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Published: May 19, 2010
Throughout the recent economic slump,
investors began to wonder if the world’s oldest billion-dollar
corporation would even survive. Think about that. A hallmark of
American industry on the brink. . . Sound familiar?
So what was this ‘mystery’ company? General Electric (NYSE:
GE)? Nope. General Motors? Not even close.
After forming in 1902, United States Steel Corp. (NYSE: X),
with its high fixed costs, had seen its fair share of ups and
downs in the ensuing century-plus, but nothing quite like this.
Rivals such as Nucor (NYSE: NUE) perfected the fine art
of variable expense management, which means that costs dropped
sharply when revenue slowed. But now it's time once again for an
upturn.
The entire steel industry has surged back, and U.S. Steel’s high
fixed costs have become an advantage. That’s because new
incremental revenues should flow very quickly to the
bottom line. For example, sales next year are forecast to
rise only +10%, but profits should triple. Similar revenue
growth in 2012 could add another 40% to the bottom line.
That moderate sales growth is expected to come from a
combination of higher volumes and higher prices per ton.
Industry capacity utilization, a measure of how close to
capacity the major steel mills are operating, is set to keep
rising, and as mills move closer to running full tilt, the major
producers can impose meaningful price increases. We’re not there
yet. U.S. steel mills are operating at around 74% of capacity,
up from 64% last November. As that figure approaches 80%, it
becomes far easier to push for price hikes. Right now, processed
steel fetches about $700 per ton, though it fetched more than
$1,000 back in 2008. As steel prices move back toward that peak,
U.S. Steel should benefit from both higher volumes and higher
selling prices.
It’s fair to wonder why prices should rise if the Chinese
economy is already running flat out. Simply put, industrial
demand in the rest of the world is just getting going again. In
places like Turkey, Brazil and southeast Asia, steel demand is
rising, even as global inventories remain fairly low. In the
United States, demand should keep building as auto sales
continue their rebound, and eventually, the construction market
hums back to life.
Yet steel service centers, which act as a middleman for buyers
and sellers, are keeping record low levels on hand, perhaps
because they suffered large losses when steel prices plunged two
years ago. According to the Metals Service Center Institute, the
industry carried 2.0 months of supply in April, down from the
3.0 to 4.0 months of supply they normally carry. That drawdown
has modestly muted end-demand for the steel mills, but that
headwind should soon become a tailwind.
Yet the clearest read on demand is in scrap
steel prices. Scrap is used when supplies are abundant, but
supplies are tightening, pushing prices up +100% in the last 12
months. When scrap supplies tighten, traders push up the costs
of iron ore, which is used in the production of steel. And
that’s just what’s happening now. The good news for U.S. Steel:
the company has vertically integrated its operations into iron
ore production, and is well-insulated against price hikes for
this key raw material.
Rising demand and firming prices should enable U.S. Steel to
report its first quarterly profit in several years when results
are released in July. And quarterly profits should grow quickly
from there, even if pricing and demand improve only modestly, as
the company is right at its
break-even point with high fixed costs. Analysts think that
U.S. Steel can earn more than $2 a share during the second half
of 2010, and more than $6 a share next year. The key question is
whether the global economy remains on the mend into 2012. If so,
U.S. Steel can see per-share profits approach $8 and
earnings before interest, tax, depreciation and amortization
(EBITDA) should approach $13 a share.
Shares of U.S. Steel have historically traded at around 6 times
peak cycle EBITDA, on an
enterprise value basis. A rising cash balance should enable
the company to have more cash than debt by the end of 2011, so
the company’s enterprise value and
market capitalization will be roughly the same.
So if shares achieve a six times multiple on projected 2012
EBITDA, then shares have roughly 50% upside to around $78. (As a
point of reference, shares trade for nearly $200 less than two
years ago). Of course, investors need not wait until 2012 to
reach that target price, as investors always look one to two
years out in their forecasts to justify a stock’s valuation. As
the industry dynamics continue to improve over the remainder of
this year, that 2011 and 2012 outlook should come into sharper
focus.
-- David Sterman
Contributor
StreetAuthority |
