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 (
? Nope. General Motors? Not even close.
After forming in 1902,
United States Steel Corp. (
, 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
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
Disclosure: David Sterman does not own shares of any security
mentioned in this article.
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