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The steel industry has been whipsawed through the past couple of years from the summer of 2008 when prices reached all time highs through the economic downturn which saw drastic price drops and diminished demand, to the last few months which have seen steel prices rise again. While steel prices have not yet returned to all time highs, there have been significant increases. Other metals, in particular copper, have also shown significant increases. Copper is currently trading well above its previous highs from 2008 with some projections suggesting prices going over $5 per pound.

United States Steel Corp. (NYSE:X) is the leading U.S. producer of steel by revenue. It operates in three main segments: flat rolled, tubular, and Europe. Globally, it trails both ArcelorMittal (NYSE:MT) and Pohang Iron & Steel Co., Ltd. (NYSE:PKX). Domestically, it is slightly larger by revenue but smaller by market capitalization than Nucor Corporation (NYSE:NUE). In fact, on a price to sales basis, X is ranked 18th among 24 steel producers screened by Zacks.com. Is United States Steel Corp. a potential long investment or simply a stock to avoid?

15 Leading Steel Producers
Ticker Name Annual Sales ($ Millions) Market Cap ($ Millions)
MT ArcelorMittal 78,025 55,381
PKX Pohang Iron & Steel Co., Ltd. 28,346 35,963
X United States Steel Corporation 17,374 8,185
NUE Nucor Corporation 15,845 14,805
OTC:SMMLY Sumitomo Metal Industries Ltd. 14,144 11,871
GGB Gerdau S.A. 13,482 22,650
SID National Steel Corporation 7,690 24,604
TX Ternium S.A. 7,382 7,183
CMC Commercial Metals Company 6,306 1,875
STLD Steel Dynamics, Inc. 6,301 4,022
OTCPK:USNZY Usinas Siderurgicas De Minas 6,245 5,843
AKS AK Steel Holding Corporation 5,968 1,732
MTL Mechel Steel Group OAO 5,754 11,926
SCHN Schnitzer Steel Industries, Inc. 2,301 1,682
GSI General Steel Holdings, Inc. 1,668 132

Discounted Cash Flow Analysis

I completed a discounted cash flow analysis on United States Steel Corp. to evaluate it as a potential long investment. The discounted cash flow method is one of the basic tools for valuing companies. Essentially it states that the value of an enterprise is equal to its future cash flows discounted at an appropriate rate to account for the risk in those cash flows. This methodology produces a value that is reflected to the expected cash flow. It does not provide any insight into potential risks or sensitivities.

The appropriate discount rate is based on whether the cash flows have been adjusted for servicing debt or are prior to debt service. I used the unlevered free cash flow method which targets an enterprise value. The appropriate discount rate should then reflect both the cost of debt and the cost of equity. In this case, a weighted average cost of capital (WACC) is appropriate. The required equity return can be calculated using the Capital Asset Pricing Model (CAPM) with an equity risk premium, an equity beta, and a risk free rate (approximated by the 10 year U.S. Treasury Bond rate). The unlevered free cash flow in its simplest form equals net income + depreciation/amortization – changes in working capital – capital expenditures + interest expense * (1 – tax rate).

WACC Components
WACC Component Value
Risk Free Rate 3.4%
Beta 250.0%
Equity Risk Premium 6.0%
Required Equity Return 18.4%
Cost of Debt 5.0%
Tax Rate 35.0%
Debt Weighting 33.0%
Equity Weighting 67.0%
WACC 13.4%

The key assumption in the WACC is the beta for the equity, I used 2.5 which is consistent with the 2.45 reported by Zacks.com and 2.5 by Yahoo!Finance. The industry average pulled was around 1.7-1.8 with the range going from .8 to 2.6 for the larger steel producers. This is a clear variable for conducting sensitivity. Since beta's are calculated based on price histories and not an observed "asset beta" it is possible that X beta is overstated. I also used about 2/3 equity to 1/3 debt based on approximate market values of these items. The one observation is that with a 2.5 beta, the required equity return looks unrealistically high. A deeper fundamental assessment of the competitive landscape might reveal additional insights, justifying this required return.

Historical Income Statement
Year Status Revenue Revenue Growth Net Margin Net Income
2008 Historical 23,754 NA 8.9% 2,112
2009 Historical 11,048 -53.5% -12.7% (1,401)
2010 Historical 17,374 57.3% -2.8% (482)

The next key observation about the steel industry is that it cycles through good times and bad times. It is not that unusual for steel prices to rise by 50-100% over a single year period. This creates challenges when projecting forward. One of the key variables to consider here would be gross margin and long term growth. These would be key sensitivities. My base case assumptions were a restoration to 13.5% gross margin with a 5% long term growth.

Base Case Unlevered Free Cash Flow ($ Millions)
Year Status Net Income Depreciation Change in Working Capital Capital Expenditures Unlevered Free Cash Flow
2008 Historical 2,112 605 (585) (896) 599
2009 Historical (1,401) 661 1,267 (619) (406)
2010 Historical (482) 658 (701) (676) (879)
2011 Projected 322 617 (211) (676) (78)
2012 Projected 833 623 186 (690) 829
2013 Projected 1,403 629 (139) (690) 1,081
2014 Projected 1,480 635 (114) (690) 1,185
2015 Projected 1,548 640 606 (690) 1,979
2016 Projected 1,619 644 (71) (690) 1,378

This base case shows a slight overvaluation of the stock.

Base Case Valuation Summary ($ Millions)
Valuation Component Value
Enterprise Value $ 12,054
Debt and Liabilities $ 4,825
Cash $ 578
Potential Equity Value $ 7,807
Current Equity Value $ 8,185
Potential Appreciation -5%

Comparable Analysis

After the discounted cashflow analysis, I compared X to its competitors based on forward P/E, P/B and P/S. I also included recent operating margin.

Steel Producers Valuation Comparables
Ticker Market Cap P/E (F1) P/E (F2) Price/Book Price/Sales Operating Margin (ttm)
MT 55,381 13.6x 9.1x 0.8x 0.7x 5.0%
PKX 35,963 8.5x 8.4x 1.2x 1.3x 13.5%
SID 24,604 9.8x 7.2x 5.6x 3.2x 18.1%
GGB 22,650 10.5x 7.1x 2.0x 1.7x 8.9%
NUE 14,805 18.5x 12.5x 2.0x 0.9x 0.9%
MTL 11,926 8.0x 7.7x 2.5x 2.1x NA
X 8,185 15.8x 10.8x 2.1x 0.5x -2.3%
TX 7,183 9.5x 9.1x 1.0x 1.0x 12.2%
OTCPK:USNZY 5,843 9.6x 7.4x 0.6x 0.9x 13.8%
STLD 4,022 11.1x 8.5x 1.9x 0.6x 2.3%
CMC 1,875 25.1x 9.4x 1.5x 0.3x -2.1%
AKS 1,732 22.3x 10.9x 2.7x 0.3x -0.8%
SCHN 1,682 15.1x 11.8x 1.7x 0.7x 3.6%
FSTR (L.B. Foster)
387 13.8x 12.1x 1.6x 1.0x 4.3%
ROCK (Gibraltar)
321 26.7x 14.8x 0.6x 0.4x 0.2%
ZEUS (Olympic Steel)
306 18.2x 13.6x 1.2x 0.6x 0.4%
CHOP (China Gerui)
251 4.8x 4.0x 1.7x 1.1x 19.3%
USAP (Universal Stainless)
217 12.8x 11.0x 1.4x 1.1x 7.0%
SHLO (Shiloh)
193 17.6x 11.6x 1.9x 0.4x 1.5%
Average (>$4B) 19,056 11.5x 8.8x 2.0x 1.3x 8.0%
Average (<$4B) 774 17.4x 11.0x 1.6x 0.7x 3.7%
Average 10,396 14.3x 9.8x 1.8x 1.0x 5.9%

X does not compare favorably to its peers showing the lowest operating margin overall and the lowest price to sales among the large steel producers. Its price to book is consistent with some of its larger peers but higher than the two leading companies: PKX and MT.

Relative to its 52-week highs and lows, X is substantially off its low and in the middle in terms of distance to its high.

Conclusion

United States Steel Corp. appears to possibly be slightly overvalued. However, this valuation is highly sensitive to gross margin, beta, and long term growth prospects. The chart below shows this sensitivity with long term growth across the top, ranging from 4% to 6%, and Gross margin down the left hand column ranging from 9% to 19%. The values show the relative appreciation or depreciation of the equity value from current prices.

Equity Value Sensitivity Analysis
Long term growth
Gross margin 4% 5% 6%
9.0% -83.7% -81.8% -79.2%
11.0% -50.6% -47.5% -43.5%
13.0% -17.4% -13.2% -7.9%
15.0% 15.8% 21.1% 27.8%
17.0% 48.9% 55.4% 63.5%
19.0% 82.1% 89.7% 99.2%

A deeper analysis of its cost structure to determine its overall competitiveness could also yield additional insights. For example if it has a high cost structure and steel prices continue to rise higher than current market expectations, there could be some upside. However, given its positioning outside of South America and Asia, it does not appear to be well placed to capture future growth of those regions, but rather has to rely upon more mature markets that have seen their steel consumption gradually decline over the years.

Source: Is United States Steel Corp. a Good Investment Opportunity?

Additional disclosure: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.