By K C Ma and Luca Zambelli
In February of this year, President Trump announced a 25% tariff on import steel in order to “boost American industries and correct unfair trade practices by other countries.” Among many supporters, Commerce Secretary Wilbur Ross said. "When you're thinking about the overall economy, it's not just the trivial increase in product prices, it's also the increase in employment and the strength of the economy overall.” For the first few months, the President’s plan seems working. Steel imports fell 34% from April to June, prompting job growth. U.S. Steel (NYSE: NYSE:X) restarted facilities in Granite City, Illinois, which accounts for 800 jobs. Prices of its US-made steel rose 5% to 10% in Q2 and shipments increased revenue by 15%. The company also reported its second quarter operating profit rose 38% and raised its full-year profit guidance. It expects profit for 2018 to more than triple.
However, if you think that U.S. Steel, the obvious beneficiary of the 25% steel tariff, has been better off because of the tariff, you will be proved wrong. Briefly after gaining about 25% due to the tariffs announcement, shares of U.S. Steel have lost close to 30% year to date, compared with a basically flat S&P 500. Note: 1801 = January 2018
Since the intent of the tariffs is to increase revenue and better pricing for U.S. steel makers, we examined analysts’ forward revenue and EPS after the tariff announcement. At first glance, Figure 4A and Figure 4B provide reasonable evidence on such expectation, as analyst raised both their estimates on future U.S. Steel revenue and EPS estimates amid US tariff announcements.
Obviously, it is puzzling to see that U.S. Steel’s share prices have dropped while the forward financials have been raised. It is almost like the market has imposed an additional risk premium on the sustainability of the expected gain in future growth. Actually, that is exactly what the market did. A trade war risk premium, in anticipation of retaliatory tariffs or the escalation of a trade war, have been imposed.
For the divergence between fundamentals and share prices, we need to evaluate the tariffs for its full impact, intended or not. For U.S. Steel’s shareholders and the Administration, the first “miscalculation” is that we didn’t factor in the “tit-for-tat” retaliatory tariffs which are almost guaranteed to come with any tariff (Table 1 in red). Considering that tariffs and retaliatory tariffs apply to both import and export steel, and the U.S. historically imports 3 to 4 times more steel than it exports (Department of Commerce Table below), the total negative impact from both tariffs can be estimated. In the first approximation, U.S. Steel makers like U.S. Steel enjoyed an immediate price increase (5%-10%) domestically, but their exports will face the same 25% retaliation tariffs imposed by other countries. Therefore, we could say that the net impact will be close to a draw.
On the other hand, the U.S. manufacturers have to pay 25% more on the imported steel which amounts to 75% of the total consumption. The direct cost increase and the resulting demand impact are both immediate and extremely harmful. For example, the Mid-Continent Nail plant in Poplar Bluff, Missouri, recently laid off 60 of its 500 workers because of increased steel costs. The company blames the 25% tariff on imported steel. Orders for nails plunged 50% after the company raised its prices to deal with higher steel costs. The company is in danger of shutting down production by Labor Day unless the Commerce Department grants it an exclusion from paying the tariffs. About 21,000 US companies have filed for tariff exclusions. It is estimated that tariffs against China alone could cost 134,000 US jobs, steel and aluminum tariffs could cost 470,000 jobs, and tariffs on autos and auto parts could cost 157,000 jobs. Overall, the US Chamber of Commerce has estimated that 2.6 million US jobs will be affected by this situation, this forecast includes the impact of ending NAFTA. The future tariffs that have already been proposed could cost the US economy about 700,000 jobs by next summer, according to Moody's Analytic
Finally, an inevitable question has been raised: What would have happened to U.S. Steel if the tariffs were never imposed? To answer this question fairly, we need to avoid using 20-20 hindsight. That is, we need to estimate what U.S. Steel stock shares would have traded at in 2018 if there was never any tariff. To do so, we cannot simply compare the changes in stock prices after the tariffs have been imposed. This is due to company fundamentals changing over time -- stock prices would have changed regardless of the existence of tariffs. Simply looking at the stock price alteration after tariffs changes does not give a clear picture of the tariffs impact.
Therefore, our thinking process is as follows; in order to estimate the impact of tariffs and rising interest rates, we need to first identify how the stocks in question are priced in an environment of no tariffs and low interest rates (before 2018). This process is referred to as a “tariff-free” pricing process. When we applied this pricing process to the time period of 2018, the resulting price estimates on 2018 financials would approximate to the “what-if” stock price if the tariffs have never been imposed. When we compared the what-if prices with the actual stock prices, the differences would be a good approximation for the impact of tariffs.
Since stock prices are forward looking, we selected several typical forward financial metrics. These metrics include Street consensus estimates for quarterly revenue, earnings per share, free cash flow, and gross margin over the last five years with daily values. More importantly, since rising interest rates are a competing argument to explain stock prices, the 10-year Treasury rate was also included as one of the metrics used to estimate stock price movement. Then, for U.S. Steel, we developed a market pricing structure by correlating stock prices with their corresponding forward financials for the period before 2018, i.e., 2011-2017. Remember, this is the time period before the tariffs were imposed and interest rates started to rise. A significant correlation would imply the process of how the market has priced these firms' fundamentals. Using this process, we were able to estimate U.S. Steel’s “theoretical” stock prices in 2018. In Figure 1A, for comparison, we present both the actual U.S. Steel’s price and the theoretical no tariffs price for 2018.
For U.S. Steel, we found that the stock is traded at $27, a significant 35% discount to the level of $42, if there were no tariffs.
Granted that the “no-tariffs” case is totally hypothetical. Yet the estimated target price is realistic enough to be a benchmark which responds to U.S. Steel’s current forward financials.
In this post, we look at U.S. Steel because it is particularly interesting in its own right. First, you would think that U.S. Steel, being the poster child for Trump’s tariffs, should be the first one to reap the benefit of U.S. steel tariffs. While we did see that the company was able to raise prices, increase shipments, revenue, profit, and revise the outlook upward, the optimism is not shared by the shareholders. Ironically, all the good near-term financials news from steel tariffs could not stop the 30% loss in share values in 2018.
As it becomes painfully clear that U.S. Steel’s short-term gain has been obtained at the expense of higher imported cost to the rest of the country. The U.S. steel industry constitutes over $520 billion a year to the economy and directly or indirectly affect nearly 2 million American jobs. There have been early signs of job losses which amount to hundreds times of the limited newly created steel industry jobs. Investors appear to pick up the clue of an emerging recession on its way. U.S. Steel’s stock has been undervalued by at least 30% off its significantly improved fundamental level. We can only attribute the discount a result of pricing in the trade war risk. The good news for a trade war risk discount is that once the risk is removed, the 30% risk premium is recoverable to shareholders.
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