With This Much Volatility, Should You Buy These Steel Stocks?

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

Basic materials can be one of the toughest sectors to invest in. While its seemingly easy to look at a company like Target and extrapolate growth based on consumer demand, it's very hard to predict where, say, rolled steel will go from here. I therefore encourage looking at the macro trends against market expectations to make an informed investment decision. Below, I review two major steel producers with this consideration in mind.

Gerdau (NYSE: GGB)

Gerdau, a Brazil-based producer of iron and steel, has slid 17% in value over the last 12 months. It nevertheless has taken steps to abate losses. Efforts like installing new water management systems and air cooling within plants will cut costs by €45 million each fiscal year. The firm is also laying off workers as it completes its modernization project aimed at boosting efficiency. It is particularly encouraging that some of the $50 million behind this modernization project was backed by the government with few strings attached--a clear indication that regulations will not be holding back the firm any time soon. Finally, the company is also making strategic acquisitions to reduce operating costs.

The stock trades at 8x forward earnings and is rated around a "hold" on the Street. It is forecasted for slightly weaker growth over the next five years compared to competitors. On the other hand, the company tends to create more value with its growth, which is evidenced by the 7.7% return on invested capital versus an industry average of 6.5%. The stock has more than doubled the volatility of the broader market, so I encourage, at the very least, diversifying with peer companies.

US Steel (NYSE: X)

Matters have been even worse at US Steel, which has seen its stock price decline south of 30% over the last 12 months. No matter, Credit Suisse recently upgraded the steel company from "Neutral" to "Outperform.' Like Gerdau, the company is also focused on making sensible moves to downsize. This can be most notably seen by the decision to sell off the Slovakian subsidiary due to higher labor costs and country royalties. The country is now in talks with the company to lower its fees and keep their largest employer from leaving.

Shares have risen in recent months from conservative management. However, I believe a few negative catalysts are in store for investors. First, the company is dealing with considerable oversupply in the domestic markets. This has put pressure on steel prices despite what the fourth quarter beat might suggest (EPS came out $0.39 cents ahead of consensus at -$0.35). While it is true that daily order entry rates have risen, construction remains fundamentally stressed--thus, a bad situation may very well become worse.

It may also become worse, because the steel companies are, ironically, getting optimistic. This means more mills when there is already overcapacity. Nucor's success with a natural gas plant has encouraged others to explore building their own. Governments from France to Slovakia are also preventing several market leaders from exiting or shutting down. Therefore, I believe matters will get worse before they become better.

Conclusion

US Steel now trades at a very strong 10.4x forward earnings and just under book value. It is yielding 11.8% against free cash flow, so there's clearly a lot of potential upside for those willing to take on the risk. Gerdau is more expensive at 1.1x book value and double-digit earnings erosion. In my view, investors should preferentially buy shares in Arcelor Mittal (NYSE: MT). This steel maker trades at around 0.5x book value and provides a 3.9% dividend yield. It carries significant scale, however, at a market cap of $27.2 billion. In my view, the company would be an ideal takeover target for either a team of private equity companies or a fellow steel producer. With the industry facing this much uncertainty right now, buyers would have great leverage at the bargaining table.


TakeoverAnalyst has no position in any stocks mentioned. 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. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

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