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I have been following the steel industry for years, especially the last several. Each year of the last few I have seen analysts give unrealistic earnings targets for the industry. They seem to use any excuse to run up the prices of the US steel companies. Generally, US steel stocks are highly shorted, and they get short squeezed higher very easily. My thinking is that the big brokerages make a lot of money using HFT on such stocks as US Steel (NYSE:X).

This may provide a motive for making highly questionable analysts' forecasts. It sometimes seems as if they take turns upping estimates or their ratings in order to cause more short squeezes. Two years ago their analysts forecast X would earn approximately $4 in FY2010. I thought it would more likely lose several dollars. It actually lost about -$4 that year. The analysts were only off by -$8/share. Could they have possibly done any worse?

You have to look at world wide economics and supply/demand dynamics when you make such assessments. I believe analysts' estimates of US steel companies earnings for this year are again seriously in error, especially those of US Steel. Some of the reasons are below:

  1. The ECB President has himself said that he expects the EU to enter a recession soon. He says he expects a shallow recession. However, he is not likely to admit to more before he has too. The EU recession could easily turn into a very deep recession. The recent press coverage of Spain's real estate problems may well indicate a much deeper EU recession is looming. A depressed EU economy will depress steel, which is a "cyclical" industry. US Steel has a European steel division as well as its US divisions. Its European division is sure to lose money. In fact, in Q1 2012 X plans to take a $400-$450 million charge to account for its recent sale of a European factory for $1 (to get rid of a money losing business). This should put X in a huge GAAP hole from the start. X's US division will also be affected. The shallow EU recession is supposed to have a -1% effect on US GDP. A deeper EU recession would have a larger negative effect on US GDP. Very slow growth or a US recession would have a very negative affect on X's earnings.
  2. ECRI is forecasting a recession for the US in 2012. Many disagree with this call.
  3. China recently lowered its FY2012 GDP estimate from +8.0% to +7.5%.
  4. Brazil's GDP for FY2011 was only +2.7% versus +7.5% in FY2010.
  5. Chinese total auto and truck sales are down -6% (2.95 million vehicles) year over year in Jan. and Feb. of 2012.
  6. BHP says Chinese steel production growth may slow to 4% this year. Growth in 2011 was approximately 10%, so this is substantial slowing.
  7. The Bank of China China Investment Banking Group estimates there will be steel production overcapacity for the next two years world wide. It expects only 2.2% to 2.8% year over year growth in Chinese steel production in 2012. This agrees well with BHP's figure today.
  8. The World Steel Association said steel production in Jan. 2012 was down -7.9% from Jan. of 2011. European steel production was down -5.6%.
  9. LME steel prices are still far down from the prices at which X was making a profit last summer. A recent quote was $475/tonne versus the $690/tonne high of last August 2011. US prices usually parallel LME (London Metals Exchange) steel prices in the long term, although US prices tend to be slightly higher. The chart below shows the LME steel price trend.
  10. US steel imports were 27 million tonnes in 2011 (up 19.4% from 2010). US steel exports rose 12.7% to 13.3 tonnes (WSA). With the steel markets slowing dramatically in Asia, the logical expectation is for Asian countries, especially huge steel producer China, to try to sell more of their steel in the US in 2012. One might also expect steel exports to decrease. This should put greater pressure on US steel prices throughout 2012.
  11. European car sales were down -9.2% in February 2012 with registrations of only 923,381 million vehicles.
  12. US auto sales were up 16% in February 2012, but we haven't seen much slowing in the US yet. Also some think that the unseasonably warm winter this year may have led to some spring sales being moved back into the winter. If this is true we may see lighter spring and summer sales than currently expected. On top of this the Japanese auto industry exported many less autos in 2011 due to the earthquake, tsunami and subsequent electrical problems. The Thailand flooding later that year caused still further production delays. Production should rebound dramatically in 2012. The Japanese will try to sell a lot of those extra autos in the US. US steel companies will not be providing steel for those autos. The extra auto sales due to increased imported cars will not add to US steel companies business. Further more people are buying smaller cars (gas conserving cars) this year with the high gasoline prices. Some may be taking their queue from Obama's and other politician's speeches. The US automakers use less steel to make these cars. Higher sales numbers of smaller cars does not translate one to one into more steel demand from the US automakers.
  13. David Zion of Credit Suisse estimates that the S&P500 companies had a $458B pension funding shortfall in 2011. He estimates that 114 of the S&P500 companies will have to pony up more than 10% of their operating cash flow to meet pension funding guidlines in 2012. X and AK Steel (NYSE:AKS) were among the seven worse of the S&P500. I don't have the exact figures, but I would not be surprised to find that they amounted to over 20% of X's 2012 operating cash flow. I think this is significant.
  14. Natural gas prices have fallen dramatically in the last year from nearly $5 last summer to $2.33/mmBTU today on the Nymex. This has caused many E&P companies to severely cut back on new drilling. For instance, Chesapeake Energy (NYSE:CHK) has cut its dedicated to natural gas rig count to 24 for 2012. That rig count was 75 in 2011. Many other companies are making lesser, but similar cuts. This will mean lower than expected tubular steel sales to support natural gas drilling.
  15. X has already sold $400 million in new bonds this year. It knows it will be deficit spending. Going further into debt makes it harder yet for it to eventually become profitable. X's market cap is $4.52B. X's enterprise value is $8.38B. It is heavily in debt.
  16. I reiterate that my estimates for X over the last few years have been far more accurate than the average analysts' estimates published on Yahoo Finance, which include the big brokerage house estimates. I am estimating that US Steel will lose -$3/share (excluding the factory sale losses), and it may well do much worse than I have estimated. Many are pointing to the expected increase in total light vehicle sales in 2012. In 2011 this total was 12.8 million. The estimates thus far for 2012 range from 13.5 to 14.5 million. The results so far in 2012 have been closer to the top of that range, but the economic trouble is probably coming later in the year. In addition I have tried to point out that Japan may sell anywhere from 300,000 to 500,000 more vehicles in the US this year as it rebounds from its production problems of 2011 due to natural disasters. Europe with it own auto sales flagging will try to sell more of its production in the US. I am ballpark estimating that at least 500,000 more imported cars (both EU and Japanese) will be sold in the US in 2012. These sales will not help US Steel at all. In this sense the extra auto sales are partially an illusion with regard to extra US steel demand.
  17. On top of this X is much more exposed to falling US steel prices than Nucor (NYSE:NUE) or Steel Dynamics (NASDAQ:STLD). Many US steel companies announced price rises earlier this year, but the market is noticeably weakening now. The LME is the generally accepted barometer, and its prices are still very low. I expect this situation to continue to hurt X through out the year. I note that X lost money in Q4 2011 when world steel prices were on average higher than they are now. X itself said it expects average US steel prices to be lower in Q1 2012 than in Q4 2011. How is X going to make money? The answer is it won't. Plus it should continue to face these same headwinds throughout a challenging 2012. Keep in mind that US GDP was +3.0% in Q4 2011.Most are saying it will be between 1% and 2% for most of 2012. Some are saying the US will be in recession. If X could not make money in a +3.0% growing economy, how will it make money in a slower growing or shrinking economy, especially with most of the world likely trying to dump their steel in the US? Keep in mind that US Durable Goods Orders fell -4% in January. These are the goods that use steel. The expiration at the end of 2011 of a tax incentive allowing full depreciation on equipment purchases may have prompted a slowdown in investment at the start of 2012. Even if this is true, it is hard to see a big ramp up, if the EU is about to enter a recession and most of the rest of the world seems to be slowing.

With all of these things in mind, shorting X makes a lot of sense. The two year chart below provides some technical direction for the trade.

click to enlarge

The slow stochastic sub chart shows that X is over bought. That's good if you want to start a short position. The main chart shows that X has just broken up through its 200-day SMA. However, its 50-day SMA is still below its 200-day SMA. This is a position in which signals are questionable. It could continue upward, or it could reverse to go downward. Overall, X is still in a long term downtrend. With an EU recession of indeterminant severity coming, it seems most likely that X will continue its downtrend for the near term. It will also most likely continue to accrue debt. It already has borrowed an additional $400 million with bonds this year. Plus it has announced that it intends to wrote off $400-$450 million due to the sale of the EU steel factory for $1.

Considering X has lost money for all of the last three years, going into further debt and writing off assets does not make one think that it will suddenly make money in 2012, especially with a very weak world wide steel market. Since China, the biggest steel manufacturer in the world, is saying the market will be oversupplied for the next two years, I am not encouraged to believe X will become profitable soon. Bernanke's claim that he will keep rates low through 2014 translates into an expectation of very slow growth in the US for at least two more years.

This bodes ill for X. It makes the average analysts' estimates likely wrong again. However, as much as momentum traders tout the market, they won't be able to change the basic facts. Earnings from Q1 will soon put the lie to their foolishness. Later quarters may be even worse. The EU recession will certainly get worse. China is slowing. X is a short in this environment. It is even conceivable that X will go into bankruptcy within the next 2-3 years.

Good Luck Trading.

Source: Consider Shorting U.S. Steel - Evidence Mounting That The Industry Is In Trouble