Commodities Corner: Flaming Hot Steel

August 2, 2006

The steel sector continues to generate record earnings as favorable conditions for the industry continue, unacknowledged by Wall Street.

The steel industry is booming, yet remains underappreciated by Wall Street. Many view the sector as highly cyclical due to worries about how companies will weather the next economic downturn. The current rapidly expanding economy requires obvious resources like oil, but steel also plays an integral part in the growth picture. Like their oil brethren, steel stocks are trading at unusually low P/E ratios and are hot investments to have.

The strongest individual stock in the sector appears to be the United States Steel Corporation (X). The stock recently blew away the most optimistic earnings forecasts, beating the average analyst estimate by a whopping 71 cents a share. This has forced analysts to realize the sector isn’t going to fade away just yet, and revise their forecasts for earnings upwards. Despite the buoyant prospects, some on Wall Street are still writing the sector off.

UBS downgraded US Steel today from buy to neutral, showing continued analyst foolishness. Just four months ago, UBS upgraded the stock from neutral to buy. If anything, the industry’s prospects have improved in this period. US Steel currently has over $1.5 billion of cash oh hand, but is trading with a market capitalization of just $7.6 billion. The trailing P/E on the stock is 9.1, while the forward ratio is a miniscule 6.0. If the company continues surpassing these expectations, Wall Street should jump back on board with the stock quickly.

Standard and Poors has a more conceivable outlook for the stock; rating it a buy with an $84 price target. Currently trading at $62, the stock has plenty of room to run. A quarterly 15 cents per share dividend is another added bonus of holding the stock. Additionally, the solid fundamentals make steel stocks prime buyout candidates. There have already been several acquisitions and much speculation about future deals.

Indian steel giant Mittal Steel Company (MT) unexpectedly launched a $23 billion hostile takeover bid for rival Arcelor. The bold move highlights the willingness of companies to pay hefty premiums to acquire competitors and grow their operations.

China has fueled demand for steel as it builds various structures in its general expansion, as well as facilities for the 2008 Summer Olympics in Beijing. Although the automobile industry is struggling, steel producers are still able to raise prices for their products and sell them effortlessly. In the face of high oil prices, the steel producers are able to pass these costs on to their customers in the form of high oil price surcharges, limiting their exposure to soaring energy prices.

Nucor (NUE) is a slightly different type of steel company that recycles scrap metals into new steel, instead of creating it from raw materials like the previously mentioned companies. This is considered advantageous for Nucor, due to its ability to downplay rising raw material costs. The result is a higher P/E ratio for the company, and a market cap of $16.7 billion.

Other major players in the sector include Allegheny Technology Incorporated (ATI), Commercial Metals Company (CMC), Steel Dynamics (STLD), Schnitzer Steel Industries (SCHN), Worthington Industries (WOR), and Oregon Steel Mills (OS). The companies with market caps in the $1-2 billion range are the most likely candidates for takeovers. All are worth a look, trading at relatively low P/E ratios and paying back good dividends to investors.

Favorable pricing for steel products, continued earnings growth, and bargain valuations make steel stocks a must have. Just like the oil industry, the steel’s will eventually encounter hardship at the next economic downturn. Until this threat materializes, steel stocks are great value buys, as long as you buy before someone else buys the company out.

At the time of publication, Dhinesh Ganapathiappan owned shares of United States Steel Corporation.