Through my macro research, one company that I keep coming back to is United States Steel Corporation (NYSE:X). Maybe it is due to my interest in manufacturing, or my bet on the recovery of the United States economy--regardless, this industrial producer just keeps catching my attention. The unique difficulty in modeling the company's finances through a DCF analysis illustrates much of the risk inherent in this stock.
U.S. Steel is led by excellent management, but the nature of its operations make it vulnerable to chaotic changes in inventory size, prices of raw materials, and economic output. With a beta of 2.49 and little dividends, this is not a company I would recommend to those expecting a double dip or a prolonged recession. This is a company that, at its core, I believe to be a bet on economic resiliency of the United States.
In a stagnating economy, tax revenues are down and there is an expected decrease in infrastructure spending. A volatile economy is perhaps even more devastating in the extent that it leads to unpredictable shortages and surpluses of steel. Considering that the steel maker has a current ratio of 1.67 and a quick ratio of 0.92 (below that of most of its peers), the company could face liquidity problems if the economy takes an unexpected swing. Below is a diagram of U.S. Steel's production relative to capacity for two of its segments--flat-rolled and U.S. Steel Europe (USSE)--in millions of net tons.
The company is also engaged in other businesses of synergistic value to the core-- particularly, railroads and real estate. A volatile or stagnating economy could thus have a doubly negative effect on the company. I do not find U.S. Steel well diversified abroad, in addition to facing intense foreign competition. Below is a diagram of the corporation's steel mill locations.
Stabilizing prices for commodities and improved operating performance are several factors working in the company's favor. In 2Q11, the company reported net income of $222M, or $1.33 per diluted share. All segments, save flat-rolled, had negative income for the quarter. Flat-rolled had an income of $36M and makes up the majority of U.S. Steel's revenues.
Metal prices, foreign exchange rates, and inventory management risks will increase the possible return an investor can get from this stock. EPS has been incredibly volatile over the last five years: $11.19, $7.40, $17.96, $10.42, and -$3.36. It is expected to turn positive in 2011 at $1.49 and then increase by 182.6%. With a forward PE of 6.5 and more than half of its value lost this year, investors are hesitant about betting on a company that could be in free fall.
However, for investors confident about an economic recovery and willing to take on the risk, the fundamentals of U.S. Steel offer promise. In regards to risk, I always remind investors about the Keynesian beauty contest. Namely, equity markets operate under game theory where equilibrium prices are determined by what rational agents think others value companies at. There is one important point to add to this theory, namely that equity markets are not completely rational but correct anomalies in time. Put differently, if you feel that "others" are expecting a double dip, and further believe that "others" feel the same way about this common knowledge, then you could lock in a nice risk-adjusted return if matters do not turn out as bad as what the overall market had expected. I believe that talks of a double dip and America losing its economic lead may be reasonable, but are exaggerated.
Given the above situation, I expect solid returns from U.S. Steel. My model forecasts revenue growing by 18.2% to $20.5B and then by 9% the next year. I further anticipate free cash flow becoming positive in 2012 and rising to $382M in the next year. While mosts analysts give this company a "hold", I would rate it between a "hold" and a "buy".
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.