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The recent news emanating from China about the Steel Industry is not spelling a rebound of this sector (on a global basis) in the near-term, and is further substantiating our previous thesis in which we expected a possible bottoming in Q3/Q4. We feel that investor sentiment is very low at this point in time, and that this fact is already reflected in the valuations of steel companies; but still, a further downside is expected, albeit a limited one. We expect things to improve in Q4, as Chinese steel mills keep on cutting production, construction demand gears up, and the seasonality factor helps improve demand. Till then, it's advisable to continue to stay away from this sector. Nucor Corp (NUE) remains our favorite pick for a potential investment in Q3, while Steel Dynamics (STLD) and U.S. Steel Corp. (X) can also be potential buys at that stage.

Being the largest steel producer as well as the largest consumer, China has a notable impact on the dynamics of the global Steel Industry. Consequently, along with the global macroeconomic malaise that has resulted in a weakening of steel fundamentals, steel prices have suffered as a result of Chinese steel mills' attempts to safeguard their market shares by keeping production at high levels. However, the margins of steelmaking companies in China continue to decline, as is evident from the China Iron and Steel Association's recent statement, in which it claimed that profits of Chinese steelmaking companies had declined by as much as 96% this year.

As a result, Chinese steel mills have been forced to cut supplies in an attempt to reduce losses. Their steel output will decline this year, after a continuous incline of 31 years. According to Xue Heping, an analyst for China's Steelinfo consultancy, As steel prices fall, the pressure to cut production has only grown.

According to Mysteel data, Shanghai rebar futures dropped by 18% last week to a record-low of 3,631 Yuan, after touching year-high levels in April. In addition, Chinese rebar inventories have increased by 22%, relative to the levels last year (Rebar, or reinforcing steel bar, is used in construction).

These supply cuts will help rebound steel prices and reduce demand, and consequently lower the prices of its raw materials. But this recovery is highly unlikely before Q4, primarily because we feel that the seasonality factor is going to play its role in the rebounding of the Steel Industry; Q4 is historically stronger for steel's end markets.

Chinese steel traders have found it difficult to service their debts as a result of the country's sluggish economic growth and weak automotive and construction demand. This shows how poorly the sector is performing amidst waning demand and slashed prices. Subsequently, Chinese banks are suing more than 20 steel traders for defaulting on their loans. According to an official at the Minsheng Bank,

"We have seen more default cases since late last year. We are now on high alert and are watching our clients closely, particularly small and medium-sized companies (SMEs)."

In addition, construction demand is not expected to pick up in China before September, as some of the country's parts have been affected by extensive rains, while others are experiencing very high temperatures.

Valuations

To reiterate, we advise investors to avoid investing in steel stocks in Q3.

Q4 marks a good entry point, and we recommend investing in Nucor Corp , Steel Dynamics Inc. , and U.S. Steel Corp. , in a decreasing order of preference.

NUE appears relatively expensive compared with its peers, but it remains our favorite pick due to its historically high and stable dividend yields, sustainable competitive advantage (not producing via conventional blast furnaces), and diversified product mix. Read our previous article to have an idea of the company's latest earnings release, and the stock's catalysts.

STLD and X can also be good candidates for investments in the next quarter. STLD has a favorable cost structure, vertical integration and strong management. X looks good due to the strong performance of its European and Tubular segments, despite expectations of break-even results for its major segment (flat-rolled) in Q3.

NUE

STLD

(AKS)

X

Forward P/E (1 year)

12.3x

9x

9x

6.2x

PEG Ratio (5 year expected)

2.5

1.6

-6

1.3

EV/EBITDA (TTM)

9

7.6

7.7

6.3

Dividend Yield

3.6%

3.1%

3.8%*

0.9%

Share price performance (YTD)

2.5%

0.3%

-30.4%

-12.4%

* AKS is going to cut dividends in the future, which is not reflected in this dividend yield.

Source: Google Finance

Source: Steel Industry To Bottom In Q4