Industry Analysis: Steel And Metal Fabricating Industries

by: Friedrich Research

For those new to this analysis please refer to my introduction by going here.

Here is a table of the companies under analysis:

(Click to enlarge)

The first thing that instantly catches your eye when looking at the table above is that the majority of the companies on the list are selling at price to owner earnings levels that would classify them as value plays. This is understandable because despite what the government statistics are telling you, we are in a deep recession here in the U.S. and have been since 2008. The steel and metal fabricating companies are the raw ingredients needed to build things like homes and the things that go in them like washers or dryers as well as key components in commercial buildings or bridges. And unless I am mistaken construction of all those things are at very low levels today.

Without a recovery in the economy the stocks of these companies should remain at these levels for some time. Also with the wars ending in Iraq and Afghanistan, some $12 billion in government spending on military operations will be deeply curtailed, just as they were after World War II and Vietnam. Even worse due to the failure of the Super Committee, we could have some $600 billion cut from the defense budget and everything from missiles to ship production will just halt. There is a lot of metal that goes into a destroyer, aircraft carrier or tank, so a drastic cuts like these will definitely hurt the industry.

Europe and Asia are definitely experiencing a slowdown in construction and major projects are being curtailed if not halted altogether. Overbuilding has created a real estate bubble in China that has to someday burst. Emerging countries like India are seeing their growth rates slowing, which will affect their construction projects for sure. Remember Europe and the U.S. make up most of consumer spending around the world and the average consumer is definitely curtailing their spending as most are deeply in debt. This will affect exports from Asia and slow down their economies dramatically and thus cause major construction in those areas to be pushed out to a later date.

Competition from foreign competition is also eating into potential revenues for the companies on our list and that will not go away any time soon and may just become a bigger problem going forward. Despite this gloomy forecast, some of the elite companies from the table above are running, for the most part, “lean and mean”, so any economic miracles that may show up or major projects announced to "Rebuild America" for example in terms of new roads or bridges or to even repair the ones we have, could spark a real rally in these stocks.

CapFlow is a great way to see which firms have what I call elite managers. The last thing you want to own is a company that cannot control their costs. CapFlow separates the elite from the average and if a company has a consistent multi-year pattern of excellent numbers in this category then you have a strong player. This is no time to be holding companies that are just average, because if the recession worsens, their problems will only get worse. You need to have a buy list of companies ready ahead of time, who will not only ride out a deeper recession but will also have the free cash flow in place to buy out their weaker competitors.

The ultimate player on this list is Illinois Tool Works (NYSE:ITW) as their CapFlow is just 13% and their strict cost controls allows them to have a FROIC of 16%. This means that for every $100 of total capital invested, ITW returns $16 in free cash flow on Main Street.

FROIC is how I measure return and my goal as an advisor is to return 15% a year(over a five year period) on average for my clients and thus double their money every five or so years. The only way I can do so is by creating a portfolio of holdings that have FROIC results of at least 15%, but are also priced reasonably as measured on a price to free cash flow scale. I currently have my clients in 75% cash as I am worried about the coming downgrades of Europe by the rating agencies showing up sooner than later. But once they come and pass, and markets correct, I will have a list of strong FROIC and low Price to Owner Earnings players ready and will attack. That way I can “practice capital appreciation through capital preservation” or in other words buy strong producers at attractive prices.

The best companies on this list are:

1) Illinois Tool Works (ITW)

2) Cliffs Natural Resources (NYSE:CLF)

3) Kennametal (NYSE:KMT)

4) Worthington Industries (NYSE:WOR)

This list I then take to my "Philip Fisher Qualitative Analysis Mill" and research the hell out of them.

One thing you need to be careful about when analyzing companies in this industry, is to make sure to measure them by their owner earnings and not just by their Cash Flow alone, as most analysts and investors do. A popular stock like U.S. Steel (NYSE:X) for example only sells for $25.99 and has Cash Flow estimated to come in at $7.55 a share for 2012. At first glance this would seem to be an amazing bargain selling at just 3.44 times its cash flow, but when you factor in that its capital spending is estimated to be $5.55 for 2012, we then have a price to owner earnings number of 12.88. With a CapFlow of 73% we have a company that has a lot of fixed costs. The danger here is that if your fixed costs are high and your business slows down, you are in trouble. In 2008 U.S. Steel hit a price of $196 to only get crushed when their owner earnings per share dropped to $-9.48 and the stock ended up at $16.70 in 2009.

As an investor you can’t afford such roller coaster rides and because more than half of the companies that make up the S&P 500 Index have such high capital expenditures, you get the roller coaster rides that we have seen over the last couple of years and is a reason why no one invested in index funds has made much of a return since 1999. Illinois Tool Works had a rough ride as well dropping from $55.60 in 2008 to $25.60 in 2009, but because it was a quality company investors flocked back into it and in 2010 it was back to $53.19 while U.S. Steel has been a roller coaster from hell for its long term investors, shooting back up to $70 in 2010 to only fall back to $18.8 for its low in 2011.

You can protect your portfolio from these companies by just simply tracking CapFlow's. Slow and steady, investing in only quality companies, when the time is right to do so is what wins in this game. After all, this is your retirement we are talking about and you don’t get there comfortably by taking big risks and using shoddy research. Remember owners earnings is Warren Buffett’s major weapon and if you analyze his non-financial holdings you will see that CapFlow plays a major part in his decision making process.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: Always remember that these are the results of our research based on the methodology that I have outlined above and in other articles previously published. This research is provided as an educational tool and should not be considered investment advice, but just the results of our research. There are many ways to analyze a stock and you should never blindly follow anyone’s work without doing your own due diligence or by seeking the help of an investment advisor, if you so need one. As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.