1 Steel Stock To Buy, And 1 To Avoid For Now

| About: United States (X)

U.S. steel prices are projected to decline with steep cuts in HRC pricing. We also expect scrap prices to decline further in October. With offsetting moves in scrap prices, these developments are not expected to significantly impact mini-mill steel producers like Nucor (NYSE:NUE). However, blast furnace operators like U.S. Steel (NYSE:X) and AK Steel Holding Corp (NYSE:AKS) are not as well insulated, due to their greater fixed-cost structures and metallurgical coal purchase commitments that do not reset until 2013. We believe that mini-mills are better positioned than integrated steel producers, and see a continued downside in X and AKS. Among the mini-mills, we see long-term value in NUE.

Global Outlook

Steel producers, already struggling with falling prices, slowdown in the use of steel, and overcapacity, face another disappointing quarter and year ahead as global demand for steel is expected to fall in the next quarter and 2013. This is largely due to sluggish Chinese growth and an ever worsening debt crisis in Europe.

The World Steel Association (WSA), steel's main global body, has cut its forecasts for growth in the consumption of steel by almost one percent for this year and by two percent for 2013, compared to estimates released earlier.

WSA revised down its forecast for steel demand to 3.2 percent in 2013 from earlier released estimates of 4.5 percent. WSA Economics Committee Chairman Hans Jürgen Kerkhoff said that the worsening debt crisis in the eurozone and faster than expected slowdown in China have considerably weakened the hopeful signs witnessed in the first quarter of 2012.

The slowdown in China, the biggest consumer and producer of steel globally, is the main reason for a weak outlook. Compared to growth of 6.2 percent in 2011, the demand for the commodity in China is only expected to grow by 2.5 percent this year. However, Beijing's stimulus measures are expected to support the industry, and demand is expected to increase marginally to 3.1 percent in 2013 from 2.5 percent in 2012.

Demand in the debt ridden eurozone is expected to decline the most, by 5.6 percent, a sharp downgrade of 4.8 percentage points compared to previous estimates by WSA. The biggest decline is expected in Italy and Spain, where demand is expected to fall by a whopping 12.6 percent and 11.9 percent, respectively. Even a strong economy like Germany is expected to see a decline.

Global economic outlook and a weak domestic economy are affecting steel demand in India as well, where growth is expected to slow down to 5.5 percent in 2012 and 5 percent in 2013.

However, NAFTA region, Central and South America, and Japan provide a promising outlook for the steel industry. Due to a robust performance by the automotive industry and improvements in the construction business, steel use in the NAFTA region is expected to grow by a hefty 7.5 percent in 2012, but growth in steel demand is expected to reduce to 3.6 percent in 2013. Steel consumption in South and Central America is expected to rise by 3.8 percent in 2012 and 6.3 percent in 2013. Japan's steel use is expected to increase by 2.2%.

Steelmaking Raw Materials Drift Lower

As stated in our earlier article, metallurgical coal and iron ore are the two main raw materials used in steel production. Iron ore prices steadied after a recent rally in prices. CISA cautioned that amid over supply, iron ore prices may fall further. Following the general trajectory of iron ore and metallurgical coal, October scrap costs are set to decline more, and given the historical correlation between steel and scrap pricing, U.S. steel prices look to fall further in October.

X takes the biggest hit as vertical integration means reduced revenue with no cost benefit. Mini-mills like NUE will hold up reasonably, as we forecast scrap prices to fall along with steel prices (Mini-mills use scrap as raw material). We see continued downside in X, but for long-term investors, we still remain bullish on Nucor due to its high dividend yield, eventual recovery in non-residential construction, and positive impacts expected from the new DRI plant starting next year. NUE is also expected to benefit from lower scrap prices.

NUE and X YTD Stock Performance

U.S. Steel YTD Share performance (Source: Yahoo Finance) Nucor YTD Share performance (Source: Yahoo Finance)

Valuation

NUE

STLD

X

AKS

Forward P/E (1 year)

12.19

9.04

9.78

9.4

PEG ratio (5 year expected)

2.49

1.78

2.32

-0.81

Long-term earnings growth rate

8.02%

9.59%

5.00%

22.30%

EV/EBITDA (NYSE:TTM)

8.56

9.59

5.76

7.48

Dividend yield

3.80%

3.30%

0.90%

3.90%

Share price Performance (YTD)

-3.73%

-11.76%

-23.64%

-37.46%

Click to enlarge

Source: Yahoo Finance & Reuters

Compared to its peers, Nucor is an expensive stock with a forward P/E of 12.19x and an EV/EBITDA of 8.56x. However, we believe Nucor has upside potential due to low cost structure that will benefit from a decline in scrap prices, and is best suited for long-term investors. Though U.S. Steel's forward P/E ratio of 9.78x is better than Nucor's 12.19x, its long-term earnings growth rate is only 5 percent, compared to 8 percent for Nucor. Moreover, X's dividend yield of 0.9% is very low compared to its peers.

Note: The biggest risk to our thesis is a sharp increase in steel prices. In that case, X will outperform its peers because of its high operating leverage (high fixed costs), and because it is the favourite of hedge fund managers to play the overall economic recovery, and recovery specific to steel.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Basic Materials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.