Buy These 2 Stocks Over US Steel

By David Gould - October 28, 2012 | Tickers: MT, NUE, X | 0 Comments

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If there's one industry to be on the fence about due to macro fear, it is basic materials. Steel and iron producers are particularly vulnerable to the swings in economic events. Unfortunately, the market has become saturated with images of some of the best producers, like US Steel, being brought to their knees during the financial collapse. To sift out the undervalued stocks from the overly risky ones, I recommend mainly considering the operational fundamentals.

US Steel (NYSE: X): Too Risky

Given that it plunged into negative territory, US Steel is a very risky stock to invest in now. Some are still worried about a double dip, and the company, struggling to turnaround operations, still continues to bleed cash. Following the path of several first-mover competitors, management recently decided to increase prices by a minimum of $40/st on flat rolled steel. If producers continue to follow suit, equity analyst Dahlman Rose believes that new buyers will enter the market to increase lead times.

One main risk that US Steel faces is cheaper labor costs abroad - typically in China, which is becoming more and more of a leading steel producer. If it exports more goods, US Steel will have to fend against lower prices and thus yet tighter margins. Greater EPA regulations on the emissions of greenhouse gases could further put the country's iconic steel producer at risk of falling even further behind. With US Steel dependent on near-term capital expenditures, it can't afford to deal with a constrained demand market, let alone a tightly regulated one. Regrettably, a few of the firm's coke oven batteries are about to die, so the company will need to invest more in new facilities around the time when, I think, the economy will have hit full employment. These high expenditures during such an inflection point will deny investors the opportunity to outperform. Rising pension costs and strong labor union power further take away from the upside story.

Gerdau (NYSE: NUE) and ArcelorMittal (NYSE: MT) Both More Attractive

Fortunately, there are alternatives to US Steel. I am particularly optimistic about ArcelorMittal and Gerdau. In regard to the former, despite being extremely exposed to an uncertain European economy, the worst is factored into the stock price at a forward PE multiple of around 8x. Furthermore, the company has started to mitigate exposure to Europe through selling its Enovos International business.

Unlike for US Steel, I am attracted to ArcelorMittal's cost structure, which is so efficient due to the vertical integration and investments in countries with high labor freedom. In particular, the expansion into emerging markets will benefit from greater infrastructure spending by China via its recent stimulus package.

At the same time, ArcelorMittal also offers an attractive dividend yield of 4.6%. I do not expect this yield to go away any time soon, since the debt-to-equity ratio is low at <0.5x, and asset sales could easily finance more aggressive distributions. All in all, share repurchases however are more ideal. If the Obama administration successful hikes dividend taxes by 164%, this is particularly true. Since ArcelorMittal trades under book value, every share it buys back from shareholders is accretive to EPS and less taxing, literally, to shareholders.

You should thus consider backing a stake in ArcelorMittal with one in Gerdau. Investors have already factored in the worst for the steel and iron producer in light of the company's checkered history. Even still, the company has held shipments relatively above expectations compared to peers. Brazil has produced greater volumes for steal beams and bars while Latin America as a whole has generally had more macro visibility in the industry than originally anticipated.

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