In light of growing concerns surrounding the global economy, it is risky at this point to make an investment in steel. In my view, however, the risk will generate outsized returns as the fundamentals prevail. While domestic job figures have been disappointing to say the least, we are still heading towards full employment. In particular, I expect ArcelorMittal (MT) to outperform its industry and United States Steel (X) to underperform. Nucor (NUE) and Gerdau (GGB) are also worth a look.
ArcelorMittal is the industry's leader and, despite high exposure to Europe, has excellent fundamentals. The firm has drastically missed expectations in the 1Q12 by 59%, but it also drastically beat expectations by 90% in 4Q11. The general earnings track record over the last five quarters has been overall weak, but the past is not a pure indicator for future performance. The company has also done well in mitigating risk by selling its European Enovos International business.
At a 5.2x forward PE multiple, ArcelorMittal has low downside and considerable upside. The price target on the firm is roughly double the current value and the Street is rating the stock a "buy" based on data from FINVIZ.com. Moreover, the company is valued at only 39% of book value despite its impressive 5.3% dividend yield and 1.6 current ratio.
At the same time, US Steel was downgraded by Fitch. What makes me chiefly concerned about the company is labor unions. As one Seeking Alpha contributor rightly expressed: "pensions [will] sink in the stock". It has $5.2B in pension liabilities - nearly double the current market value. The firm offers just a 1% dividend yield and analysts rate the stock closer to a "sell" than a "buy" based on data from FINVIZ.com. Even still, I expect US Steel to do well based on the positive secular trends of steel. EPS is expected to grow 5% annually over the next 5 years. Using the 2013 EPS consensus of $3.47, this means $4.22 EPS by 2016. At a 9x multiple, the future value of the stock is $37.98. It would take a 14% discount rate to justify the current valuation. A 11% discount rate indicating $22.54 present value per share is more reasonable.
Nucor and Gerdau, however, have still cheaper fundamentals than US Steel right now. Nucor trades at a respective 15.3x and 10.5x past and forward earnings versus corresponding figures of 13.9x and 4.8x for Gerdau. The former even offers a 4% dividend yield while the latter offers a 2.8% dividend yield - meaningfully higher than that of US steel.
These two producers also have compelling liquidity for an industry that is heavily tied up in inventory. Nucor has a 2.7 current ratio versus 1.3 for Gerdau. With such liquidity, I believe both companies have sustainable dividend yields. This safety will keep the stocks from drastically as they otherwise would if the global economy ends up in a double dip. Accordingly, I recommend going long Nucor, Gerdau, and ArcelorMittal.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer.