U.S. Steel Is Set Up To Take Another Beating

| About: United States (X)
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Indian car sales are down -2.3% year over year so far this fiscal year, which ends in March 2012. If the recent uptick in sales continues, analysts think that sales could be flat for the year. If not, this will be a contraction year after a huge up year last year. Given that the original forecast for Indian car sales for the current year was for 16% to 18% growth, the current outlook for total fiscal year sales is very negative.

Chinese auto sales -- one of the biggest users of steel -- are down 6.5% year over year (Dec.). Auto parts maker Lear Corp. (NYSE:LEA) said European vehicle production will be down 5% in 2012. In substantiation of this, ArcelorMittal announced it will extend the recent closure of its Sestao steel plant in Spain until market conditions turn around. This plant has been closed since the beginning of Nov. 2011. ArcelorMittal (NYSE:MT) has announced a series of temporary plant closures in Europe since mid-2011. The LME Steel Billet price graph of the last couple of years (see below) further substantiates the weakening trend in EU steel.


The US in contrast is currently forecast to grow auto sales to the 14+ million mark by mid 2012. However, this forecast has gone down since the summer of 2011, when J.D. Power lowered its forecast for 2012 from 14.7 million to 14.1 million. With the coming EU recession expected to shave at least -1% from the US FY2012 GDP figure, this forecast is likely to be revised downward further. In substantiation of this view, the World Bank recently cut its world GDP forecasts for FY2012 and FY2013 from 3.6% for both years to 2.5% and 3.1% respectively.

All this seems to put earnings for US steel companies in jeopardy. Many of the above forecasts have gone significantly down in just the last few months. Many of the steel company forecasts have not caught up to the latest "steel user" industry estimates such as auto sales.

U.S. Steel (NYSE:X) earnings estimates for Q4 2011 have turned negative in the last 3 months (to -$0.85). Ditto FY2011 estimates. However, FY2012 estimates are still very positive at $2.45 per share. I saw such unrealistic optimism in both 2008 and 2009. I have no idea where the majority of analysts get their estimates from. US steel lost money in Europe in Q3 2011 (26% of its business). This is likely to worsen as the EU recession deepens. It is not going to get better as some analysts bizarrely think.

Not only this, but the competition in Europe is going to get worse. US Steel's production in Europe is already down to a 71% capability utilization rate in Q3 2011 as a blast furnace in Serbia was idle due to weak demand. The utilization rate is likely to worsen. ArcelorMittal and others are cutting production. Margins will fall too as this continues.

Russian, Ukrainian, Chinese, South Korean, Japanese, etc. steel producers will all be trying to dump as much of their steel as they can in both Europe and the US. Those markets are already suffering more than many had thought they would. That situation could easily get much worse. It seems unlikely to improve dramatically near term. This means US Steel will be severely pressured on revenues and margins in Europe in 2012. It means US Steel will be pressured on revenues and margins more than many had expected in the U.S.

This in turn means US Steel is likely to follow barely positive or negative FY2011 earnings with FY2012 earnings that are likely to be as bad or likely worse. The LME steel prices chart above already shows weakening prices. This only seems likely to continue as 2012 progresses. The EU recession will be bad for European steel prices, and one would expect it to have a negative effect on both Chinese and US economies and steel prices. These countries are two of the EU's biggest trading partners. US Steel's Q3 income in its flat rolled segment (US market) fell substantially from Q2 2011 to Q3 on lower average steel prices. The operating income was $53/ton in Q3 versus $95/ton in Q2. This doesn't seem likely to improve quickly. Rather these figures seem likely to worsen as the EU recession worsens.

Of course, you could maintain that the EU recession will be a light recession. Then the steel prices should again recover quickly. This may or may not occur. However, it is unlikely that steel prices will recover quickly, even if the EU comes out of its yet to come recession quickly. Both loan costs and gasoline prices are likely to rise when such a recovery occurs (as the emerging markets use more oil over time). This means there should be a steady trend to lighter, cheaper, more fuel efficient cars. These cars will use less steel.

I point out that China is already legislating this to a large degree. Everyone will no longer immediately buy an SUV. The likely steady rise in loan costs over the next few years (after the EU recession) should put a damper on the recovery in auto sales in the EU, the US, and China. The recovery in 2013 will not be as brisk as many are envisioning. On top of this there is the very real risk that the EU recession will be very bad. The US may even enter a new recession.

China could experience a hard landing. If any or all of these happen, results for US Steel could get much worse in 2012 and beyond than the average analyst is currently predicting. In other words, the analysts estimates are not low enough for the "good scenario" currently being predicted. The analysts are not even considering the possibility of a "bad scenario" in their estimates. This presents a good shorting opportunity for US Steel . Remember that during the just past US recession US Steel lost about -$10/share.

The one year chart of US Steel below gives some technical direction to this trade.

The chart shows a strong downtrend that has been consolidating to the upside of late. The 200-day SMA is still headed strongly downward. This indicates that X is more likely to continue to move downward, than not. The slow stochastic sub chart shows X is at or near over bought levels for the short term. This means that getting into a short trade on X at this point is a good risk from a technical standpoint. Technically down is the most likely direction from X's current state.

Take into account that a lot of worldwide business activity virtually ceases during the Chinese New Year, which starts Monday Jan. 23, 2012, as many Asian go to visit their relatives for two weeks. This might lead you to conclude that now is an excellent fundamental time to start a short position in US Steel. The fact that US Steel's dividend is currently under 1% should help you in making this decision.

If the trade looks like it is working well near the end of those two weeks, you could keep in on. If that's not the case, you might just exit the trade for the near term to wait for a more appropriate time. Due to the Chinese New Year effects, it is unlikely that you will lose much with a big gain by X to the upside during this time.

There are many other factors that could affect this trade. The situation in Greece is critical. It that blows up, it could put the overall markets back into the "sell everything" mode. This would help your trade immensely. Other countries could possibly cause the same problem. On the opposite side, the US Fed could decide to start a QE3 program. This might push all commodities prices up in the near term. This would tend to hurt a short trade in X.

The EU is scheduled to agree on an Iranian oil embargo on Jan. 23. The implementation of this embargo has been tentatively agreed to be delayed for six months. The affect of this on the markets is uncertain at this point. My observation so far is that the delay agreement is tending to soften oil prices in the near term and commodity prices in general. You will probably want to keep an eye on this situation.

I note shorting X's stock is only one option. You can also buy put options on X or a put option spread on X.

Good Luck Trading.

Disclosure: I am short X.