Billionaires Are Betting on Small Steel

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

What's the best way to play a potential turnaround in the steel industry? Well it’s not the company you would think. United States Steel (NYSE: X) is considered the bellwether of the steel industry, but we believe AK Steel (NYSE: AKS) is the best bet in this space. Cliff Asness of AQR Capital also thinks so and is the top fund owner of AK Steel, owning 4.3% of the steel company. AQR upped its stake over 60% last quarter, along with other notable billionaires, including Ken Griffin, Steve Cohen and Israel Englander (check out Israel Englander's newest picks).

Steel volumes are expected to be up in 2013 on the back of rising U.S. GDP and robust auto sales. Further helping boost the industry should be bullish demand from the construction industry as a turnaround in real estate gains traction. Standard & Poor's expects steel consumption to be up 7% in 2013, and also anticipates an increase in auto sales in 2013 to 15.4 million units, from 14.4 million units projected in 2012.

We believe that other top competitors just do not have the same prospects that AK presents, including US Steel, Steel Dynamics (NASDAQ: STLD), Ternium (NYSE: TX) and ArcelorMittal (NYSE: MT).

US Steel has the lowest expected EPS growth rate of the five steel stocks with a 7% CAGR, and its valuation is less than stellar at 15x forward earnings, in line with its historical P/E. The steel company does have more international exposure than AK Steel, but we do not like its tubular-related products exposure. Almost 20% of revenues for the first nine months of 2012 were in its tubular segment, which has vast exposure to the oil and gas markets. As a result, US Steel is more dependent on the number of oil and gas wells drilled, and can easily see demand impacted by new drilling and storage techniques. AK Steel only derived 2% of its revenues from tubular over the same period. Billionaire Jim Simons was one manager betting on US Steel in 3Q 2012 (check out Jim Simons' top picks).

AK has seen the same pressures, if not more, as other steel companies: The S&P Steel Index was down 11% through mid-December 2012, where the S&P 1500 was up 13%, but AK Steel was down almost 50%. Over the last five years, the steel stock is down 90% and has seen earnings decline at a 50% compounded annual growth rate over that same period.

With all the negative pressure and poor historical performance, why invest?

We see the downward pressure as a possible buying opportunity, where the future turnaround in AK’s operations should help drive earnings growth. The steel stock’s valuation remains low despite a positive earnings outlook. The steel company has managed to meet or beat earnings each of the last four quarters and is expected to have an annual EPS growth rate of 27% over the next five years, the best CAGR of all five steel stocks. One of AK's initiatives is to invest heavily to internally generate half of its iron ore and coal requirements, with plans to start mining for coal in the first half of 2013. AK Steel is also looking to better penetrate higher margin businesses, including carbon, stainless and electrical steel.

AK trades at only 0.1x sales, compared to US Steel at 0.2x. Assuming AK should trade more in line with the steel giant, given similar debt loads (both with debt-to-asset ratios of 25%) and an expected rebound in profitability, the steel stock could see upwards of 100% upside based on 2013 sales estimates.

What’s holding major competitor Steel Dynamics back is that a big portion of the company’s revenues (40% for the first nine months of 2012) are derived from the struggling rail industry, and not the auto and construction industries. This duo is where the majority (80% for the first nine months of 2012) of AK’s steel products shipped. Steel Dynamics does pay a reasonable dividend at 2.9%, but its valuation (11x forward earnings) and growth (8% 5-year expected EPS CAGR) are nothing to get excited about. Billionaire George Soros was selling off his entire stake of Steel Dynamics last quarter (see George Soros' latest picks).

Ternium, meanwhile, is a Latin American steel company that derives almost 45% of its revenues from outside of North America. ArcelorMittal is another non-U.S. based steel company, but we continue to prefer the U.S. steel companies to these two operators, given that the expected robust steel demand should be driven by the auto and construction markets in North American. Ternium does pay a solid dividend yielding 3.2% and has a cheap valuation at 8x forward earnings, but recent guidance puts operating income for 4Q lower than expected due to lower average prices and higher operating costs.

ArcelorMittal also pays a robust dividend yielding 4.3%, but it has an expensive valuation at 19x forward earnings. Recent news shows the company boosting its already healthy ($2.9 billion) cash position with the sale of a $1.1 billion stake in one of its Canadian iron ore mine operators.

To recap: AK Steel trades at the very low end of the industry on a P/S basis but has some of the more robust growth prospects. We see AK as one of the potential big benefactors of a rebound in the steel industry.


This article is written by Marshall Hargrave and edited by Jake Mann. Insider Monkey's Editor-in-Chief is Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article.  The Motley Fool owns shares of ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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