It is no secret that steel was one of the hardest hit industries during the financial collapse. Over the last five years, the Dow Jones US Steel & Iron Index has lost more than half of its value - sending many beacons of industrialism down on its knees. US Steel (X) plunged into negative territory with a whopping $1.4B loss in 2009. The good news is that fears have overblown secular risks and significantly discounted the industry. In my view, investors should lightly diversify across Vale (VALE), US Steel, and Gerdau (GGB) while holding a relatively larger stake in Vale. Below, I review the fundamentals of each producer.
For such earnings power, Vale is one of the cheapest stocks on the Street. It trades at a respective PE and forward PE multiple of 4.7x and 5x past and forward earnings. The dividend yield on the stock is 3.3% while ROA, ROE, and ROI are all on the double-digits. Analysts are nevertheless reserved on the firm's future with forecasts for 2.5% annual negative growth over the next 5 years versus 26.3% annual positive growth over the past 5 years. I believe the bar has been set far too low for a firm that delivered during one of the toughest times in the industry's history. Accordingly, Vale may generate higher risk-adjusted returns in the years ahead.
From a fundamentals perspective, however, the story is more of a mixed bag. Vale is ultimately diversified in a variety of different industries from steel production to nickel, copper, and aluminum mining and rail support. Second quarter results were disappointing with recurring EBITDA of $5.5B, but much of the weakness stemmed from iron ore spot prices dipping below $120/ton. Commodity prices fell 5% for iron ore, 10% for nickel, 7% for copper, and 18% for coal. At the same time, iron ore volumes meaningfully improved. Iron ore EBITDA margins went up sequentially by 200 bps to 64% as cash costs fell. Management, however, is likely to trim its capital budget. More than three-quarters of the $8B it spent in 1H12 went towards growth projects; but, with $21B in net debt, a period of conservative budgeting may ensue.
On the face of it, it won't take much for basic materials producer to appreciate in value. Even if EPS falls from $3.50 in 2013 (consensus) to $2 in 2016, the future value of the stock will still be $30 at a 15x multiple. It would take an aggressive 11% discount to justify the current valuation under these bearish assumptions.
Since US Steel is a pure play on steel on industry, it carries more risk than Vale. While the company trades at just 6.4x forward earnings, there is a reason why analysts rate it closer to a "buy" than a "sell". Demand for metals are highly dependent on macro trends and, thus far, jobs figures have been disappointing. China is the global leader in steel consumption but also a significant producer, so it could substantially depress prices through increasing supply.
In my view, however, the economy is heading in the right direction, China is not a force to be feared against US power, and more free market-oriented trade agreements will drive value creation. Unfortunately, much of US Steel's coke over batteries are dying and greater capital investments will be needed to meet demand. The high fixed cost-nature of steel also makes economies of scale incredibly relevant in expanding margins. With $3.5B in net debt, the iconic producer, however, is constrained in its M&A ability.
To fight margin pressure, US Steel has decided to increased prices to a minimum of $40/st on flat rolled products. I believe that this action will inspire a bit of game theory wherein competitors price similarly and push out lead times. Lower construction activity will also remain a major headwind for value creation and make it hard for US Steel to outperform its more diversified peers. The S&P has downgraded its outlook on US Stable to negative. Accordingly, I recommend an investment only if you are confident the economy will recover quicker than what economists expect. Otherwise, you're betting off going for more diversification.
Gerdau is yet another pure steel play and thus carries substantial risk. It is around double as volatile the broader market but has a forward PE multiple of 5.6x and a PEG ratio of 0.87, which indicates that future growth has not been fully factored into the stock price. The 2.7% dividend yield also goes a long way in encouraging investors to opening a long position before doing the same thing for US Steel.
Management is scheduled to have its second quarter earnings call on August 1st. I believe that it will be a strong quarter with notable momentum in specialty steel and Brazil. Gerdau's decision to increase long steel prices by 8% in domestic markets for June will also, in my view, pay off. Specialty steel volume should grow by 3% sequentially to around 720K tonnes.
Perhaps most importantly, the company has yet to see a decline in steel shipments in reaction to macro uncertainty. Brazilian demand for steel beams and bars continues to be strong. This economic development is further complemented by tax and trade incentives. On the other hand, this has encouraged competition and put pressure on margins. Fortunately, the firm's electric arc and blast furnace capacity grant exceptional flexibility in operations to better meet volatile conditions. While the foundation is already strong, management should focus on expanding its iron ore mine with partners going forward.
All references to analyst ratings are sourced from FINVIZ.com.
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. Investors are cautioned to perform their own due diligence.