NEW YORK (
) -- Investors have been awaiting a steel-stock rebound for more than three months.
A recent series of profit warnings from the likes of
didn't surprise Wall Street so much as confirm the difficult fundamentals that have been in place for some time. With the costs of raw materials high and demand weak, it's hard to make any money right now if you're a steelmaker.
Industry observers note that the third quarter had long been stacking up as lackluster-to-ugly; those concerns have been priced into steel stocks at this point.
The way forward for the sector, then, would seem to hinge on three catalysts: Steel prices, China and the U.S. construction market, with the first item on that list being the chief factor.
"The one point data point that has been driving steel stocks has been steel prices," says Mark Liinamaa, the metals and mining analyst at
Of course, as action during Thursday's trading session demonstrates, macroeconomic news can swing the shares of steelmakers at any moment. An unexpected rise in jobless claims, for example, as the Labor Department noted on Thursday, can punish these names. Shares of
were falling 2.4% on heavier-than-average volume Thursday afternoon.
But you can't talk about steel prices these days without also talking about China. The country, which propels the fortunes of steel companies worldwide to a degree unthinkable even five years ago, has sparked concern among investors with its recent efforts to curtail production at its most polluting, energy inefficient steel mills. There are lots of them. The shutdowns could remove 25 million metric tons of steel-forging capacity from the Chinese industry by the end of the year, according to Morgan Stanley. Others have estimated as much as 50 million.
On the surface, that would seem like a good thing. Declining supply ought to prop up prices and, therefore, steel stocks, no?
In short, sort of. Here's why the answer might be no: With that much less iron ore and coking coal being bought by a reined-in Chinese steel industry, pro investors worry that global prices for those raw materials will also decline, which, in turn, would hurt the ability of even U.S.-based steelmakers to hike their prices. Pricing weakness, to the casually observing investing public, looks a lot like falling steel demand. If the market reacts to the belief that demand for steel is in decline --
! -- you've got a psychological recipe for some weak stock prices.
Market Vectors Steel ETF
The good news, according to Liinamaa, is that those fears may in the end be unfounded. The next catalyst for steel stocks may indeed be that raw materials prices, especially of seaborne iron ore, will actually hold up later this year, Liinamaa said. And, if that's the case, the Chinese reduction in capacity as it pulls the plug on aging, inefficient blast furnaces may also give support to worldwide steel prices.
Shares in the sector will also get a lift if any positive sign emerges at all from the U.S. construction business. So grim is the talk of investment pros on the subject that one begins to wonder if anything is being built in this country at all, other than the new World Trade Center.
"The market that continues to be dead is construction," says Rick de los Reyes, the global metals and mining analyst at the mutual fund
T. Rowe Price
in Baltimore. Automobiles, appliances, the tubes used to pipe natural gas -- all major steel end markets -- have more or less recovered from the depths of the recession. Prices for the kinds of steel used in these industries have, therefore, shown recent strength.
From a longer-term perspective, steel stocks aren't likely to break out and recover in earnest, Reyes says, until capacity utilization overall in the U.S. approaches the mid 80s -- that is, 85% or more of the nation's steel plants up and running full out. Right now, U.S. furnaces are working at about 70% of capacity. Ultimately, Reyes says, until that number improves, the industry won't have real pricing power (and, thus, a spark for stocks in the sector). And the only way for capacity utilization to improve, is for the construction market to come back from the dead.
As of its latest filing, T. Rowe Price owns Nucor and U.S. Steel, which happens to be Reyes' favorite stock in the sector at the moment. One of his reasons: U.S. Steel focuses on so-called flat products, or steel that's used in cars, appliances and the pleasingly named end market known as oil country tubular goods, or OCTG for short. This most iconic of steelmakers, based in Pittsburgh, promises to benefit from rebounding demand in its core end markets. Manufacturers of so-called long products -- the I-beams and rebar and other steel materials that go into buildings and infrastructure -- may have to wait a while longer for demand to return and pricing to stabilize.
The most prominent long-products steel companies include the mini-mill operators Nucor and
. As a consequence of their exposure to the derelict construction industry, these companies have seen their stocks get bashed. With Nucor, says Reyes, "the only thing that's been holding that stock up is its dividend yield," which stands at about 3.8%. Its stock is down nearly 19% year-to-date. Commercial Metals' stock has traded wildly this year, whipped around by buyout rumors, though it has remained stuck under $15 since June.
Mini mills, by the way, or electric arc furnaces, use recycled scrap metal as their primary raw material, unlike the old-line blast furnaces, which use iron ore.
Given all this, you'd think that a wise trading strategy might have been to go long the shorts and short the longs.
But it isn't quite so simple. Steel Dynamics, a mini-mill operator, has a mixed product offering. And AK Steel, which produces mostly long products, has suffered from a host of company-specific concerns that, in addition to the industry-wide problems, have dogged its stock for months. Namely, AK sourced much of its coking coal from the Massey-owned mine in West Virginia that exploded. Further, unlike the 100% integrated U.S. Steel, AK doesn't own its own ore mines. Thus, when iron ore prices rise -- which they had been doing for most of this year -- AK's profits get squeezed.
With all this in mind, here are four steel stocks to play as we move into the fourth quarter.
P/E Ratio: 80.5
Weighted Alpha: -19.30
Nucor, the country's largest steelmaker, is also the country's scrap-recycler nonpareil. Mini-mill technology was basically invented at the company in the late 1980s by the guys who went on to found Steel Dynamics. (Their story was chronicled in
The New Yorker
magazine and in the book
.) Nucor CEO Dan DiMicco, is an outspoken critic of Chinese export and currency policies. Nucor is widely respected for its consistent dividends and its balance-sheet strength.
In mid September,
for the third quarter, saying that it now expects earnings between 5 cents and 10 cents a share; analysts on average had been expecting 31 cents.
, net income fell 32% to $91 million, or 29 cents a share. Revenue rose 15% to $4.2 billion.
Nucor had cash and cash equivalents of $2.02 billion and long-term debt of $3.08 billion at the end of 2009.
Nucor sells for a book value multiple of 1.65, compared with an industry average of 1.94.
Roughly 27% of the 11 analysts covering Nucor rate the stock at the equivalent of strong buy; 18% have sell ratings on the stock.
P/E Ratio: N/A
Weighted Alpha: -14.6
The Pittsburgh-based U.S. Steel is the only 100% integrated steelmaker in the nation. Because it controls its own raw-materials sources, and its costs are mostly fixed, the company has the boom-bust mixed blessing of operating leverage, which supercharges profits during upcycles, and lambasts them during downcycles. Ditto its stock price.
in July, it disappointed investors with a surprise loss and a murky outlook. The company lost $25 million, or 17 cents a share in the July period, narrower than the loss of $392 million, or $2.92 a share, it reported a year earlier. U.S. Steel blamed the most-recent red ink on a stronger greenback, which hit an inter-company loan it had made to its European unit. Revenue in the second quarter more than doubled to $4.68 billion
U.S. Steel had cash and cash equivalents of $1.22 billion and long-term debt of $3.34 billion at the end of 2009.
U.S. Steel sells for a book-value multiple of 1.45, compared with an industry average of 1.94.
Of the 12 analysts covering U.S. Steel, one-third rate the stock at the equivalent of strong buy. Only one analyst has a sell rating, while five have hold ratings on the stock.
P/E Ratio: 13.76
Weighted Alpha: -36.7
AK Steel, based in West Chester, Ohio, is a blast-furnace operator and producer of flat steel products. Born in 1994, though with roots going back to 1899, AK is heavily exposed to the automobile industry, a fact symbolized by the company's most famous product: the "Armco" crash barriers used on Formula One tracks. Armco was AK's predecessor company. A component of the S&P 500, AK has struggled with raw materials prices this year.
Along with Nucor and Steel Dynamics,
in September. Pressured by rising raw materials costs and maintenance shutdowns at one of its plants, the company didn't give specific EPS guidance.
, net income rose to $27 million, or 24 cents a share, from a year-ago loss of $47 million, or 43 cents a share. Revenue more than doubled to $1.6 billion.
AK Steel had cash and cash equivalents of $462 million and long-term debt of $606 million at the end of 2009.
AK Steel sells for a book value multiple of 1.74, compared with an industry average of 1.94.
Of the 10 analysts covering AK Steel, two rate the stock at the equivalent of moderate buy; the rest have hold ratings on the stock.
P/E Ratio: 15.2
Steel Dynamics, based in Fort Wayne, Ind., is often called the "mini Nucor." That's because its three founders, who run the company, used to work at Nucor, where they were responsible for pioneering the world's first electric-arc furnace, or mini mill, which makes steel out of scrap metal. Steel Dynamics' management is widely praised, though it admits to making a mistake at the outset of the recession, levering up to buy back its stock at values that have since cratered. The company has been throwing a lot of cash at developing a plant in Minnesota called the Mesabi project, which promises to produce a feedstock that would serve as a substitute for scrap metal.
With Nucor and AK Steel, Steel Dynamics warned that its per-share earnings would fall below analyst estimates, its profit margins squeezed by higher scrap price.
, Steel Dynamics swung to a profit with earnings of $49 million, or 22 cents a share, compared with a year-ago loss of $16 million, or 8 cents a share. Revenue more than doubled to $1.6 billion.
Steel Dynamics had cash and cash equivalents of $9 million and long-term debt of $2.05 billion at the end of 2009.
Steel Dynamics sells for a book value multiple of 1.5, compared with an industry average of 1.94.
Of the nine analysts covering Nucor, four rate the stock at the equivalent of strong buy and four others a moderate buy. Just one analyst has a hold rating on the stock.
-- Written by Scott Eden in New York
>To contact the writer of this article, click here:
>To follow the writer on Twitter, go to
>To submit a news tip, send an email to:
Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.