Steel Industry: How To Trade Steel Stocks

| About: AK Steel (AKS)

Steel Industry Update

Recently, AK Steel (NYSE:AKS) has been downgraded by Goldman Sachs from Neutral to Sell, and then by Dahlman Rose from Buy to Hold. As a result, its stock price declined by almost 19% to reach a 52-week low of $4.66, yesterday. The stock later reversed its losses and is now trading near $5.14.

Two days ago, Bloomberg reported that Baoshan Steel, China's biggest publicly traded steelmaker, has lowered its steel prices as demand from makers of appliances and cars slowed. As a result, the stock prices of all the major companies suffered a huge drop. Nucor (NYSE:NUE), Steel Dynamics (NASDAQ:STLD) and US Steel (NYSE:X) suffered a price decline of approximately 2.9%, 4.8% and 6.5% respectively.

Investment Thesis

We recommend a long position in AK Steel due to its lower iron ore costs in future, attractive growth opportunities, and lucrative valuations. Now, the bearish review by both these investment research companies has further substantiated our aggressive recommendation. We believe that AKS' stock price has already adjusted to reflect the uncertainties surrounding AKS' future. For the investors who think its stock appears too risky, we recommending an options strategy as well.

Trading Ideas

We recommend the following two trading ideas:

  1. Buy AKS shares and use yesterday's low as stop loss level

Take a long position in AKS shares and use yesterday's 52-week low price of $4.66 as a stop. Its shares should not break yesterday's lows of $4.66.

  1. Buy call options on AKS

Its call options with a strike price of $10, expiring in September, are currently trading at just 4 cents. Buy paying this premium investors can get exposed to a massive upside in AKS.

We expect AKS' earnings to improve next quarter, once it starts using low-cost and high-quality iron ore. This cost advantage will be obtained because AK Steel has incorporated Magnetation LLC in October 2011, a joint venture with Magnetation Inc., a high-growth iron-ore producer.

AKS is recently awarded the Metallic "Supplier of the Year," an award by Chrysler Group LLC due to its exceptional quality of products and timely delivery. This award also exhibits strong customer satisfaction levels. We believe this will have a positive impact on its future operational performance.

Furthermore, its Price-to-sales ratio of 0.1x is the lowest among all its competitors, which makes it an attractive option. Its long-term growth rate of 26% is also the highest among its competitors. However, its EV/EBITDA of 13x is on the higher side. Once its iron ore costs reduce after Magnetation's plant is operational in 3Q2012 its gross margins will improve giving a boost to EBITDA.

Regarding other major players in the steel industry, our recommendations are as follows:

  1. We continue to recommend Nucor as a buy because of its modern steel making techniques, use of scrap steel, focus on environmental protection, highest dividend yield, successful strategic alliances, and potential growth opportunities.
  2. Steel Dynamics is a buy because of its declining iron ore costs as a result of the joint venture with Magnetation in Minnesota, long-term growth prospects and cheap valuations.
  3. We were bearish on US Steel because of its high beta, high fixed costs, weak liquidity position, reduction in its credit rating by Fitch and poor stock performance. However, due to positive comments from Us Steel on an analyst day yesterday, we think its share will rise as well. X remains the most levered play on recovery of the US steel industry.

We advise investors to read our in-depth analysis on the steel stocks, titled "The Buying Opportunity In Steel Stocks"

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