I've followed the steel industry for quite some time, and honestly it can be quite a bit disconcerting to read "professional" opinions within the industry. Barron's is out in full-force recommending U.S. Steel (NYSE:X) as a potential 50%+ upside play, and JPMorgan's Michael Gambardella is still out there maintaining wanton bullishness across the entire domestic steel industry, throwing $37/share price targets on what continues to be a crippled company (U.S. Steel).
Every once in a while, I have to take the time to throw some cold water on the expectations that permeate this industry. Despite all the hub-bub revolving around recently implemented tariffs and anti-dumping duties, overall steel imports only fell 2.3% by tonnage y/y in August. While certainly there has been some benefits in some products, such as hot-rolled steel, imports continue to swell in tubular products (see growing losses in U.S. Steel's tubular division). At the end of the day, U.S. Steel is fighting an incredibly tough battle against much better capitalized and structurally sound companies - both domestically and overseas. From my perspective, the entire investment thesis revolves around the hope that the U.S. Government continues to hold U.S. Steel's hands as it navigates its problems. I don't disagree that dumping is a problem, and I recognize that having a thriving domestic steel industry can be viewed as necessary to our national interest. But the current market situation hasn't stopped fellow domestic producers like Nucor (NYSE:NUE), or even tiny producers like Steel Dynamics (NASDAQ:STLD), from being consistently profitable. Fundamentally, I believe U.S. Steel has, and continues to, suffer from mismanagement. That mismanagement is what got the company in the pickle it is in today, not Asian steel producers dumping products below cost.
First, we should go back to May of this year, when U.S. Steel announced a bond offering to retire some upcoming debt. Unlike the vast majority of companies in the market, which have been taking advantage of low interest rates to reduce interest expense and push out maturities, U.S. Steel reaped no such benefit on its refinance. Its 2021 note issuance, maturing in just five years' time, priced at 8.375%. It used this capital to primarily retire notes maturing in 2018 and 2020, notes that were actually carrying lower rates than the new bond. You can find that below in the results of the tender:
The unwillingness of the fixed income market to price this debt at a rate better than 8.375% shows the risk that investors are bearing by holding the common equity, even in the immediate timeframe. Bond markets are often much better indicators of risk, and if fixed income investors (in this high-yield market) are demanding north of 8% on a five-year bond, investors in the common equity should be concerned. Nonetheless, even with those facts, this tender coincided with a bottom in the stock price - a bottom that fed a rally that rolled on all the way through to August 2016.
Queue U.S. Steel management, whom we've already highlighted as being a bit below par. Why let a golden opportunity like a rocketing stock price go to waste? The company quickly took advantage of the pop in its share price to issue 18.9M shares back in August, resulting in 11% dilution to current shareholders. Of course, proper incentive structures would align management with shareholders so that equity raises impact insiders as much as shareholders. Unfortunately, management had little to lose given insider ownership is next to nothing. Investors that bought into the mid-summer rally were quickly burned, and that secondary offering proved to be a tipping point which radically shifted momentum.
All along management has stated that the steel market is improving and long-term fundamentals strengthening. Therein lies the rub with me. U.S. Steel had $820M in cash available at the end of Q2 2016, along with $2.4B in liquidity. Why tap the equity markets if prospects seemed so strong? It certainly wasn't needed to manage working capital - the company managed to navigate its 2011-2013 fiscal years with less cash on hand.
This runs counter-intuitive to recently reported results. U.S. Steel was actually free cash flow positive through the first half of 2016 ($313M operating cash flow, $217M capex). See the below statement from management on improving outlook for context:
"While we began to realize some benefit from recent price increases in the second quarter, we will see better average realized prices, primarily in our Flat-Rolled and European segments, in the second half of the year…"
With that in mind, the company should, at worst, post only marginal free cash flow losses for 2017. The reason for the negative turn should occur primarily because working capital tailwinds should shift given current guidance ($400M in positive working capital guided for 2016, currently $532M through Q2). This is in spite of earnings improving sequentially over Q1. With Q2 being the first quarter of positive operating income in many years, U.S. Steel should have been working off of a solid base heading into the end of the year.
Key words being should have. Obviously, prospects were not as strong as management put on, and the capital raise was about as big of a red flag that anyone could put out there for U.S. Steel. Earnings estimates have since fallen drastically, and now are only expected to show an 8% improvement on a non-GAAP basis y/y in 2017. So when you see analysts throw out the possibility of $25-37/share price targets in a year, just remember how quickly management has shown the propensity to raid shareholders at prices well south of those targets.
I understand the brand value of the name that U.S. Steel holds with many investors, but simply is a broken pick in the space. If you want steel exposure, do it directly through well-run domestic companies (Steel Dynamics), larger international peers ( POSCO (NYSE:PKX)) or indirectly through industry counterparties (Suncoke Energy Partners (NYSE:SXCP)). Don't dabble in the junk.
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Disclosure: I am/we are long PKX, SXCP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.