4 stocks that could rally with steel

  • By Al Root,
  • Barron's
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Andrew Carnegie, America’s original steel magnate, had three principles for investors: Buy when you have inside information, buy only in growing industries, and always team up with other investors to assure an influential stake in a company. Remember, the Securities and Exchange Commission didn’t exist in the late 19th century and early 20th century—the heyday of Carnegie and his fellow robber barons.

Whether he was nervous about steel’s long-term growth prospects or simply got a good offer, Carnegie unloaded his stake in what became United States Steel (X) to John Pierpont Morgan Sr. in 1901 for $480 million (more than $20 billion today).

The company enjoyed some good years during and after World War II, but industry growth has been stagnant for more than a half-century. U.S. production peaked in the 1970s at about 150 million tons. Last year, it generated about 95 million tons. On the eve of the stock market crash in 1929, United States Steel shares reached $260. They haven’t been back since.

There are hopes for a new revival that ends an earnings trough this year. Tariffs, trade case wins, and President Donald Trump’s pledge to bring back U.S. manufacturing will boost steel’s fortunes. The price of steel has risen to $703 per net ton, off recent lows of $675, and a number of analysts expect it to head near $800 or above in the year ahead. It was as high as $924 last year. “We see steel prices going up $100 a ton from here,” to $795 on average, says Bank of America analyst Timna Tanners.

Given the industry’s volatile history, we’d be a little cautious on the stocks. United States Steel would be our pick among the big producers, but we’d stick with a one-year time horizon and keep a close eye on steel and iron prices. Other inexpensive shares include U.S. steel producers like Commercial Metals (CMC) and Steel Dynamics (STLD), which are benefiting from higher prices and their defensive positions as low-cost producers. A pricier option is Nucor (NUE). It’s a low-cost, scrap-based steel maker, too, but it trades at a higher valuation.

Among the catalysts is the fact that the U.S. is short of steel production and needs imports to satisfy demand. That makes steel imports the price setter in the marketplace. Trump’s 25% tariff on imports supports higher prices for both domestic and foreign steel.

Nucor CEO John Ferriola argues that the industry’s health has improved more because of victorious “trade cases” than tariffs. “Countries violate our trade laws, and, when we win trade cases, the duties are good for five years and we can review them [prior to expiration.]” The industry has had a string of wins against foreign steel producers charged with dumping—selling steel in the U.S. below their domestic prices—over the past three to five years.

Long-neglected American steel has another thing going for it. The U.S. market is insulated from soaring global prices for a key ingredient. U.S. companies that use giant blast furnaces to make steel source their iron ore from domestic mines located in places like Minnesota. When global iron-ore prices rise, as they have after Vale ’s (VALE) tragic dam collapse in Brazil took 70 million tons of iron ore out of the global market, U.S. producers gain a cost advantage from their domestic iron supplies.

Tanners thinks the situation favors United States Steel. As a higher-cost producer with more fixed costs, it has more to gain from rising prices. It also mines its own iron ore. She expects the company to post earnings per share of $3 in 2019, versus $5.36 in 2018, when steel prices were higher. The stock trades at just 7.2 times current earnings, a 35% discount to its historical average. Her target price of $31, 60% above recent levels, works out to about a 10 times multiple.

Some other steel stocks are too cheap to ignore, and not just because commodity prices are poised to rise. Commercial Metals trades at 8.6 times forward earnings estimates and Steel Dynamics, 8.4 times. That’s about a 35% discount to historical levels.

A bull on the stocks, longtime Goldman Sachs steel analyst Aldo Mazzaferro, who now runs an independent research boutique, explains that “there is still growth in electric furnace steel production.” Commercial Metals, Steel Dynamics, and Nucor don’t operate blast furnaces—they remelt scrap (see related story). That gives them a capital and operating cost advantage.

Commercial Metals, which earned $1.49 in fiscal 2018, is expected to earn $1.84 a share in 2019 owing to recent acquisitions. Mazzaferro’s target price for Commercial Metals is $31, or almost double recent levels. Steel Dynamics is forecast to earn $4.17 a share this year, down from $5.49 in 2018. Tanners sees Steel Dynamics hitting $48, up 35% from Friday’s level.

Nucor is an idea for more-conservative steel investors. It is the upstart that pioneered making steel from scrap metal—eliminating the need for costly blast furnaces and mining infrastructure. Nucor didn’t make any steel until 1968. Now, it’s the largest domestic steel mill and capable of producing 27 million tons a year.

Nucor’s focus on costs and profitable growth makes it the Southwest Airlines (LUV) of the steel business. It produces profits and earnings growth over time and in nearly all economic environments. Nucor has produced only one annual loss in the past 30 years, in 2009 during the financial crisis. It is expected to report $6.12 in EPS in 2019, off from $7.68 in 2018.

Nucor stock also trades for about 10 times earnings—a 20% discount to historical averages—not quite as cheap as some other opportunities that Tanners and Mazzaferro see. Tanners’ target for Nucor is $71, up 20% from recent levels.

One compelling reason to stick with the low cost, scrap-based producers is the industry’s occasionally misguided attempts to boost output, which it’s doing right now.

“There is a glut coming,” Tanners insists. Over 20 million tons of new capacity is planned by U.S. mills. That’s nearly 20% of total U.S. steel capacity. Tanners doesn’t buy the bulls’ argument that the industry can be self-sufficient and push out all imports. “The global capacity doesn’t go away; it will still affect pricing,” she says.

Investors who buy shares can benefit from higher steel prices, cost-protection on domestic iron, and effective management. But don’t forget that even Carnegie was an eventual seller.

Steel’s complexity promotes volatility

Steel is a funny commodity. It’s not as monolithic as oil or copper. That makes it difficult to compare steel producers or get a real-time read on pricing in the marketplace—two things that investors in commodity stocks rely on to assess values correctly. Its many properties and fragmented underlying markets mean it has a limited futures market to provide liquidity and reassurance to investors. That promotes volatility.

The problem is that steel isn’t just steel. It varies greatly by size, shape, chemical composition, and strength. For instance, steel girders are strong enough to hold up skyscrapers, and paper-thin steel with a tin coating is flexible enough to create a seamless can. And steel products go through up to a dozen discrete processes to make a finished product. It’s impossible to compare operating costs without a detailed knowledge of product mix and processing technology.

The most basic distinction between U.S. steel mills is the raw material used to produce the steel.

Traditional steel makers like United States Steel start with iron ore and coal in a huge (and expensive) blast furnace. A blast furnace can churn out two million tons of liquid metal a year. The pig iron that gets produced is refined into steel by blowing oxygen into a bath of molten metal at supersonic speeds.

Other steel makers like Nucor don’t start with ore—they remelt scrap metal. Nucor boasts that it’s the largest recycler in North America. The scrap is melted using electricity in smaller, less expensive vessels. Scrap has another advantage. Historically, it has been less expensive than the coal and ore needed to make pig iron.

Even though steel is an unusual commodity, it’s still a commodity and will always be cyclical. But understanding the nature of that variability can give investors an edge when evaluating companies.

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