Is U.S. Steel A Steal?

| About: United States (X)

Summary

The lure of tax cuts, deregulation and infrastructural spending and the potential of unleashing outsized economic growth in the greater economy remains irresistible.

For many of these companies enmeshed in the Trump trade equation, valuations take on a tertiary role as momentum drives stock values to new highs.

While short interest should be running wild, such trades remain sidelined as the VIX is posting lower than the annual readings of any year in the benchmark's history.

U.S. Steel's market valuation since the election is cut from the same bolt.

The contradiction continues. Mr. Trump's stupefying weltanschauung notwithstanding, investors who are roundly skeptical of the new president in both form and substance are as yet unwilling to fight the current momentum of a market that continues to sketch out new highs. The siren call of tax cuts, deregulation and infrastructural spending on everything from a sea-to-sea wall on the U.S.-Mexican border to fixing and augmenting the country's transportation resources to financing more military muscle that combined carry the potential for unleashing outsized growth in the greater economy is just too irresistible. Principles invariably take a second seat to profits. Spinning such fiscal yarns, given the overwhelming political deterrents in times recently past, would have been considered delusions of cosmic proportion.

Yet with the seemingly firm Republican lock on the reins of government at the federal level, delusion spins quickly to slam-dunk in many investors' minds irrespective of political persuasion. It doesn't hurt to have a healthy array of underlying economic indicators trending, sometimes convincingly, in positive directions. At the same time, major economies of Asia and Europe continue to buy outsized monthly levels of sovereign and corporate debt assets, creating a magnet for dollar-based assets. The current electoral cycle in Europe also is witness to capital flows being directed to U.S. shores as the yield on the 10-year Treasury note, at 2.31% (24 February), has fallen to its lowest level since the last week in November. And the Federal Reserve waits patiently in the wings for its opportunity to jump-start a rate increase cycle.

It's as close to the perfect storm as it gets for dollar-based assets: Given current market conditions, equities face far less selling pressure as a result and U.S. markets continue to ride a seemingly endless wave of almost unbridled optimism - and we're seeing just such a trend across a wide swath of the U.S. market. Short interest should be running wild at this juncture - which creates the current market window in which the Trump trade both resides and thrives. Valuations on the S&P, at about 18 times expected earnings according to FactSet, are lofty by measures of the past decade but since the election appear, at the moment, to be tertiary considerations. Short interest on the S&P 500 benchmark since the election as measured by the VIX posted an average reading of just 12.25 - lower than any annualized average reading of any year in the history of the VIX, which dates back to January 1990. At Friday's market close, (24 February), the VIX had fallen even further to a reading of 11.49.

The result? Issues from well-known corners of the market such as Morgan Stanley (NYSE:MS): up 42%; Boeing (NYSE:BA): up 25%; Bank of America (NYSE:BAC): up 43%; New York Times (NYSE:NYT): up 33%; CSX (NYSE:CSX): up 51%; to the relatively unknown corners such as Permian Basin Royalty Trust (NYSE:PBT): up 36%; Mesabi Royalty Trust (NYSE:MSB) 85.45%; Texas Capital Bancshares (NASDAQ:TCBI): up 52%; to the downright obscure corners such as Tutor Perini Corp. (NYSE:TPC): up 51% - have soared since the election. Each of these issues tie directly into market expectations around the mesmerizing lure of tax cuts, deregulation and infrastructural spending with perhaps the sole exception of NYT, which has seen its shares skyrocket due to its informative and interpretative skillset. U.S. Steel (NYSE:X), up 76.57% since the election, is cut from the same bolt.

Overcapacity, business cyclicity and fragmentation largely describe the headwinds faced by the steel industry in much of the world. The issue of overcapacity usually points the guilty finger, rightfully so as it turns out, in China's direction where out of Asia's 1.1 billion metric tons of steel produced through the end of 2016, 808 million metric tons derived from China, according to data from the World Steel Association. China accounts for about half of the world's 1.61 billion metric tons of steel output through the end of 2016. In a convergence of impacts resulting from China's economic slowdown, its shift from investment to service-driven growth and continuing weak global investment growth all dish up strong headwinds for steel demand worldwide. Further downside risk comes from high corporate debt levels from years of issuance in historically low interest rate environments to fund largely nonproductive purposes such as stock buyback and enhanced shareholder dividend programs that now face the prospect of a new cycle of short-term rate increases, compliments of the Federal Reserve. China's industrial overcapacity has not only led to defaults on outstanding debt, cuts in output and millions of idled workers in the coal and steel sectors, but has led to flooding international markets with surplus steel products, depressing prices worldwide.

Business and economic cyclicity are closely related. The impact of the Great Recession of 2007 saw the demand for durable goods of all shape and sizes plummet as overall economic activity in the U.S. came close to literally grinding to a halt. Roughly 8.6 million jobs in the U.S. were lost from January 2008 to December 2009 in the Automobile manufacturing, the largest driver of North American steel consumption, witnessed both a government bailout of General Motors (NYSE:GM) and Chrysler in 2009 and the annualized sales of light trucks and passenger vehicles plunge to 9.023 million units through the end of February 2009 - a level last seen in December of 1981. The return of annualized vehicular sales to the pre-crisis level of 16 million units didn't happen until June of 2014. Not unsurprisingly, U.S. Steel posted a string of annual negative growth numbers from 2009 through 2013, scratching out an infinitesimally small gain in 2014 only to see earnings continue to slide in both 2015 and 2016.

Throughout much of the emerging market space, steel manufacturing remains highly fragmented, painfully competitive and in dire need of consolidation to capture what remains of economies of scale in the sector. More recently, M&A activity and bankruptcies have driven the industry toward greater efficiencies in North America and Europe as production facilities became more intensive, specialized and focused on more narrow segments of the economy such as supplying steel products for the automotive, oil and gas, consumer durable goods and construction segments of the greater economy. U.S. Steel has research facilities in Pennsylvania, while its tubular production facilities are closer to the center of oil and gas activity in the Houston area of Texas. The company maintains automotive operations in Michigan, while its European operations base out of Slovakia, a Eurozone member state.

Total sales for the nine months through the end of the third quarter 2016 came to $7.61 billion, down from $9.002 billion for the same period YOY for a 15.45% decline for the period. U.S. steel fields three segments:

  • Flat-rolled steel which is fashioned into slabs, rounds, sheets, plates and tin for a variety of end uses including automobiles, construction, railroad cars, ships, oil & gas service and containers. The segment comprises 75% of total sales for the nine months through the end of the third quarter 2016. Total sales of flat-rolled steel came to $5.64 billion for the period, a decline of 15% over the same period year over year. Much of the decline came from the permanent shutdown of a blast furnace and flat rolled finishing operations in Fairfield, Alabama in January 2015. Other facilities closed during the year were coking operations in Gary and the coking operations at Gary, Indiana in February and a hot strip mill Granite City, Illinois in December. The Company took a $275 million restructuring charge as a result of the plant closing. The Granite City mill partially reopened in February 2017;
  • U.S. Steel Europe (USSE) also produces flat rolled steel for construction, transportation, appliances and oil services for the EU market. USSE contributed $1.62 billion for the nine months through the end of the third quarter or 21% of total sales for the period. USSE produced $1.84 billion in total sales for a decline of just under 12% on a YOY basis. The decline was largely attributed to weak economic growth in the EU and weak demand for steel products. The strong dollar and comparatively weak euro added exchange rate risk to the equation;
  • Tubular steel production continues to be a small percentage of overall production, roughly $303 million or 4% of total sales through the end of the third quarter. Sales of tubular products plunged 141% over sales levels in the first nine months of 2016. The tubular market mainly serves the oil and gas industry and the decline of both crude oil prices and drilling activity wreaked havoc on sales of equipment to service and drilling companies throughout the period. The average price of West Texas Intermediate (WTI) on the New York Mercantile Exchange in 2015 was $49.47, dropping to an average price of $43.50 in 2016. The average price of WTI in the new year through the week ending the 21st of February was $52.88. With the rise in the price of WTI in U.S. markets, drilling activity has expanded, with the expectation that the upward price pressure on crude will translate into upward pressure on sales of tubular steel products through the course of the year.

U.S. Steel continues to spend an inordinate amount of time filing anti-dumping (AD) and countervailing duty (CVD) cases against a long list of countries including China, India, Italy South Korea and Taiwan over the issue of stainless steel. By July of 2016, after almost a year of deliberation, the U.S. International Trade Commission and U.S. Customs and Border Protection is now enforcing these decisions and collecting AD and CVD duties on stainless steel products from these countries.

In July of 2015, the company filed similar complaints regarding cold rolled steel products from Brazil, China, India, Japan, South Korea, the Netherlands, Russia and the UK. Further filings in August were in regard to hot-rolled coil from Australia, Brazil, Japan, South Korea, the Netherlands, Turkey and the UK. U.S. Steel is also involved in several appeals with the Court of International Trade regarding tubular goods cases as well as defending ongoing appeals of decisions rendered by the World Trade Organization.

The company has further set into motion a case under Section 337 of the Depression era Smoot/Hawley Act (1930) against 10 of the 11 largest Chinese steel producers and distributors alleges price fixing, the theft of trade secrets and the circumvention of AD and CVD duties already in place through transshipment. The remedy sought in these cases is the total ban of Chinese steel and alloy products from U.S. markets.

With all of this said, in the wake of the Trump election, Morgan Stanley upgraded its stock ratings on U.S. Steel, AK Steel (NYSE:AKS) and iron ore producer Cliffs Natural Resources (NYSE:CLF). Mr. Trump's infrastructural spending plans could boost domestic steel demand by an estimated 22 million tons for each year the program is in place, according to market reports.

U.S. Steel is likely not a steal at current valuations. Headwinds to growth are both numerous and entrenched in the markets it serves both domestically and abroad. Still, the company remains enmeshed in the lure of tax cuts, deregulation and infrastructural spending that comprises the sine-qua-non of the Trump-trade. The realization of investor expectations regarding U.S. Steel relies heavily on the ability of the Trump administration to push his spending priorities through a likely reluctant Congress where offsetting spending cuts on the discretionary side of the equation are growingly sparse and deficit spending at such levels is likely a non-starter. Yet until the political equation plays out, U.S. Steel is likely to benefit from outsized market expectations.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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