Have We Seen The Bottom in the Steel Industry?

Masam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The steel sector has lately been a hot topic amongst the traders. This was not the case a couple of weeks ago. People had lost interest in this sector, given the fact that it was running on massive overcapacity. Therefore, investors had heavily shorted the players in the steel industry. However, some experts believe that bullish catalysts for this industry are on the horizon. This has generated some genuine interest in this industry, leading steel stocks to soar since the start of this year.

The following chart shows it all:

<img src="/media/images/user_15211/capture1_7_large.PNG" />
 

 

Steel Dynamics (NASDAQ: STLD) has rallied the most with almost a 10% gain in the first week of January. Similarly, AK Steel (NYSE: AKS), US Steel (NYSE: X), Nucor (NYSE: NUE), Metals USA (NYSE: MUSA) and the metal processor Worthington Industries (NYSE: WOR) – all have shown greater than 5% rally in the seven day time period.

The rally has brought a considerable change in the short interest in these stocks:

 

<img src="/media/images/user_15211/capture2_4_large.PNG" />

The Bullish Catalysts

The following bullish catalysts have been identified:

1)      The resolution of the fiscal cliff

2)      Attractive steel industry fundamentals

3)      An upside risk to China

The investment projects put on hold ahead of the fiscal cliff could be taken off the shelf, which will definitely give business capital spending a lift.

Given that the fiscal cliff issue has almost been resolved, we move our focus towards the industry fundamentals. The recent proprietary channel checks suggest that improving local demand (within the U.S.), disciplined supply and low inventories will support higher prices. The local demand for steel seems to be on a rise in the context of rising industrial production and rising auto sales (the year finished off with an auto SAAR of above 15 million). The supply seems to be disciplined in the light of muted imports.

Apart from that, it is also expected that the investors will be surprised by:

1)      A potential non-residential construction recovery – non-residential recovery normally lags housing recovery by 9-12 months.

2)      Cost containment – the iron ore and metallurgical coal prices are expected to decline in 2013.

 China is the largest consumer of steel in the world. A faster-than-expected growing Chinese economy can mean a higher-than-anticipated rise in the steel demand, leading to a rise in steel prices and a straightaway improvement in the steel companies’ bottom line.

In the light of these bullish catalysts, the following steel stocks have been chosen that are expected to benefit the most.

Top Stock Picks

U.S. Steel

The company is expected to be a winner in this situation given that:

1)      It is levered to the right markets. The company has a high exposure to the rapidly-growing auto sector (almost 30% of the overall revenues).

2)      The weak expectations for the tubular results have already been priced-in. The Oil Country Tubular Goods (OCTG) are pipe and tube products used in the petroleum industry. With the sell-side claiming that the rig count at oil sites will reach a bottom by the end of the first half of this year, OCTG demand recovery is expected in the second half of this year.

3)      I believe the combination of a) concerns over the Fiscal Cliff, b) high short interest and c) negative sentiment towards high beta cyclicals will reverse in the coming months, with Q4 results likely a bottom for X’s earnings.

Reliance Steel (NYSE: RS)

Reliance Steel is best positioned to benefit from a 2013 U.S. demand recovery, given its diversified end market mix, product mix (carbon steel, stainless, aluminum) and lack of raw material cost headwinds. It has a stellar track record of acquisitive growth. Additionally, I believe that if/when we do get a recovery in non-residential construction, normalized EPS could be $7/share to $8/share, which implies an $84 to $96 share price based on its historical P/E multiple of 12.

Nucor

NUE is the best positioned company to capitalize if either:

1) Industry dynamics worsen and current players need to divest assets (Nucor has a strong balance sheet) or

2) Economic conditions improve and we get a U.S. recovery (particularly in non-res. construction).

The company continues to move forward on its strategic investments. Its Direct Reduced Iron (DRI) facilities in Trinidad and Louisiana (under construction) will help it to benefit from cheap natural gas. Its plans to expand Special Bar Quality production will start reaping benefits for the company in the second half of 2013.

AK Steel

There are some problems with this company. The stock is a leveraged beta trade in the steel industry given its high gearing ratio (its debt equals 58% of its market cap), massive pension liabilities, and exposure to raw material costs. However, many of the issues have already been factored in the stock price. Also, it is the most levered to higher steel prices. I foresee:

1)      A margin improvement from lower material costs

2)      Minimum funding issues given the recent financing

Olympic Steel (NASDAQ: ZEUS)

This company is a top pick given:

1)      Its high leverage to steel prices

2)      Improving demand environment

3)      Attractive Valuations: The stock is currently trading at a 7% discount to its historical multiple.

Foolish Bottom-Line

Just on a concluding note, the steel sector is poised to grow given a potential rise in steel prices in the near future, higher-than-expected growth in China and the cheap valuations at which many of the industry players are operating.


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