Avoid Copper and Steel for the Time Being

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

China’s latest Purchasing Managers' Index (PMI) reading showed a contraction of manufacturing. The implications are huge for a variety of sectors. I would like to focus in what could happen to basic materials related companies such as the production of steel and copper. I believe that the companies herein mentioned do not offer an interesting investment prospectus and you should steer clear of them.

Copper

Copper, apart from being a commodity, is sometimes used as the barometer for the manufacturing industry. The metal has a variety of properties due to its good thermal and electrical conductivity. As China’s manufacturing declines, I fear the demand for copper will dim. The demand for steel is also directly proportional to the manufacturing levels, and steel may share the same fate. The decline in the commodities prices will hurt companies’ revenue in the interim.

Freeport-McMoRan Copper & Gold (NYSE: FCX) and Southern Copper (NYSE: SCCO) are two of the biggest producers of copper in the world. Freeport-McMoran trades with a price-to-earnings ratio of 9.9, and a forward P/E of 7.2, while Southern Copper trades with a P/E of 14.5, and a forward P/E of 13.2. These companies may look appealing to the traditional value investor since they are trading below the industry’s P/E average of 16.5.

Freeport’s revenue remained unchanged at $4.5 billion for the first quarter of 2013. However, its net income declined 16% to $648 million on a year-over-year basis. What worries me is that the company’s cash from operations increased by $30 million to $831 million, but its free cash flow declined from $94 million to $26 million. Declining prices of copper will negatively impact its revenue, and its free cash flow may come negative in future quarters.

This could endanger the 4% dividend payment, and the stock may decline further. One advantage for Freeport is that on May 31, the company announced the completion of the acquisition of Plains Exploration & Production. Furthermore, on June 3, the company announced the acquisition of McMoRan Exploration Company. The decline in revenue from its copper business may be partially offset by its new oil business.

Southern Copper fared worse in the first quarter of the 2013. Its revenue declined by 11% to $1.6 billion, and its net income fell 21% to $495 million due to higher costs of operation. What worries me is that the inflow of cash from operations declined 18% to $594 million, a steep decline. What’s more is that the free cash inflow declined from $543 million to $278 million.

Although its free cash flow is high as of March 31, I fear that the free cash goes to outflow in the coming quarters. Without a doubt, its dividend payment may be in jeopardy. On the positive side, a recovering US economy, including the housing market, may strengthen the demand for copper. An increase in the home sales and new home orders should increase the revenue from copper to some extent. Further, the company is cutting its costs of operation by reducing its copper exploration activities until global markets improve.

Steel

According to Reuters, the growth in China’s steel demand is expected to slow to a near-standstill in 2013, adding pressure on iron ore prices after a 17% decline in May. Although China’s urbanization and infrastructure construction is continuing, it is slowing its pace. Therefore, the steel consumption will weaken in the second and third quarter of 2013. Production mills may reduce steel output in an effort to drive the commodity prices upward.

United States Steel Corporation (NYSE: X) is a major steel producer in the United States. One issue for U.S. Steel is that several steel-exporting countries, mainly China, had surplus production last year. China’s steel exports to the U.S. rose by 34% last year. Further increments in the importation of steel to the U.S. will put further downward pressure on the commodity prices, and U.S. Steel will be deprived of capturing the rise in demand for steel as the economy recovers.

In addition, China’s urbanization plans are set to slow down in the coming months. U.S. Steel’s exports to China should decline significantly, and the company’s revenue may be impacted significantly.

From a valuation standing, U.S. Steel trades with a P/E ratio of 116. Its sales for the first quarter of 2013 declined 12% to $4.6 billion on a year-over-year basis. However, due to lower costs of operation, its net loss narrowed from $219 million to $73 million for the same period. Its cash from operations declined by almost 50% to $233 million, and its free cash flow also contracted by 50% to $117 million.

Even with a shrink in free cash flow, I do not believe the dividend payment is in jeopardy. However, investors should observe that the free cash flow does not continue to shrink in future quarters. I would recommend avoiding this stock for the time being.

A foolish note

In brief, I believe China’s PMI contraction will have a significant impact in various sectors. The copper-production companies should see a deep impact in their revenue due to a weak demand for the commodity.

Although Freeport-McMoRan is trying to hedge this adverse condition by diversifying into oil exploration services, I believe investors should avoid investing in this stock as revenue is mainly comprised of metal sales.

Southern Copper is experiencing shrinks in its free cash flow. If revenue keeps falling short, the company will not have enough cash to pay its duties, and the company could slash its dividend offer. Investors should not be exposed to the company if this happens, so they should steer away from it.

Finally, the demand for steel is expected to be weak since China’s urbanization program is expected to slow down. This will create huge supplies for the commodity putting downward pressure in prices. It is likely that U.S. Steel’s revenue will fall short in coming quarters, and investors should also avoid this stock.

Overall, investors should put their money to work in another sector for the time being.

After putting together a blockbuster deal to expand into the oil and natural gas industry, Freeport-McMoRan will have plenty on its plate as it tries to adapt to the new industry, as expanding into oil and gas carries plenty of inherent volatility. FCX had a profitable copper business, and on top of this foray into a new industry it still has to contend with mining industry bellwether BHP Billiton. To help investors determine if Freeport-McMoRan is a buy or a sell, The Motley Fool has compiled a premium research report on the company. Simply click here now to access your copy today.


Robinson Roacho has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. 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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