Danger Stock Picks: 3 Steel Producers To Avoid

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If you are looking to buy low and sell high, I encourage you to not jump into bear markets or "play against the tape". Sure, the large steel producers could recover a few years down the road; but, for now, many of them are going to continue to struggle. I recommend looking at geographical exposure and predicting macro events to gauge how safe a company's operations are. Below, I review several stocks with this in mind.

Avoid Gerdau (NYSE: GGB), ArcelorMittal (NYSE: MT)

Gerdau trades at 7.3x forward earnings versus 9.8x for ArcelorMital, but the latter is quite cheaper in terms of liquidation value with a market-to-book ratio of 0.43x. The Indian steel maker faces considerable headwinds that are holding back value. France's President, François Hollande, has proposed everything from banning ArcelorMittal from operating in the country to nationalizing the struggling Florange plant. The French government is pushing for ArcelorMittal to sell its assets instead of shutting down--something that the company is not as enthused about, as evidenced by its insistence upon selling only the plant's idled part. Latest reports are that a private steel industrialist will put 400 million pounds into renovating the plant and that a deal is being discussed to avoid nationalization. So weak labor freedom is just one major headwind for ArcelorMittal.

There are several others. Legendary short seller is betting against iron ore and has called the metal a "bubble" that will see prices fall below $100 per ton next year and then $80. He points to Chinese growth slowing--a point that is reflected in ArcelorMittal's reports of weakening iron ore prices. In the third quarter, the company lost $709 million, which is $479 million, or 3.1x, than what analysts were expecting. In general, the industry has tremendous overcapacity with a supply ability of 1.8 billion tons representing a surplus over expected orders of 1.5 billion this year.

Gerdau, on the other hand, has done quite well for itself relatively. It is up 8.7% over the last 12 months but still does not generate substantial free cash flow. The $15.3 steel producer has been recovering and yielded $789 million over the twelve trailing months, or a 5.2% yield. Return on invested capital of 7.7% is also quite weak - below both the cost of capital and the industry average. Input costs are rising while pricing remains under pressure. For this reason, I recommend avoiding the stock and looking elsewhere.

US Steel (NYSE: X): Not The Place To Be

US Steel may be the place to be. It was recently rated a $31 stock by Argus in its "buy" report. Standpoint Research is even more optimistic and has a price target of $34. The stock has been hovering around $21.10 over the last 4 months. Free cash flow has sharply recovered from $1.3 billion loss in 2Q10 (ttm) to $385 in gains in 3Q12 (ttm), which represents a terrific 12.3% yield. On the other hand, the domestic steel producer has a poor return on invested capital.

The company is also looking to exit Slovakia, which is part of a broader downsizing in Europe where demand is slowing. This is particularly disappointing in light of the region's cheap labor and advantageous location. Producers, like steel conglomerate Thyssen, has been speculated as a buyer given its interest in the European market. Management has also guided for continued fourth quarter weakness in both North America and emerging markets with a loss in flat-rolled business.  Performance, on the other hand, has been quite good of late. It had positive surprises of 36.7% and 38% leading up to third quarter, which was also better than expected.

EPS is still expected to double, and the insiders appear to be buying into that prospect, as evidenced by their ownership rising to 27%. It has been testing against resistance. While I don't recommend aggressively purchasing shares, I find the investment preferable to Gerdau.

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