Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Steel stocks got walloped last month.
Shares of steel minimill operator Nucor (NYSE: NUE) fell 13% from the end of July to the end of August, while U.S. Steel (NYSE: X) plummeted 30%, culminating in price target cuts on both companies at the end of the month, when investment banker Citigroup lowered its targets for Nucor and U.S. Steel to $55 and $12, respectively.
The reason? In part, it's the ongoing trade war between the U.S. and China, which has weighed on the global economy and caused steel consumers to cut back on their orders. In part, it's...still the trade war, which heated up even more last month after China restarted a threatened 25% tariff on imports of American cars and trucks, promising to hurt automobile production in the U.S., as well as demand for steel to produce such vehicles.
Image source: Getty Images.
But hope springs eternal for steel investors, and this morning, the industry is getting a bit of a lift from a note out at Credit Suisse. In a positive initiation just reported by SteetInsider.com, we learn that the Swiss megabanker thinks steel prices are due for a turnaround -- perhaps as early as Q1 of next year. Surveying the industry, the analyst picks European steelmaker ArcelorMittal (NYSE: MT) as perhaps the first steel specialist to benefit from an improving global economy.
Here's what you need to know.
Reversing course on steel sentiment
Just four months ago, Credit Suisse was feeling bearish, warning that the Trump administration's cease-fire on steel tariffs against Canada and Mexico would admit a wave of cheap steel into the U.S., depressing prices for U.S. steelmakers. The threat of cheap Canadian steel from Stelco in particular prompted the analyst to downgrade American companies Steel Dynamics (NASDAQ: STLD) and AK Steel (NYSE: AKS).
Today, however, Credit Suisse is looking to foreign shores for a revival in steel demand, initiating coverage of European steel giant ArcelorMittal with an outperform rating and a $29 price target.
Steel prices continued rising for about a month after Credit Suisse's downgrades, you see, topping out around $920 a ton for U.S. Midwest domestic hot-rolled coil, for example. But they then fell as low as $525 a ton by early July. That month, however, global steelmakers began slowing production of their product, and partly as a result of that, steel prices inched back upwards in August, reaching $584 per ton.
Credit Suisse expects this trend of reviving steel prices to continue, and predicts a clear turnaround in the steel market within the next six months, which would imply better prices toward the end of Q1 2020.
Who will benefit?
Credit Suisse predicts that ArcelorMittal could be a top stock to buy on strong steel prices, and "a major cash generator following two years of investing in growth," as StreetInsider reports. And indeed, the company is already showing some strength in this regard.
True, profitability as calculated according to generally accepted accounting principles (GAAP) is down lately, but over the past 12 months, free cash flow at ArcelorMittal has jumped to $1.8 billion, trending up sharply from the $891 million in positive cash profits produced last year. And ArcelorMittal isn't the only one.
Nucor's free cash flow is also climbing, hitting $1.4 billion over the past 12 months, according to S&P Global Market Intelligence data, despite a slide in GAAP profitability. And at Nucor's archrival, Steel Dynamics -- one of the companies Credit Suisse downgraded in May -- free cash flow of $1.2 billion is at least holding steady for the time being.
Not all steel companies are doing as well. At AK Steel, for example (the other company Credit Suisse downgraded last spring), cash generation is slipping and capital spending is rising, resulting in a one-third decline in trailing free cash flow versus 2018 levels. U.S. Steel, where free cash flow turned negative last year, is seeing the cash drain worsen in 2019 -- even as the company reports $1 billion in GAAP profits, indicating poor quality of earnings.
But as a general rule, what's good for one steelmaker (i.e., greater steel demand and higher steel prices) should tend to benefit even these weaker players.
Caveats and provisos
One concern that doesn't get much mention in Credit Suisse's note, I think, that does deserve highlighting, is debt. Too-high debt loads can weigh on any stock, even in a bull market for steel, and would be especially problematic if Credit Suisse's forecast proves to be off the mark and steel prices don't rebound as quickly as predicted.
In that regard, I have to say that Nucor and Steel Dynamics, with debt loads just a small fraction of their market capitalizations, look much better-positioned to ride a bull market (or ride out a bear) than their rivals do. Using a common industry metric, both companies also carry total debt-to-EBITDA ratios of less than 1.5, versus 1.8 for ArcelorMittal, 2.1 for U.S. Steel, and 3.3 for AK Steel.
If I were looking to invest in steel stocks on the basis of Credit Suisse's upgrade today, I'd be considering shares of these companies in basically that order of attractiveness.
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