 Vallourec: Potential still under-appreciated by the market 6 8.4% FCF yield in 2015E through material EBITDA growth and capex reduction 7 Vallourec: Superior cost position 9 Vallourec becoming Tenaris? 10 Further optionality afforded from industrial recovery 11 Growth likely to come from capacity additions 12 Vallourec growth profile 12 Tenaris growth profile 15 Resulting FCF profiles 16 Comparison of cost positions 17 Relative cost positions of mills 18 Steelmaking and engineering margins 19 Raw material price outlook 20 Scrap 21 HRC 21 Iron ore and HBI 22 Currency and inflation considerations 23 Valuation 25 Share price performance 27 Ratio analysis 30 Option value from OCTG trade case 33 OCTG medium- and long-term demand outlook 37 Summary 37 US 39 Canada 44 International market holds big opportunity 44 Brazil 45 Mexico 46 Middle East 47 Barriers to entry 48 Vallourec option value from industrial recovery 49 Vallourec VLLP.PA 52 Tenaris TENR.MI 53 Tubular view 3 23 September 2013 Executive summary In this report, we present our view of the tubular sector, and outline in detail the reasons for our preference for Vallourec over Tenaris. The investment case in summary revolves around the contrast in outlooks for growth and FCF generation for the two companies. In the current environment, particularly in the US and in the near term, we believe OCTG prices will remain relatively stable and that growth will thus be driven by volume rather than price. Vallourec should see material growth from the new VM2 and VSB mills, which are in the final stages of completion, and which we estimate will help EBITDA improve to €1.1bn in 2014E. This marks a significant difference to 2012, when delays in the ramp-up of these key mills hurt profitability and weighed heavily on the share price. The material improvement in 1400 12% EBITDA, combined with a material reduction in capex, should make Vallourec one of 10% the highest FCF generators within basic resources1200 , in our view. 8% Tenaris by contrast appears to have a different1000 road map ahead, with no capacity 6% 4% additions until 2016E when the new Bay City mill800 comes online, which we think will be accompanied by a material increase in capex and a deterioration in FCF yield relative to 2% 600 Vallourec (Figure 8). 0% Tenaris is a solid company, but fully priced400 in our view; and we think Vallourec -2% -4% offers significantly better value and growth 200potential, especially over the medium term. With a rapidly increasing focus on the more profitable oil and gas business, it could -6% 0 -8% be argued that Vallourec is in the process of becoming what2010 Tenaris2011 is now. 2012 2013E 2014E 2015E Figure 8: Vallourec and Tenaris capex and free cash-flow yieldVLLP Capex TENR Capex VLLP FCF yield TENR FCF yield Source: Company data, Credit Suisse estimates We discuss the investment case in detail, addressing the following issues: (1) Comparison of capacity additions and FCF profiles (2) Growth implications from key clients and contracts (3) Comparison of cost structures (4) Valuation, in terms of: a. Our target price calculations b. Relative share price performances c. Ratio analysis (5) The medium- and long-term OCTG demand outlook for key geographies, and what this means for Vallourec and Tenaris. Tubular view 4 23 September 2013 Our investment case Vallourec and Tenaris are the two main players in the oligopolistic market for premium OCTG (Figure 9). Both produce seamless pipes and connections to be used by oil and gas companies for drilling activities, and seamless pipes to be used in industry and power generation. Tenaris also produces welded pipes to be used in the oil and gas market, which are generally cheaper and lower quality than seamless. Premium pipes and connections are normally used in the most challenging drilling environments, such as deep water, shale plays and sour gas (Figure 10). Figure 9: Worldwide premium OCTG market share Figure 10: Premium OCTG consumption by application Deep water VAM Others oil 13% Others (Vallourec/Sumi 21% 32% tomo) 32% Shallow water 24% Others gas 17% TMK 6% Shales oil and Tenaris Hydril gas RoW 30% 2% Shales oil & gas USA 23% Source: Tenaris Source: Tenaris The use of horizontal drilling and hydraulic fracturing (fracking) to exploit shale plays has revolutionised the energy landscape in the US. Figure 11 shows how unconventional natural gas production has completely changed US natural gas production. Premium OCTG casing, tubing and connections are used for more challenging drilling environments, both in the US (which remains the largest OCTG market by some margin) and in more challenging drilling environments outside the US. Figure 11: US natural gas conventional and unconventional production (Bcf/d) 45 40 35 30 25 20 15 10 5 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E Conventional Unconventional Source: EIA, Bentek Energy, Credit Suisse estimates Tubular view 5 23 September 2013 Tenaris: A solid but fairly valued company Figure 12: Average EBITDA margins 2010-12 Figure 13: Gearing ratios 2012 30% 60% 56% 25% 50% 47% 25% 23% 39% 19% 40% 36% 20% 18% 28% 30% 25% 24% 15% 12% 20% 20% 18% 10% 20% 15% 10% 8% 7% 7% 7% 10% 6% 6% 6% 2% 5% 3% 2% 0% 0% -10% -3% AM AM Salz Salz Outo Outo Voest Voest SSAB SSAB Tenaris Tenaris Aperam Aperam Thyssen Thyssen Acerinox Acerinox Kloecner Vallourec Vallourec Kloeckner Halliburton Halliburton Wood Group Wood Wood Group Wood Baker Hughes Inc.