U.S. Steel: Goldman Continues To Boost Steel Sector Momentum

Nov. 5.13 | About: United States (X)

Shares of US Steel (NYSE:X) continue to add to their impressive momentum in recent times.

The reason are some bullish research comments from Goldman Sachs (NYSE:GS) about the wider US steel sector, allowing US Steel to continue to move higher. This latest move comes after shares have already returned some 50% over the past quarter.

Note however that momentum going forward depends on structurally higher steel prices, not controllable by US Steel, unfortunately. After the significant momentum I remain a bit cautious.

Goldman Becomes Bullish

Goldman Sachs upgraded US Steel from "Sell" to a "Buy" accompanied by a $30 price target. The price target suggests some 16% upside from Friday's closing price.

Analyst Sal Tharani furthermore gave an upgrade for the entire sector as risks associated with oversupply are already priced in at the moment. Tharani expects a recovery in steel prices in the coming year. While volatility within the cyclical sector will remain the norm, investors should look beyond near-term headwinds for structural improvements.

Particularly for flat steel, the supply-demand fundamentals become more appealing with supply being taken out and demand drivers being firmly in place. Lower iron ore costs, which are input costs for steel makers for firms like US Steel, bode well for margins going forward.

Third Quarter Results

Just last week, US Steel reported its third quarter results. Revenues for the third quarter came in at $4.13 billion, down 11.2% on the year before.

The company reported a $1.79 billion loss, compared to a minor profit of $44 million last year. Note that the company took $1.78 billion in goodwill impairment charges during the quarter which is the direct result of structural weakness in the sector.

Valuation

US Steel ended its third quarter with $697 million in cash and equivalents. Total debt stood at $3.94 billion, for a net debt position of around $3.2 billion.

Revenues for the first nine months of the year came in at $13.15 billion, down 11.4% on the year before. The company reported a loss of $1.94 billion, driven by goodwill charges. This compares to a $74 million loss the year before.

At this pace, annual revenues of $17-$17.5 billion should be attainable for 2013 as the company will report a large GAAP loss.

Factoring in gains of 4% on Monday, with shares exchanging hands at $27 per share, the market values US Steel at $3.9 billion. Equity of the firm is valued at merely a quarter of annual revenues.

US Steel currently pays a modest quarterly dividend of $0.05 per share for an annual dividend yield of 0.8%.

Some Historical Perspective

Long-term investors in US Steel have seen terrible returns. Shares rose from $30 in 2004 to peak around $190 in 2008. Shares lost over 90% of their value to levels around $17 in 2009.

After shares recovered to highs of $60 in 2011, shares have traded in a $15-$30 price range over the past two years.

Despite the headwinds, US Steel has increased its annual revenues by a cumulative 75% to $19.3 billion between 2009 and 2012. Note that US Steel has reported only GAAP losses in recent years, although they have narrowed significantly. 2013's revenues will come in markedly below 2012's revenues as US Steel will report a huge loss based on impairment charges.

Investment Thesis

Note that US Steel continues to make progress in aligning its cost base to the difficult market circumstances, even as it is close to finalizing its fifth year of GAAP losses in a row.

Excluding the huge goodwill impairment charges, US Steel managed to report adjusted losses of $20 million for the third quarter. These losses of $0.14 per share were much lower than the loss of $0.43 per share expected by the market. The flat-rolled segment in North America was the driver behind the better than expected results and shows the large degree of operating leverage within US Steel's business model.

This just illustrates that US Steel still highly relies on market circumstances, determining its real profitability. To counter years of continued losses, US Steel initiated project Carnegie, aimed to improve both revenues and costs. The company plans to execute on this strategy in order to be profitable in each possible market circumstance.

To further improve profitability, the company has decided to shut down the operations at Hamilton Works by the end of this year, leading to a non-cash charge of $225 million. This would result in a $50 million cost reduction per annum and reduces cash needs by another $25 million per annum.

All these items make a difference as US Steel continues to operate in difficult market circumstances, operating with modest losses on an adjusted basis. Yet the real improvement has to come from real steel demand resulting in higher cyclical demand and prices, allowing US Steel to report meaningful earnings again.

In such a scenario revenues of $20 billion and earnings of a billion should be attainable, which looks really attractive at the current $4 billion equity valuation. That being said, the operations further have to support a net debt position of over $3 billion.

Despite the upgrade and the cost initiatives, structural changes have to materialize to continue to drive longer term momentum. Over the past three months, shares have already advanced by some 50%. To further drive gains, the demand for steel has to improve structurally, something which US Steel cannot control.

I remain on the sidelines.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.