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Steel shares have been lagging in 2013. The Market Vectors Steel ETF (SLX - ETF report) is down over 15% year to date compared to the SPDR 500 ETF (SPY - ETF report) which is up over 19% year to date.  The underperformance of the steel sector puts it in the spotlight for a turnaround and may be a contrarian’s delight.  The graphic displays the relative performance of the steel ETF.

Global growth shows signs of improvement:

There are signs the global economy’s growth rate may be reviving, and this could brighten the outlook for the steel industry.  The July U.S. manufacturing PMI jumped 4.5 to 55.4 posting its strongest result since June 2011, while the July Eurozone manufacturing PMI hit a two year high at 50.3.  Both indices look to be in an upswing and suggest the economic cycle is turning higher.  The global economy is not firing on all cylinders as the emerging markets are still lagging, but strength in the U.S. and Europe could help bolster EM export markets.

China is cutting steel capacity:

Beyond signs of improved economic growth, there are signs that China is working to cut capacity in its steel industry.  The National Business Daily indicated that China could reduce capacity in the sector by 400 million metric tons.  The reduction is expected to amount to about 40% of China’s steel capacity.   A reduction in capacity could help pricing power among global steel producers.

Valuation is attractive on a price to sales basis:

Steel companies have a history of reporting losses and volatile earnings depending on the economic cycle.   As a result, price to earnings ratios can become negative or not meaningful.  Sales are usually positive and make the price to sales ratio easier to use for valuation in a historical context.   The table below displays the price to sales ratio for a select group of steel stocks.

The price to sales ratios for the stocks in the table are all well below their 10 year average and toward the lower end of the range.  This hints the sector has an inexpensive valuation and is cheap.  Nucor (NUE - Analyst Report) and Commercial Metals (CMC - Snapshot Report) are trading at the smallest discounts and appear most expensive relative to their historical valuation.   Arcelormittall (MT) and U.S. Steel (X - Analyst Report) are trading farthest from average and appear most inexpensive.  However, relatively to the peer group, AKS and X have the lowest price to sales ratios.

Valuation looks less attractive based on next year’s earnings:

The following table highlights the price to earnings ratio based on the outlook for the next fiscal year’s earnings (think 2014).  In this case, most of the companies are trading at a premium to their average.  The sector looks on the expensive side.   NUE and Steel Dynamics (STLD - Snapshot Report) have the narrowest premiums to average.   STLD and AKS also have the lowest ratios relative to the group.  

Earnings estimates have generally come down:

The next table highlights the Zacks Rank and earnings estimates revisions over the last 30 days.  The Zacks Rank is founded on analyst earnings revisions. Simply speaking, companies with the greatest upward revision to earnings estimates are ranked as a #1 (Strong Buy), while companies with the largest downward revision to earnings estimates are ranked with a Rank #5 (Strong Sell).  Notice that steel companies range in the Rank #3 to Rank #4 categories.  Slow global growth and the weak tone of economic activity in the emerging world have hurt the earnings outlook.  

 

Notice that NUE has seen the greatest ratio of downward to upward revisions, but STLD has seen a more two way flow.   Analysts appear most cool toward NUE, but there appears to be a debate brewing over the direction of earnings at STLD.

Dividends are not supportive to the group:

The table also highlights dividend yields.   Dividend yields are limited for NUE and Olympic Steel (ZEUS - Snapshot Report), while AKS does not pay a dividend. MT, STLD, and CMC seem to provide the strongest dividend opportunities.

MT’s dividend yield stands out as way to get paid, while waiting for price appreciation and a sector turnaround.  However, free cash flow after dividend payment was negative in 2011 and barely positive in 2012.  Free cash flow after dividend payment has been trending weak compared to longer term history. The high dividend yield may reflect uncertainty over sustainability.

STLD, with a 2.8% dividend yield, has shown more stability in its free cash flow after dividend payment and may provide a more conservative way to wait for price appreciation.  CMC had negative free cash flow after dividend payment in fiscal 2010 and 2011, but positive free cash flow after dividend in fiscal 2012. 

Short interest has been building.  Could a squeeze be around the corner?

Generally, short interest has been rising in the steel sector.   It reflects caution in the sector. According to the NASDAQ website, short interest has built in most of the stocks.  The table displays the high and low in the short interest ratio since last August.  There is potential for a re-positioning in the sector - buying or short covering. The one exception seems to be ZEUS, which has seen its short interest ratio plunge in recent months. AKS and CMC seem to have the most elevated short interest, but MT and NUE are not too far behind.

Sentiment toward steel pricing seems cautious.  Automotive seems like a bright spot, but general commentary on the industry has been unexciting.  The recent lift in the European and U.S. manufacturing PMIs coupled with ideas of China cutting capacity could improve psychology and interest in the sector.   

Conclusions:

The steel has been out of favor. However, signs of accelerating economic growth may revive investor interest in the sector.  Earnings estimate revisions reflect apathy to cautious toward the sector with EPS estimates falling more than rising.  The value play is not clear as price to sales and price to forward earnings ratios provide a mixed outlook.  A basket approach, buying the ETF SLX may be the easiest way to play for recovery and bet against the crowd.

Technically, one could make the case that the SLX is near testing the breakout of a three year downtrend and has rotated back above the 2011 and 2012 lows.  This may suggest the downtrend is running out of gas.

Those looking for value and repositioning in individual names may think about NUE and AKS.  Both companies carry high short interest ratios compared to the last year. NUE looks relatively inexpensive based on its two year forward earnings per share estimate, while AKS has a low price to sales ratio both outright and compared to its peers.   Both are Zacks Rank #3 (Hold). See if you can steal some profits from the market in the steel sector.

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