Steel Stocks: Update from Recent Earnings

As the US economy continues to slow, the domestic steel industry continues to accelerate. My article on March 9th, gave investors a quick industry overview, and my steel stock focus list. After listening to the steel firms conference calls, and reading their earnings reports, I have changed my focus list, The two foreign companies: PKX and GGB, have been replaced with two domestics: GNA and STLD. My new focus list is:

Gerdau Ameristeel (GNA): Infrastructure, mining, commercial, rail
Steel Dynamics (STLD): Recycle, Infrastructure, fabrication
Reliance Steel (RS): Aerospace, fabrication, farm, wind power
Commercial Metals (CMC): Recycle, infrastructure, Europe
Insteel Industries (IIIN): Concrete, Infrastructure, bridges
Universal Stainless (USAP): Power generation, aerospace, oil/gas, tools

Several themes were emphasized during the conference calls, and earnings reports. These recurring themes lead me to be bullish on the domestic steel sector, even as the stock prices have risen. These themes are:

- Pricing power
- Capex
- Weak dollar
- Low inventories

Pricing power is very important for industries during all business cycles. As raw input costs rise, a firm must be able to pass these costs on to the end users. Without this power, margins get squeezed, and cash flows, profits decline. This margin squeeze effect is currently causing problems for many domestic industries such as: Housing, discretionary retailers, refiners, cement/aggregates, etc.

For the steel industry, pricing power remains strong, especially for the end demand steel users mentioned in my original steel article: Infrastructure, oil and gas, aerospace, recyclers. The above factors/themes are all interrelated. The weak US dollar is keeping foreign steel imports low, hence pricing strong. For 2008 new international iron ore contracts have just been set, 65% higher than last year. This is giving US recyclers huge pricing power.

In Commercial Metals latest conference call, management says "mills are running flat out". CMC also is raising its re-bar prices. International re-bar prices are averaging around 1,000 a metric ton, were as in the US, the price is still around 800. Today Universal Stainless just announced 5-7% increases on all tool products effective today! Its very simple - pay up or try and find a cheaper deal overseas - not a chance.

Reliance Steel's CEO Dave Hannah stated "We passed the increase is on to our customers, as fast as or faster than we receive the higher cost material, leading to an increase in our gross profit margins" Keith Busse, CEO of Steel Dynamics said "Prices for both flat-rolled steel and scrap climbed faster and higher than we had anticipated, accelerating the margin growth we had predicted for the second quarter".

Another very positive sign for the domestic steel sector is that firms have continued to invest heavily in new high tech equipment, that reduces cost and increases productivity. Universal Stainless has invested 700,000 in its Dunkirk location. CEO Dennis Oates commented: "We expect to reduce the round bar production cycle in Dunkirk by as much as two weeks resulting in a payback that is less than one year." Reliance Steel invested 124M in state of the art equipment that management claims in its CC created market share gains.

The weak dollar was a consistent theme in ever conference call I listen to. While I do not think the US dollar will weaken much further, any level near our current level means international prices are higher then the current domestic prices. With high energy cost as well, imports are drying up, leaving the domestic steel firms to fill demand with much lower supply and competition. The only firm on my focus list that stated it may not be able to pass further input cost increases on, is Insteel Industries. IIIN is in the cement industry, which is having margins issues.

The low inventory levels at the service centers were also talked about in every conference call. While most executives did not know when these inventories will be filled again, they all acknowledged this gives the domestic steel firms solid pricing power for the rest of 2008.

My current favorites from my focus list would be Reliance Steel, Steel Dynamics, and Universal Stainless. Here are some bullet points for these three steely investments:

Reliance Steel
- Shortest lead time in industry, and with low inventories, a major advantage
- Farm gear, oil and gas have strong demand
- Continued improvement in our gross profit margins
- In January 2008, the Company repurchased 2,4M shares at $46.97 per share
- 1.60 is the estimated quarterly earnings per share, giving RS a PE of 9.5

Steel Dynamics
- Net income increased 40 percent and net sales more than doubled
- Second quarter backlogs for structural steel and merchant bars are strong
- Strong cash flow over 200 M in first quarter, with a 13% cash flow yield
- .90 is the estimated quarterly earnings per share, giving STLD a PE of 9.4

Universal Stainless
- Power generation and tool demand strong, with visibility out to 2010
- Only 5% international sales, just hired new marketing VP to increase this
- Backlog momentum increasing
- Oil and gas, especially deep water has huge potential
- Just increased pricing for tool products 6%
- .65 is the estimated quarterly earnings per share, giving USAP a PE of 14

Disclosure: Author currently owns stock in USAP and GNA, and has sold his position in IIIN

Comments

[steel magnet]

Demand for steel is strong globally your article leans toward domestic steel only and away from foriegn steel. Can you state other factors that support stronger markets in the U.S. than foriegn markets other than the weak dollar "which may not stay weak". Factors that show a slow down in foriegn steel other than a weak demand from the U.S.?

[bellard]

I still really like the internationals also: PKX, GGB, MT, etc..., but I think the domestics are better valuations right now. Its not just the weak dollar per say, its global inflation helping the domestics. Coking coal, and coal prices are running 30% higher internationally vs the US. Also with energy prices soo high, imports into the US are drying up.

US steel inventories are also very very low - another factor for better future cash flows from domestics vs intl....