Despite Steel Uncertainty, Consider Buying These Two Stocks

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It is no secret that the steel market has one of the riskiest environments. Surpluses and high labor costs have constrained margins and limited upside. However, many stocks in the industry are now very cheap on a historical P/B basis and are positioned for upside from here. This could be seen in the high-digit gains that were recorded just from rosy China PMI data. Below, I review three steel producers with emphasis on book value, supply and demand, growth, and corporate strategy.

Pros and Cons of a US Steel (NYSE: X) Investment

The domestic producer of steel has been particularly vulnerable to this challenging environment. It is bad enough that chronic overcapacity has threatened the industry with a surplus of 300 million tons, but it is even worse that more mills are being set up. This would further drive down profit margins and add to the risk, which has been highlighted by ArcelorMittal's (NYSE: MT) difficulty in exiting France. The Prime Minister has discussed everything from nationalizing ArcelorMittal's plant to more royalties. It's a headache that the company never anticipated. Yet the stock is now more than 50% cheaper than book value, which means it could theoretically sell off its plants and generate cash that it is more than double the current market capitalization. US Steel currently trades at 0.9x book value, but if it sold off its assets to a synergistic buyer, the value would become closer to 1x if not much more.

However, US Steel is taking the right steps. The company is reportedly exiting Slovakia, a major move, since US Steel is the region's largest private employer with 11,000 local employees. Suitors are also apparently circling the Slovak operation for its cheap labor and ideal location. And with ArcelorMittal likely cutting its dividend yield from 4.4% to 1.2% after reporting an unsuspecting third quarter loss, US Steel may receive a wave of new investors. It generates strong free cash flow that yields 6.7%. Argus and Standpoint Research both released equity reports targeting the stock at $31 and $34, respectively. This indicates upside between 29.5% and 42%.

A Safer Investment: Gerdau (NYSE: GGB)

The Brazilian steel producer has seen less headwinds than US Steel and ArcelorMittal. Its financial position is still strong with a low weighted average cost of debt at around 5.5%. This is despite the company's net debt increase of 31% over the nine months ending 3Q12 and a 5% decline in steel production that is exacerbated by rising competition.  Because of its reduced risk, the stock trades at a premium multiple of 1.13x book value.

Going forward, management is aiming to increase yearly production to 24 million tons through a new processing plant that won't open until 2020. Steel consumption is estimated to rise 3.6% to 100 million tons in 2013, outpacing GDP growth by around 150 bps. A particularly strong tailwind will come in from Latin America: 6.4% growth to 43.5 million tons.

Analysts forecast 11.9% annual EPS growth over the next five years. Assuming expectations are met, 2016 EPS will come out to $1.57. At a multiple of 12x, this translates to a future stock value of $18.84. Discounting backwards by 10% yields a present value of $11.70, a 34.2% premium to the prevailing price. Free cash flow has also started to recover and now stands at $790 million, which is a yield of 5.2% and growing.

TakeoverAnalyst has no positions in the stocks mentioned above. 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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