Which Steel Is the Most Solid?

Lately Steel Makers have been on a tear. Last week the laggards were far outperforming the more fundamentally sound, more highly performing steel makers of this year. That is usually the sign that a rally is getting long in the tooth.

Cramer interviewed Nucor's (NUE) CEO DiMicco Friday. Cramer tried to get him to say the steel industry was about to explode upward. He shot Cramer down. Clearly Cramer was looking for his reaction. My take from all this was that steel prices have risen. Partially they have risen due to the low inventories as USA steel makers had drastically cut their inventories in 2009. Partially they have risen on increased demand due to the Cash for Clunkers program earlier this year. The remaining dealerships have to replenish their inventories. This replenishment production is slated to finish up at approximately the end of December. Whether demand continues to exist beyond this point remains up in the air.

Both NUE CEO DiMicco and U.S. Steel (X) CEO Surma have expressed the same thoughts about this. The US auto sales were relatively flat y-o-y for Ford, GM, and Toyota. They were much lower for Chrysler. Other manufacturers seem unlikely to be buying their steel from US or even Western Hemisphere companies (or are negligible in terms of numbers). We shall have to wait to see if the US auto industry numbers pick up.

Others are saying the Chinese auto sales numbers for November were good. They think this should stimulate steel demand. It should for Chinese companies. However, it is far from clear that it will have much effect on Western Hemisphere steel makers. According the steel industry analyst, Michelle Applebaum, “Chinese November exports hit a new record for the year . They were at the highest level of the year at 2.87 million tonnes, up 6% from 2.71 million tonnes in Oct. (and more than double the low of May). The uptick in exports and a 12% decline in total imports caused net exports to increase 42% for the month of Nov.” Does this sound like Western Hemisphere producers are likely to be selling more steel to China in the near future? Does this sound like the competition from China is likely to abate? It doesn’t seem likely.

This leaves the Western Hemisphere steel companies with the other markets around the world -- principally Europe and the US. The Russians, the Chinese, and the Ukrainians are all growing their production. They will provide serious competition. Many others such as the Japanese, Koreans, and Europeans will also be trying to gain market share. Western Hemisphere companies will be extremely pressured to do well even in a good economy. For instance, China has doubled their steel exports in the last 6 months. Let’s see how well-positioned these companies are to compete. The chart below provides some important details:

Stock	2010 PE	Price/ Cash Flow	% Short Interest	%Debt/ Capital	Rev./ Empl.	ROE	%Rise since Mar. 9	%Rise since Nov.2
X	48	-	17	40	$249K	-15.5%	171%	37%
STLD	13.8	41	77	52	$600K	-6.3%	133%	35%
ATI	29.5	15	14	33	$349K	+4.7%	105%	16%
AKS	16.4	-	9	43	$620K	-48.4%	233%	32%
RS	14.1	13	4	30	NA	+5.0%	91%	16%
NUE	15	38	3	29	$572K	-3.2%	34%	8%
CLF	15.8	12	6	18	$426K	+7.4%	233%	22%
GNA	13.2	-	4	48	$425K	-39.5%	147%	21%
GGB	11	26	2.3	42	$306K	+2.2%	276%	18%
SID	15.5	-	1.5	77	$114K	+52.8%	171%	5%

What can we glean from the above data? First Gerdau (GGB) seems to be the star of the bunch. It has grown at the highest rate since Mar.9, yet it still has the most reasonable FY2010 PE -- 11. Cramer recently recommended this as a good play on Brazil’s imminent infrastructure development and on Brazil’s infrastructure build for the 2016 Olympics.

Given the numbers this all sounds very logical. Cramer may be right about this one. Another steel play Cramer has recommended recently is NUE. This has a reasonable FY2010 PE -- 15. However, it has grown the least since Mar. 9, 2009, so I am not convinced it has bright future. If no one has bid the stock up much in the last year, it is probably not reasonable to believe it will do extremely well in the future, although the estimates indicate a likely substantial improvement. Consider also that CEO DiMicco did not seem to think NUE’s earnings were about to explode. This stock probably still represents a substantial risk given its earnings were negative for the TTM period. The idea that it will become strongly profitable within the next year might be termed speculation.

If you look at the steel stocks with the highest amount of short interest, you perhaps see a pattern. Except for Allegheny (ATI), they have very poor cash flow, Debt/Capital, and much higher than average growth since Nov. 2, 2009. This behavior of an above average growth spurt by the laggard stocks in a sector often indicates that the end of a surge upward is near or at hand. Three stocks meet this criteria: X, Steel Dynamics (STLD), and AK Steel Holding Company (AKS).

Of these X and STLD would seem to be the best short opportunities. X has 17% short interest, negative cash flow, and a FY2010 PE of 48. This stock is clearly overvalued when compared to a large group of other stocks which have FY2010 PE’s of 16 or below. It is trading at a 3-fold premium to those. The idea that X will go from losing -$10+/share in 2009 to profitability in 2010 seems to be speculative at best. Even the steel company CEOs do not wish to aver confidence in the estimates. A good part of X’s recent surge is likely short covering as the sector surge has continued. It is likely short covering as some analysts keep touting these stocks beyond reason. I tend to think this is fairly typical pump and dump behavior by brokerages. Many agree with me (notice the short %). Still there are always some who believe the hype.

The CEOs are saying that the surge from the Cash for Clunkers auto inventories replacement will be over by the end of December. They have not noted especially strong orders beyond that for the US automakers CFC‘s replacements.

People talk of the great China auto sales, but unfortunately, Western Hemisphere steel makers are not likely to benefit from those sales substantially. They are going to be lucky at this point to retain the US and European business they have in the face of increasing Chinese, Russian, and Ukrainian exports. STLD and AKS are also both possible shorts. In fact STLD has 77% short interest. However, both of these companies are at least predicting much better earnings than X for 2010 (about 3-fold better). Plus I am reluctant to go near any stock that has 77% short interest (STLD), as it may move dramatically positively on a short squeeze.

I would elect only to short X. Many things are going against it. On top of everything else, it has a very low revenue per employee figure ($249k) for a USA steel company. More successful USA steel companies seem to average about $600K per employee. This is another indication of problems. You cannot compare X directly to South American steel makers in the revenue per employee area.

I will refrain from comment on most of the other steel makers. Aside from GGB (a Cramer pick), the ones I would be most inclined to invest in would be Cliffs Natural Resources (CLF) and Reliance Steel (RS). Given that CLF is being added to the S&P500 on Dec. 18, 2009. It may be a good near term play to the upside. Cramer’s pick of NUE has some appeal, but I do not like its growth profile. I think this surge may have played itself out for the moment until some hard US industry specific good news comes out. Analysts cannot keep touting Chinese demand growth when these companies simply are not servicing much of it. That hype has to die the death that hype without hard numbers generally does.

I am more inclined to think these stocks are due for a pullback as the Cash for Clunkers order work ends. There may be good orders next year, but it would be wise, given the current valuations (and current economic conditions), to wait for actual news about great US and European steel orders beyond CFC’s. The hard indications are not there yet. The numbers the stocks are trading on are end of year 2010 numbers, not current earnings. Speculating beyond even FY2010 numbers seems foolish at best. That is why the FY2010 PE of 48 for X makes me want to short that stock. Even that high number may be very unrealistic. I can see no hard facts behind the estimates for the steel makers. The market should eventually correct for the hype and speculation.

Specifically with respect to X, the technical chart seems to indicate that it should move downward soon. It is over bought in the Williams %R indicator. Money flow into the stock is trending downward. It is at its upper Bollinger Band (a point from which it usually moves downward). Additionally the price of X is substantially above its 20-day, 50-day, and 200-day sma's. If the sector starts to retrace, as it should, X should outperform to the downside. Of course, you may wish to wait until the sector retracement more demonstrably starts. The SLX chart below the X chart indicates that Money is still flowing into the steel industry stocks.

X chart:

The 1 yr. X chart:

More than the 3 month chart, the 1yr X chart shows the voulme has been steadily decreasing since May. This adds to my inclination that a retracement in this stock is coming soon.

SLX Chart of 12-12-09:

You can see on the SLX (a steel ETF) chart that even though SLX is over bought on the Willaims %R, the Money Flow indicator shows that money is still moving into steel makers. I believe it is on the cusp of changing direction, but it is often best to be sure. it is also best to consider the overall market.

The GGB Chart from 12-12-2009:

I tend to think this may not be the best time to enter GGB as I am expecting a retracement in the Western Hemisphere steel stocks. I do like the stock longer term though.

The 1yr. SPY Chart from 12-12-2009:

The SPY chart looks like it is getting toppy. Plus the volume has been steadily decreasing since April. This makes me think that a retracement will occur soon. A retracement in the overall market will aid a retracement in steel.