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The steel industry is poised to benefit from solid demand in the United States and emerging markets like India. However, steel stocks have to struggle with equity market volatility and a host of other broader factors. Below, we discuss some of the key reasons and what investors in the steel sector should be wary of in the coming months and years.

Valuation Questions

Steel stocks had a roller coaster ride this year, but the industry has been a strong performer since around mid-June 2017 and has led the market since then. Year to date, the Zacks Steel industry is up +23% vs. the +18.9% gain for the S&P 500 index in that time period.

The industry has historically traded at a discount to the broader market, on most traditional valuation metrics, likely reflecting the deep cyclical nature of its business. On a trailing EV/EBITDA multiple basis (a preferred valuation metric for cyclical industries like steel), the Zacks Steel Industry (the medium level industry classification that includes steel makers as well specialty operators) is currently trading at 5.6X trailing 12-month EBITDA, at a discount to the S&P 500 index’s 11.7X multiple at present.

Over the last 10 years, the industry has traded as high as 28.1X and as low as 3.9X, with a median of 6.7X. As would be expected with all deep cyclical industries, valuation multiples top out at the bottom of business cycles and peak at the bottom. In other words, the industry is expensive when the multiple is at its low point. As you can see from the above 10-year history for this multiple, which is mirrored by other traditional multiples as well, the current multiple is closer to the bottom than to the top.

In other words, the industry’s valuation can’t be called cheap by any means, but it isn’t stretched or expensive either.

Rise in Cheap Imports in the United States

The continued surge of steel imports in to the United States has hollowed out much of the domestic steel industry. Per the latest figures released by The American Iron and Steel Institute (“AISI”), finished steel imports for the first 10 months of 2017 shot up 19.4% and 15.4% year over year, respectively.

Imports have captured almost 28% of the U.S. market, year to date. The largest offshore suppliers were South Korea, Turkey, Japan, Taiwan and Germany. Steel imports had dipped briefly last year due to Commerce Department anti-dumping and anti-subsidy duties imposed on steel products from China and some other countries.

These cheap imports hurt the margins of American steel players like Steel Dynamics Inc. (STLD - Free Report) , United States Steel Corp. (X - Free Report) , ArcelorMittal (MT - Free Report) , AK Steel Holding Corp. (AKS - Free Report) and Nucor Corp. (NUE - Free Report) .

Geopolitical Tensions

Performance of some key emerging and developing economies has deteriorated due to internal structural issues, lower commodity prices associated with China’s economic slowdown, and escalating political instability. Geopolitical tensions and political instability in the Middle East and Africa continues to have a negative effect. Political uncertainty in the Brazilian economy has resulted in a sharp decline in steel demand.

Can the Auto Sector Sustain the Momentum?

The global automotive sector is reporting a strong performance in 2017 with an especially strong performance in Turkey and Mexico. However, in the United States and China the auto sector could moderate and this trend is likely to extend to other countries in 2018.

Excess Capacity: Perennial Problem

The biggest obstacle to persistent growth and profitability in the steel industry is excess capacity. The industry is under relentless pressure caused by years of excess steel-making capacity, further aggravated by weak demand and uneven economic growth.

To solve this problem, steelmaking capacity needs to be reduced for the industry’s profit margin to reach a sustainable level, and to raise the capacity utilization rate from below 80% levels. The industry remains highly fragmented compared with other global businesses. However, the restructuring and consolidation needed to eliminate overcapacity is progressing at a slow pace.

Impact of Low Oil Prices

The energy sector, which was once buoyant due to shale discoveries and rising production of crude oil, accounts for 10% of steel consumption in the United States. Steel is necessary to make rigs and transport oil. Steel demand from the energy sector is being impacted as exploration companies have reduced capital expenditure budgets in the wake of tumbling oil prices.

Steel products used by the energy industry are also known as oil country tubular goods (or OCTG). U.S. Steel being the biggest supplier of these goods in North America is bearing the brunt of it.

Lower oil prices would urge energy companies to preserve capital to shore up their balance sheets instead of spending money on new exploration. Thus, leading suppliers to the energy sector, such as United States Steel and Tenaris S.A (TS - Free Report) , are likely to be under pressure throughout the year.

Low Crude Steel Capacity Utilization

The crude steel capacity utilization ratio remained stubbornly below 80% in the last three years. The average capacity utilization in the 2016 was around 69%. The average capacity utilization till October 2017 was around 72.7%. Excess steel capacity has been a perennial problem for the steel industry as steel prices generally move in tandem with capacity utilization rates. To remain competitive and rationalize operations, some major steel companies have resorted to idling steel plants.

Increasing Use of Aluminum in Auto Industry

Currently, steel is the major raw material for the auto industry, the second largest steel consumer. However, major automakers like Ford Motor Co. (F), General Motors Company (GM - Free Report) and others are becoming increasingly aluminum-intensive, given the metal's recyclability and light-weight properties. The global push to improve fuel efficiency in vehicles is expected to more than double the demand for aluminum in the auto industry by 2025. Hence, in order to remain competitive, the steel companies will have to come up with better and lighter varieties of steel.

How to Play the Industry

The short-term prospects are a bit clouded considering the headwinds plaguing the steel industry globally as discussed above. So, it would be prudent to stay away from steel stocks that carry an unfavorable Zacks Rank now. Particularly, we suggest staying away from stocks such as Zacks Rank #5 (Strong Sell) stocks such as Thyssenkrupp AG and Universal Stainless & Alloy Products, Inc. (USAP - Free Report) .

The estimates for Thyssenkrupp AG have declined 2% for fiscal 2017 and 21% for fiscal 2018. Universal Stainless & Alloy Products has witnessed a 50% drop in earnings estimates for fiscal 2017. The company also has a negative average earnings surprise of 43.14% in the trailing four quarters.

However, investors, who can look beyond the near-term clouds to the industry’s bright long-term prospects, may consider buying some steel stocks based on a favorable Zacks Rank.

We also recommend stocks such as POSCO (PKX - Free Report) and SSAB AB (SSAAY - Free Report) , both carrying a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Check out our latest Steel Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is shaping up for the future.

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