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.

**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.

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