Source: Google Finance
As the stock chart of the Dow Jones U.S. Iron & Steel Index (DJUSST) shows, steel pretty much collapsed in mid-2008 against broader markets. In contrast to the S&P 500, value has not come back from mid-2008. More specifically, the U.S. Iron & Steel Index has basically a third of its value left from late May 2008 while the S&P 500 is just down a nominal 3%. I think what is the most important thing to emphasize about the stock chart, however, is that steel has dramatically outperformed the broader market over the last 12 years.
On a theoretically level, investors are being rewarded for taking on greater risk. Steel can have just as good fundamentals as technology, but it is assigned higher discount rates due to uncertainty. When these rates overwhelm growth, they make present value of future streams of income artificially low. When growth is actually realized, the future stock value turns out to be much higher than what investors originally assumed.
And there is few moments when steel is currently as discounted as it is now. From economic uncertainty to federal budget cuts for infrastructure, the bear case has become the mainstream mindset of retail investors. I find, however, that ArcelorMittal (MT) is one of the most undervalued stocks. U.S. Steel (X) and Nucor (NUE) are also worth a look, but they are much riskier.
The last time ArcelorMittal fell to a local low in early-December, the stock more than doubled in roughly 12 months. It is now just 44.6% of its 52-week high and more or less in-line with its 52-week low. Even for steel stocks, ArcelorMittal is particularly cheap at a forward multiple of 5.7x. It is 60% cheaper than book value but 118% more volatile than the broader market. Perhaps the most delightful element of the company is that it isn't even as risky as the market assumes. It offers a 5.1% dividend yield but remains depressed due to 28.3% annual EPS decline over the past 5 years.
ArcelorMittal is forecasted for 25.6% annual EPS growth over the next 5 years. That means 2016 EPS of around $4.07. At a 12x multiple, the company's future stock value is nearly $50. At a 12% discount rate, the price target is $30.33, implying that the stock will more than double in value. That is a very aggressive discount rate for a company that offers a dividend yield of 5.1%. Dividends were halved after the 2008 collapse; but, excluding that blip, management has been increasingly generous towards shareholder in its free cash flow policy. It would take an absurdly high 27% discount rate for the company to be worth $14.85 in present terms.
Assuming the company only yields half of the annual growth it is expected to over he next five years - which has a negative impact magnified by lower compounding - the company would have a present value of $17.10 at a 12% discount rate and 11x multiple. ArcelorMittal may be risky, but not that risky.
By contrast, I am more unsure about U.S. Steel and Nucor. U.S. Steel is expected to bleed $0.46 per share this year and then turn positive next year at $1.44. A 11x multiple on the 2014 EPS consensus of $4.33 would imply a future stock value of $47.63. Discounting backwards by 12% yields a price target of $27.02. There is a 1% dividend yield on the stock, and predicting where earnings go for a steel producer may go when it is negative territory is just about speculative as it gets.
The company is valued at 6.7x past earnings and 0.84x book value, so it is more expensive than ArcelorMittal on a multiples-basis. Accordingly, I recommend going with the cheaper and safer competitor. Analysts current rate U.S. Steel closer to a "sell" than a "buy" and they rate ArcelorMittal a "buy" according to data from FINVIZ.com.
Nucor may appear to be a riskier bet than U.S. Steel based on multiples, but it is not once you get down to the fundamentals. The company may trade relatively high at a respective 15.7x and 10.8x past and forward earnings multiples, but it also offers a dividend yield of 3.9% and comes across undervalued when you consider growth. The stock has a PEG of 0.59, which means future growth expectations have not been fully factored into the stock price. Discount rates when present valuing future streams of free cash flow -- a solid way of factoring in risk -- ought to be lower at Nucor than they are at US steel, because the former has almost just as much volatility as the broader market while the latter is 143% more volatile than the broader market.
Nucor is expected to yield 2013 EPS of $3.48 and grow 12.48% over the near-term, which means 2016 EPS of around $5. At a 15x multiple, the future stock value is $75. At a 12% discount rate, the company is worth $42.56. Factoring in the 3.9% dividend yield, Nucor will provide a healthy income stream on top of the positive margin of safety. The discount to intrinsic value and dividend yield are still less than they are at ArcelorMittal, so I recommend holding more of the Luxembourg steel producer.
Disclaimer: 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. Investors are cautioned to perform their own due diligence.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.