Recent news during the last week from the Bank of England, the UK business secretary Vince Cable, and technology research firm Gartner are re-invigorating fears of a global-dip recession, that may first make its appearance in the eurozone countries. Although the U.S. economy is relatively less weak, an escalation of the sovereign debt crisis in Europe could then nudge the U.S. into a double-dip. And if demand collapses in Europe and the U.S., it is difficult to imagine how the Chinese economic engine will buck that trend for long.
The steel sector that had dropped almost 50% peak-to-trough this year is one of the most economically sensitive sectors. In the last dip in the 2008/09 crisis, the average steel stock corrected 80% peak-to-trough from May to November. This time around, the sector is under threat not just due to a possibility of weakening demand related to the double-dip, but also due to increased capacity and the resulting weakening of pricing power, and higher input costs, especially iron ore.
The average steel stock is currently trading in the low- to mid-single-digits forward P/E ratio, at a steep discount to the projected earnings growth. Furthermore, many steel manufacturers are reporting impressive quarterly numbers, including one today from United States Steel Corp (X) and another last Thursday from Nucor (NUE). However, most stocks still trade 40% below the peak earlier in 2011 and 60% below the peak in 2008.
At the same time, though, the long-term outlook for the steel sector continues to be bullish. Global steel output currently at 1.3 billion tons annually has been rising steadily (from 850 million tons in 2000), driven mostly by economic growth in China, which now accounts for almost half of global steel output of 1.3 billion tons annually. Besides China, the Indian steel market is expected to grow significantly in the years ahead, from a production of 124 million tons in 2012 to 275 million tons by 2020, which would make it the second-largest steel manufacturer, ahead of 3rd-place EU. The U.S. at 6% of the global steel production, and shrinking as a share of the global market, will slide to 5th place.
Since what’s keeping a majority of the investors away is the fear of a double-dip recession, we tested to see which steel stocks would outperform on a relative basis in the event of a double-dip recession. We based on our analysis on not just forward P/E, but also price-to-book (P/B) ratio and the price-to-sales (PSR) ratio, the last two being relatively immune to pricing fluctuations that are characteristic of the boom-bust cycle that is characteristic of the steel sector.
We determined, based on our analysis of the major steel stocks, that at the depths of the 2008-09 recession, specifically at the end of 2008, the average steel stock traded at a forward P/E of 7.0, at an average P/B ratio of 1.7 and at an average PSR of 0.8. Based on that (see table), we determined that the best values in the steel sector, even after factoring the worst case of a double dip recession, are:
- AK Steel Holding Corp. (AKS), a U.S. manufacturer of flat-rolled carbon and stainless steel for the automotive, construction and appliance industries;
- United States Steel Corp. (X), a U.S. manufacturer of flat-rolled and tubular steel products for the automotive, container, construction and appliance markets;
- Arcelor Mittal SA (MT), a Dutch manufacturer of finished and semi-finished carbon steel products used in the automotive, appliance and machinery markets; and
- Mechel Oao Ads (MTL), a Russian manufacturer of mining and steel products for construction, engineering, defense and other industries.
All of the above-listed steel companies trade below the target price determined based on either and all of the above three measures of forward P/E, P/B and PSR, with MTL faring the best, as the calculations suggest that it is trading at least at a steep 50% discount even under this worst case scenario of a double-dip recession.
In an earlier article, we determined which steel stocks would fare the best if steel prices rebounded from here. Our conclusion based on that analysis was that in this best case scenario, X, MTL and MT from the above list would fare the best, at least double or even tripling from current prices. Furthermore, AKS was also expected to do well, although not as well as first group.
The following four companies are expected to fare average, as they are trading above the target prices determined under the worst case scenario of a double-dip, on two of the three measures:
- Gerdau SA (GGB), a Brazilian producer and seller of common and special steel rods for the industrial and civil construction markets;
- Companhia Siderurgic Ads (SID), a Brazilian producer of galvanized, hot and cold rolled and tin mill steel products;
- Nucor Corp. (NUE), a U.S. manufacturer of hot-rolled steel and steel joists for the automotive, construction, machinery and appliance industries;
- Steel Dynamics Inc. (STLD), a U.S. manufacturer of flat-rolled, structural, bar and rail steels, and recycles ferrous and non-ferrous scrap metals; and
- Allegheny Technologies (ATI), a U.S. manufacturer of specialty alloys used in the aerospace, construction, automotive and electrical energy industries.
The following three companies are expected to fare the worst, some significantly, from current prices in the worst case scenario of a double-dip recession:
- Tenaris SA (TS), a Luxembourg manufacturer of seamless and welded steel tubular products for energy and industrial applications;
- Illinois Tool Works Inc. (ITW), a manufacturer of plastic and metal fasteners and fastening tools for the construction, automotive, and appliance markets; and
- Vale SA (VALE), a Brazilian company engaged in the mining of iron ore and pellets, manganese, alloys, gold, copper, potassium, and kaolin.
This article along with the previous one referred to earlier is a top-down analysis of the relative valuations in the steel sector in the case of two extreme scenarios; a global double-dip and a strong rebound in steel prices from current levels. In succeeding articles, we plan to build on this and delve into depth into each of the major companies in the steel sector.
Disclaimer: Material presented here is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock, you should do your own research and reach your own conclusion. Further, these are our opinions, and we may be wrong. We may have positions in securities mentioned in this article. You should take this into consideration before acting on any advice given in this article. If this makes you uncomfortable, then do not listen to our thoughts and opinions. The contents of this article do not take into consideration your individual investment objectives, so consult with your own financial adviser before making an investment decision. Investing includes certain risks, including loss of principal.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.