U.S. Steel’s Turnaround Could Get Scrapped in a Down Market

NEW YORK (TheStreet) - U.S. Steel (X) has been working on a turnaround by cutting back on expenses and lifting its sales. The Pittsburgh company surprised the market with a second quarter adjusted profit in July and followed that up in late October with its highest third-quarter segment operating income since 2008.

However, the performance of the second-largest steel producer in the U.S. will likely go downhill from here, thanks to deteriorating oil prices and increasing competition from foreign producers.

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U.S. Steel serves the energy market via its tubular business, which is its second-largest source of earnings overall, responsible for 18.3% of the company's total segment income from operations in the first nine months of this year. The company is the biggest producer of energy tubular products in North America.

In an email interview with TheStreet, Charles Bradford, president of the metals and mining investment research firm Bradford Research, said the tubular business, which has been highly profitable for a number of years, was already on the "edge of disaster." The consumption for tubular goods, such as pipelines, stands at between six and eight million tons while four million tons of new capacity is either being built or being finished to fill this gap. As such, "U.S. Steel's tubular business was likely to suffer from lower prices" due to the new supply.

Further, the 48% drop in WTI future prices over the last six months to its multi-year lows will impact the amount of drilling activity in 2015. A handful of oil producers, such as ConocoPhillips (COP) and Oasis Petroleum (OAS) , have already announced capital expenditure cuts but Goldman Sachs's Brian Singer said in his recent report that other oil producers will make similar announcements through February.

For U.S. Steel's tubular business, a slowdown in oil and gas drilling will impact the demand side of the equation, which will exacerbate the pricing environment.

Moreover, cheaper foreign steel will exert downward pressure on domestic prices, narrowing the premium over global prices which U.S. steel producers have been enjoying for years.

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"Steel prices outside the U.S. are usually lower than domestic steel prices" Bradford said, particularly in countries like Russia that have lower production costs due, in part, to the availability of cheaper raw materials. Moreover, the strength of the U.S. dollar against other currencies is a "serious problem" for U.S. based steel producers since it leads to "lower costs overseas."

The difference between U.S. and Asian prices for hot rolled coil steel has climbed to unusually high levels, currently at $180 per short ton, Bradford said. The Chinese hot rolled coil prices, as per Axiom's Johnson, are near one of their lowest levels since 2003 while the U.S. prices are still "substantially" higher than their five-year lows.

The lower price of foreign steel makes it more appealing to consumers and is fueling the metal's imports in the U.S. to "near record all-time high levels" during the three months ending October, Johnson wrote.

The non-U.S. based producers are tapping into the healthy demand for steel which could remain "decent" in 2015, Bradford predicted, thanks to the recent recovery of the non-residential construction market, the largest market for steel which drives 40% of the demand, as well as strength in the automotive sector, the second largest market which underpins 20% of the demand. 

These increasing imports would reduce U.S. hot rolled coil steel's premium over global prices from between $75 and $100 per short ton to between $50 and $70 per short ton in 2015, Johnson predicted. This could be bad news for U.S. Steel as well as other steel stocks, such as AK Steel (AKS) . 

With grim prospects of tubular business due to lower oil prices and a drop in steel prices in 2015, U.S. Steel's earnings may have peaked, Johnson warned.

U.S. Steel did not respond to email and phone messages from TheStreet requesting comment. The company's shares have dropped by 3.7% for the year to date and are currently trading around $28.50.

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TheStreet Ratings team rates UNITED STATES STEEL CORP as a Buy with a ratings score of B-. TheStreet Ratings Team has this to say about their recommendation:

"We rate UNITED STATES STEEL CORP (X) a BUY. This is driven by multiple strengths, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its revenue growth, compelling growth in net income, notable return on equity, impressive record of earnings per share growth and largely solid financial position with reasonable debt levels by most measures. We feel these strengths outweigh the fact that the company shows weak operating cash flow."

You can view the full analysis from the report here: X Ratings Report

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage. At the time of publication, the author held no positions in any of the stocks mentioned.

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