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The Steel Sector

There is significant trepidation amongst investors when it comes to the Steel sector. Oversupply in the industry has weighed on prices and hence on companies' bottom line for several years. Production continues to outpace demand. Demand is significantly being depressed by issues in China. The U.S. steel industry has been particularly hit as companies abroad are able to produce at cheaper prices. There are two solutions to balance this supply versus demand conundrum.

No. 1 Companies cut production (supply) to cause prices to rise

No. 2 Worldwide demand increases

Anyone who believes No. 1 will happen is fooling themselves. Some production cuts have been made, but nothing of significance. And most of the production cuts have been from a select few companies in order to reduce costs. If the extreme depression in steel prices hasn't already led to significant production cutting moves by companies, it is unlikely it will anytime soon, especially since many companies expect demand to increase come late 2013 or early 2014. In fact, based on earnings reports from many companies, production started to increase this past quarter.

This leaves No. 2, an increase in worldwide demand. Companies think this is coming and analysts are starting to believe the same, but what are investors thinking? Obviously, during this age of free money from the Fed that pours into stocks, investors have been relatively cautious. Growth stocks remain the weakest part of the market, while defensive, high-dividend stocks continue to push to all-time highs. Investors want stocks, but haven't wanted steel.

What can cause this to change? The wheels are in motion for investors to start looking harder at the steel sector. With companies talking more upbeat on the future than they have in several years, and as analyst like Goldman Sachs start to improve their outlook on steel and China, investors will start to seriously look at opportunities in steel. However, caution has to remain high, and selectivity in the sector is the key for success.

Many have argued that the lack of a rally in growth stocks since the market bottom in 2009 versus the all-time highs set by the market is signaling that the economy is really not improving but is merely being propped up by stimulus. This is a perfectly reasonable argument and one I actually buy into. However, I have not used this as a reason to stay away from the market, and I am not using it as a reason to sell and be scared of the market right here. In the coming years it will be something to keep an eye on, but for the short term, U.S.-based steel companies are setting up for a nice buy opportunity on dips for at least the next year.

The steel stocks with most sound fundamentals are among U.S. steel companies: Nucor Corp. (NYSE:NUE), U.S. Steel Corp. (NYSE:X), Steel Dynamics Inc. (NASDAQ:STLD), and AK Steel Holding Corp. (NYSE:AKS).

Nucor Corp.

Nucor is one of the best-performing steel stocks this year. They are positive for the year in spite of being part of a sector that has been rocked. Their well thought out investment plan has kept them in a position of strong cash and high rewarding assets. They have a highly touted 2,500,000-ton direct reduced iron (DRI) facility in Louisiana; its largest project currently underway and is expected to come online in the third quarter of 2013. This processes facility will allow it to drastically improve cost and streamline steel production, making it more competitive in the global market.

Nucor uses mini-mills. As a mini-mill producer, Nucor relies on scrap metal, and now is expanding to use of DRI. Investors are applauding the move to DRI made by Nucor as the reduced costs will allow for it to be more competitive in the global market. It has plans to continue increasing its DRI facilities. This is the big reason why it has been able to outperform peers. A secondary benefit for Nucor is that its reduced use of scrap metal will likely push scrap metal prices lower, benefiting the business that will continue to purchase scrap metal. Lower scrap prices have started to be seen this quarter. Another potential benefit is that it would not be nearly as affected by a potential tax on CO2 emissions as the process for producing DRI generates 0.6 tons of CO2 versus the approx. 1.8 tons used by blast furnaces. While there are no expectations to see such a tax in the near future, the likelihood continues to rise as environmental concerns grow.

The fundamental picture on Nucor is one of the strongest among U.S. steel companies. The company reported EPS of $0.26 versus a consensus of $0.25, becoming one of the select steel companies to beat on earnings expectations. The first quarter earnings are down 39 percent from last year's first quarter earnings of $0.46 per share. This is not something to get overly concerned with as Nucor believes the worst is behind it, and the worst wasn't as bad as analysts feared. It remains cautiously optimistic toward earnings in the next few quarters and then expects strong earnings growth to kick up in 2014. The optimism comes on an uptick in steel demand and the cost cutting the DRI facilities allow. Nucor trades at 2013 10x EV/EBITDA and 2014 6x EV/EBITDA, a little higher than some of its peers like U.S. Steel and AK Steel, but it is actually making money while paying a 3.4% cash dividend yield.

Nucor is a safer and more stable way to play the steel sector. Its high-quality balance sheet gives investors a confident place to play sector wide demand growth. Nucor has an A3 Moody's credit rating and S&P gives Nucor the No. 1 rating of all major steel companies. Wall Street analysts are forecasting an EPS of $3.80 in 2014. This would make the stock very cheap at its current levels. Some may be concerned with how high it is trading relative to trailing earnings, but this fear should be calmed by how future projections make this a real value play.

While no one would call Nucor a defensive stock with a beta of 1.08, it is the best defensive play for investors looking to dip their toes into what they hope is an uptick in the steel industry. The relatively low beta, high dividend yield, future projections, being a leader in the sector, and its solid prospects for becoming more globally competitive due to its DRI technology, make Nucor my number one play for the steel industry.

Steel Dynamics

Another company committed to the use of DRI is Steel Dynamics. It too has been rewarded this year by gains as its commitment to DRI was reaffirmed; giving the cost cutting benefits that will increase earnings growth. It is a great value play considering forward earnings projections and its potential to gain more traction in the global market.

Steel Dynamics is trading at 6.5 times 2013 EBITDA and 5.9 times 2014 EBITDA. This is also higher than stocks like AKS and X. Some have argued that Steel Dynamics (as well as Nucor) trading at levels this high suggests that much of the good news has already been priced in. I disagree. This merely shows how investors prefer these stocks to their competitors as safer plays in the industry and that they still have much room to grow.

From a pure price action standpoint, Steel Dynamics has recently hit a 52-week high. This shows significant bullish momentum that is likely to continue. Its stock price performance along with growth in EPS, reasonable debt, and good cash flow make this an attractive option for investors.

Many analysts rate Steel Dynamics as a buy and suggest that an inflection point in the sector came this earnings quarter, an inflection that will lead to sustainable growth in the coming years (analyst comments on STLD). Of Wall Street recommendations tracked by S&P Capital IQ, the average opinion on Steel Dynamics is outperform.

While arguments can be made from a bullish and bearish standpoint on the steel sector and specifically Nucor and Steel Dynamics, the bottom line is that the price action shows that investors, who want exposure in a potential rebound in the industry, are looking to these high dividend, low debt, and sustainable projected growth stocks as the place to be. This trend is just starting and it is not too late to jump on the train.

High Risk, High Reward

For those who truly believe in the rebound potential coming in steel, AK Steel and U.S. Steel Corp. make for attractive options. They do carry higher risk and are likely to continue to be sold hard if no rebound materializes, but they will pop big if steel demand grows. U.S. Steel Group has reported that it is considering making a similar transition to DRI technology.

AK Steel and U.S. Steel Corp. both are sitting near 52-week lows, which have led them to trading at attractive valuations relative to Nucor and Steel Dynamics. U.S. Steel Corp. is trading at 2013 7.9x EV/EBITDA and 2014 4.8x EV/EBITDA. AK Steel is trading at 2013 5.1x EV/EBITDA and 2014 3.9x EV/EBITDA. These two stocks are low dividend, high beta stocks that are currently heavily shorted. Short float on U.S. Steel Corp. is nearly 30%, while short float on AK Steel is 32%.

Both stocks are highly levered to growth in global steel demand. Their attractive valuations and high short interest can lead to a major rally if significant growth in the industry advances. Strong growth prospects will send investors chasing losers, and the shorts will cover fast. This growth is arguable, which makes me more bullish on the more stable plays of Nucor and Steel Dynamics right here. I need to see more realized growth and not just chatter of hoped for growth before I move into the higher-risk plays like AK Steel and U.S. Steel Corp. However, if the growth starts to significantly materialize, I will move my money.

Source: Nucor And Steel Dynamics To Lead