How To Play North American Steel

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 |  Includes: NUE, RS, SLX, STLD
by: Morningstar

By Bridget Freas

Steel is a highly cyclical sector that depends on strong economic growth to drive infrastructure spending as well as consumer demand for cars and appliances. 2009 was undoubtedly a disastrous year for the North American steel producers, but fundamentals started to turn the corner in 2010 and into the first half of 2011 as the supply chain thinned out, high input costs provided steel pricing support, and demand from the automotive, agriculture, and energy sectors picked up speed.

However, the past year has undone much of this progress in earnings and this is painfully evident in steel company valuations. Indeed, the Market Vectors Steel ETF (NYSEARCA:SLX) has plummeted 40% since last July. Economic woes in China and Europe are the main culprits, as steel is a globally traded product whose selling prices and input costs are correlated all over the world.

The U.S. is a relative bright spot as demand continues to grow with the World Steel Association forecasting a 6% growth in consumption in 2012 and 2013. This compares to a 2012 expected contraction in Europe and very little growth in China, a big factor since the country consumes nearly half of all global steel produced. If we take out China, the world is still consuming about 10% less steel than it did in 2007. Considering the increasing investment in underdeveloped economies, infrastructure needs in the U.S., high oil prices, and population growth -- global steel consumption needs are still growing even while they might suffer short-term lulls.

In the meantime, however, U.S. steel mills are feeling the pressure of slower growth elsewhere. Steel imports surged more than 30% for the first four months of 2012 before stabilizing through the summer as steel prices slumped to match weakness in Europe and China. Raw material prices remain high by historical standards, but we believe we are past the worst of the margin contraction from an input cost perspective and are starting to see some sustained relief. The price of coking coal has fallen some 20% year to date and although the price of iron ore has plummeted in the last week in what we think is a short-term blip, it has averaged about 30% below last year's peak for most of 2012. We see room for further cost relief in the next few years. However, we expect U.S. steel prices to continue to struggle until Europe and China regain their footing.

2012 is going to be another lackluster year for steel producers and near-term visibility is murky, but we believe market valuations significantly discount the long-term earnings power of several domestic-focused steel plays.

Nucor (NYSE:NUE)

The largest of the domestic mini-mills, Nucor has a solid strategy, strong balance sheet, and is the safest play in North American steel in our view. Nucor's operational flexibility with a more variable cost structure and captive raw material sources help navigate a volatile demand environment and provide a hedge against the potential for higher scrap costs. While flat-rolled steel has seen the most demand recovery due to strength in the automotive and machinery sectors, Nucor still has considerable upside potential from its exposure to long products, which typically comprise 40% of sales and have less overcapacity risk. These products are more commonly used in the construction sectors, which have been anemic for nearly four years.

While an eventual recovery might still be a couple years ahead, any signs of life there would be a bonus. With a conservative approach to financial leverage, Nucor has the strongest balance sheet in our steel coverage while also sporting one of the highest dividend yields among developed-economy steel companies.

Steel Dynamics (NASDAQ:STLD)

Steel Dynamics tends to trade at a discount to its closest peer Nucor due to its smaller size and higher financial leverage but we feel that gap could have room to close. Progress in new products such as rail has mitigated the effects of the downturn and its innovative Mesabi Nugget project should remove a major earnings drag when it fully ramps with internally sourced iron ore concentrate in 2013.

A more attractive long-term growth story given its smaller size and status as a relative newcomer to the U.S. steel sector also bodes well for the company. Steel Dynamics is the only U.S.-based steelmaker under our coverage to be profitable every quarter since the start of 2010, despite the continued depressing state of the construction markets, which in normal times make up roughly 40% of its business.

Reliance Steel & Aluminum (NYSE:RS)

If you want exposure to stronger demand, without the downside risk of raw material price fluctuations, Reliance is one to watch as the largest domestic metal service center. The company's impressive history of making accretive acquisitions without putting its balance sheet in jeopardy could buoy the company during a struggling economy as we may see some previously unwilling sellers become more open to a sale.

The company has been successful in building out new revenue streams through its acquisitions, particularly within pipe and tube and other specialty products. Also, as a distributor of steel, Reliance's operating cash flow is somewhat protected by the release of working capital should another downturn materialize.

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