U.S. Steel's Future Depends On What China Does Next
- U.S. Steel has risen tremendously as COVID-19 supply-chain issues limit production and increase demand.
- China recently drastically cut production in its steel-producing hub which creates far more steel than the entire U.S.
- Officially, the cuts were made in order to reduce pollution for climate goals, but the country's severe coal shortage is likely a contributing factor.
- If China keeps these cuts long-term or if the country's low production costs finally rise, U.S. Steel's rally may only be beginning.
- However, if the situation "returns to normal", U.S. Steel may drop as its high leverage requires more consistent profits than has been found this decade.
This first quarter of 2021 has seen many aggressive moves across financial markets. The main theme has been a return to the "relation" trade wherein long-term rates are rising and benefiting the value of cyclical stocks. One company that has gained tremendously from this trend is U.S. Steel (NYSE:X).
I've been bullish on U.S. Steel for some time beginning at the end of 2019 in "U.S. Steel: This Turnaround Has Huge Legs". While the stock slipped initially during the beginning of 2020, it is currently up 80% since the article was written. As mentioned in the summary, the primary bullish factors I saw included an infrastructure bill and a spike in construction/vehicle production both of which have partly come true. Other bullish factors included U.S. Steel's superior financial position and excessively low valuation.
While it has only been around 16 months, the world today is far different than it was then. COVID has caused significant changes to the global industrial system which have generally benefited materials companies like U.S. Steel. Additionally, a surge in investment activity has caused many low-valuation companies to rise to their fair value. In the article, I mentioned that it seemed likely X would rise to $30 within three years. It has risen to $25, though at a faster pace than anticipated due to the significant changes which occurred last year. Given this, it seems like a good time to take a close look at the company in order to judge whether or not it is a good time to take profits.
How COVID Helped To Save U.S. Steel
One of the most interesting impacts of the challenging situation today is how it has uncovered the extreme interdependence of the global supply chain. There has been a relatively small decline in productivity which has been seen in nearly all segments of the global supply chain. One of the most important being the shipping industry which is facing severe shortages and imbalances. The recent Suez canal blockage is perhaps only the "tip of the iceberg" compared to the general shortage of shipping which has led to a spike in freight rates.
This issue led to a severe coal shortage across China and forced the global steel manufacturing giant of Tangshan to aggressively cut output. This has caused coking coal and iron ore prices to slip and steel prices to rise. Officially, the 40-50% production cut was due to "pollution reduction efforts", but it seems more likely to be caused by the country's severe coal shortage which has led to widespread blackouts. Both may be true, but as long as China cannot get enough coal, steel prices will continue to rise.
As discussed in the previous article regarding U.S. Steel, aggressive Chinese production growth was the primary reason for U.S. Steel's long-term decay. In fact, at 144M tonnes of steel production, the city of Tangshan alone produces almost twice as much as the entire United States so the city's 40-50% cut will have significant benefits for U.S producers.
If these cuts are long-term or if China is legitimately working to "win the war on pollution" (as the CCP has stated in regards to steel cuts) then U.S. Steel's rally may only be beginning. Not only would this lead to improved market share in the near term, but would also increase production costs in China and increase global steel prices. U.S producers such as Nucor (NUE), Cleveland Cliffs (CLF), U.S. Steel, and others have had to face lower profit margins due to the fact that China produces far more steel with far lower environmental regulations - giving them far greater competitive viability.
Put simply, if China's anti-pollution efforts are sincere and/or if the country's coal shortage continues, the long-term outlook for U.S producers is likely better than it was in the past. Fortunately, demand for steel in the U.S will likely remain solid, but the current bill has far less spending toward roads, bridges, dams, etc (I estimate to be about a quarter of the bill's $2T value) than is believed to be necessary (over $4T).
Dissecting U.S. Steel's Financial Situation
Steel prices have risen by over 50% since the beginning of 2020 with a strong spike in recent weeks. This implies that U.S. Steel's Q1 margins will likely be much stronger than before and the recent move suggests its Q2 margins will be even better. This comes after a period of difficulty caused by negative margins. See below:
Steel is a historically volatile business given the fact that producers make money based on the difference between raw material input costs and the price of steel. Most have struggled with negative profits over the past decade, with China (and other Asian countries) producing steel at much lower operating costs than U.S producers. That said the recent favorable shift for U.S. Steel should boost its CFO margin back to the 8%+ level.
Indeed, U.S. Steel's current 2021 EPS outlook is $5.83 which equates to $1.56B in net income. Against its $14.8B revenue outlook, we get a forward profit margin expectation of just over 10% - potentially making 2021 among its most profitable years. This also gives the company an extremely low forward "P/E" of 4.3X which is below Cleveland Cliffs of a still low 5.9X. Today, most large companies have "P/E" valuations closer to 30-40X so there is significant reason to believe the steel industry is undervalued despite its gains.
That said, the consensus analyst EPS outlook for U.S. Steel wanes after 2021 with earnings expected to shrink back below $1 by 2023. Under this view, the company is not a value opportunity and may even be overvalued. U.S. Steel also has over $8B in total liabilities which gives it bankruptcy risk in the chance that the steel market reverses lower.
The Bottom Line
Like other steel producers, U.S. Steel is in a very unique situation today. Demand for steel has been surprisingly steady despite COVID while supply has been negatively impacted. The shortage will likely grow this quarter as China's production falters, likely leading to great profits for U.S producers. Among those, U.S. Steel has arguably the lowest valuation however it also carries higher risks due to its leverage.
If the strong environment for steel lasts into the coming years, I believe X may rise much higher. This would be particularly true if China is seriously looking to overhaul the industry and reduce pollution. If China continues to create trade barriers with Australia or if freight issues continue, the country will likely continue to lack the raw materials necessary for its monumental production levels.
Overall, there are reasons to believe the steel market is in a long-term turnaround. However, there is also a significant chance that it returns to normal, or at least to normal steel production levels. Given this as well as U.S. Steel's heightened valuation, I would no longer buy the company and am neutral on X. It is possible the stock reverses lower as investors take profits and China fixes its coal issues. The opposite is also possible, but I would prefer U.S. Steel at a price of $20 given immense uncertainties surrounding the situation. That said, I do currently prefer U.S. Steel to its competitors since I believe it has the most upside potential given its forward valuation.
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