Steel industry outlook
We’re now midway into 2019. The US steel industry had a somber start to the year, and the sell-off only deepened as the year progressed. All major steel companies including U.S. Steel (X), AK Steel (AKS), Nucor (NUE), and Steel Dynamics (STLD) fell to their 52-week lows in May as the escalation in the US-China trade war rattled metal and mining investors.
However, June turned out to be a fairy tale month for steel stocks. Although steel stocks haven’t really gone through the roof as President Trump claimed in an interview, they saw a sharp rally in June, helping them recoup some of their losses. U.S. Steel, AK Steel, Nucor, and Steel Dynamics saw an upwards price action of 29.5%, 37.8%, 15.6%, and 21.0%, respectively, last month. ArcelorMittal (MT) also went up 22.5%. Barring U.S. Steel and ArcelorMittal, steel stocks that we’re discussing are now positive for the year.
Section 232 tariffs
To be sure, Section 232 tariffs that President Trump imposed last year led to some sort of rejuvenation in US steel companies. Flush with cash amid higher 2018 cash flows, steel companies tried their hand at everything from buybacks to greenfield growth projects. U.S. Steel also doubled down on its plans to modernize its aging plants and even resumed the abandoned Fairfield electric arc furnace project. The project was conceived and abandoned in 2015. While 2015 started off well for steel stocks, China’s slowdown pushed US spot hot-rolled coil prices below $400 per ton. In such a scenario, U.S. Steel had to curtail its capex plans. Notably, U.S. Steel turned EBITDA negative in the fourth quarter of 2015. In the current scenario, US steel prices peaked in 2018 and have been trending downwards since the second half of 2018. Incidentally, after massive growth projects, the US steel industry had to resort to capacity curtailments in June.
US steel prices fell sharply this year to the point where prices were even below the tariff-paid steel imports. Clearly, such a scenario isn’t sustainable in the long term. Furthermore, US steel buyers went light in steel buying anticipating prices to fall further. Last month, US steel companies including Nucor announced price hikes to provide some impetus to US steel prices.
What lies ahead?
As we head into the second half of the year, we could see some upwards traction in US steel prices. Chinese steel prices have been strong aided by decent demand and higher iron ore prices. Stable Chinese steel prices should lend some support to US steel prices. The spreads between US and international steel prices don’t reflect the Section 232 premium that they should. Having said that, the complete exemption for Canada and Mexico has complicated the picture somewhat for US steel pricing. Nonetheless, from a spread perspective, US steel prices might see some upwards traction in the third quarter.
Along with the trend in international steel prices and the spreads, we also need to consider the domestic demand-supply environment. The construction sector is the biggest steel end consumer. Within that sector, both the housing starts and new homes sales fell in May. New home sales have now fallen for two consecutive months despite the fall in mortgage rates. The architectural billing index (or ABI), which acts as a leading indicator for the nonresidential construction sector, has also shown signs of moderation. The ABI was 50.2 in May as compared to 50.5 in April. The American Institute of Architects also sounded a warning note. It said “for the last four consecutive months, firm billings have either decreased or been flat, the longest period of that level of sustained softness since 2012. In addition, while both inquiries into new projects and the value of new design contracts remained positive, they both softened in May as well, another sign that the amount of pending work in the pipeline at firms may be starting to shrink.”
June flash PMI also showed a big fall in manufacturing activity and was the lowest reading since September 2009. The automotive sector, another leading steel consumer, has also shown signs of moderation. Meanwhile, we could see some supply-side discipline in US markets after U.S. Steel announced plant curtailment last month. A few days after the announcement, US steel companies announced price hikes. So, in our view, while US steel demand growth could moderate, US steel mills might also lower output, which would mean that the demand-supply equation doesn’t worsen from here.
Furthermore, and as noted by companies including Cleveland-Cliffs (CLF), US steel buyers went slow on steel purchases in the first half of 2019. Cleveland-Cliffs supplies iron ore to US steel companies. As steel scrap prices looked weak, steel buyers anticipated steel prices to also fall. As expected, steel prices have also followed steel scrap prices lower. Now, steel scrap prices could be near their lows. Typically, stability in steel scrap prices lends support to steel prices also.
Finally, the valuation
We also need to look at the valuation multiples. ArcelorMittal has an EV-EBITDA of 3.9x based on its 2020 multiples, which is the lowest among the steel companies that we’re discussing in this series. U.S. Steel, Steel Dynamics, and AK Steel have a 2020 EV-to-EBITDA multiples of 4.5x, 6.6x, and 6.9x, respectively. Nucor has the highest 2020 EV-to-EBITDA of 7.3x. However, steel companies’ valuation multiples should be read with caution, like other cyclical companies.
If we look solely at the valuation multiples, steel stocks appear fairly valued, as they are largely in line with their long-term multiples. However, the forward valuation multiples are ultimately a function of analysts’ earnings estimates. And analysts base their estimates on their forecast of steel prices. Typically, analysts’ earnings estimates lag the movement in steel prices. As a result, steel companies’ valuation multiples tend to spike near the bottom of the cycle while multiples are subdued at cyclical highs.
U.S. Steel is expected to post adjusted EBITDA of $975 million this year and $1.03 billion in next year. The estimates seem to assume almost no improvement in steel prices over the next year. But, as noted previously, we could see some traction in US steel prices.
Other near-term drivers
In the near term, positive progress in US-China trade talks could also provide some momentum to US steel prices. Also, if we see some progress in the infrastructure plans that President Trump touted in his campaign, it could help lift US steel demand, which of late has shown signs of moderation.
Another aspect to consider would be the massive investments that US steel companies like Nucor and Steel Dynamics have made into greenfield projects. Once these projects start coming online in the next decade, it would lift the shipment profile. U.S. Steel also expects to realize significant cost advantages after 2020. However, these investment plans would also enhance US steel production capacity, which is a bearish driver for steel prices. We’ve already seen a glut of steel in US markets, and U.S. Steel had to idle two blast furnaces last month.
Which stocks offer value?
In our view, in the medium-to-long term perspective, Nucor and Steel Dynamics offer good entry points. We continue to favor Steel Dynamics over Nucor due to the valuation gap between the two companies. ArcelorMittal also offers value, as European steel markets seem to have bottomed out. ArcelorMittal announced capacity cuts twice in May. Pressure could build on the European Union to address the domestic steel industry’s woes. Europe saw a surge in steel imports after the United States clamped down on imports with its Section 232 tariffs.
U.S. Steel could be another interesting play. The company is projecting millions of dollars of incremental EBITDA every year from its ongoing capital expenditure plans. However, it needs to convince markets that these figures are for real. If the company can realize the sort of EBITDA benefits that it is touting, it also looks like a “buy” at these levels. We continue to hold our bearish opinion on AK Steel. The company’s heavy reliance on automotive companies coupled with increased competition in that space makes it less attractive as compared to other steel stocks. And, with concerns over economic growth, AK Steel looks even riskier with its high debt levels.
At the time of writing this post, Mohit Oberoi, CFA does not hold any position in NUE, AKS, X, STLD, and CLF.