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4 white-hot steel stocks
An improving economy has raised demand, making this leaner, meaner sector the market's shiniest. Big names still face some problems, but smaller ones could forge ahead for some time.
By Robert Walberg
Quick -- whats the best-performing industry over the last month? Oil, Internet services, casinos? Nope, nope and nope.
The correct answer is steel -- an Old Economy industry thats up a stainless 15% in the past 30 days while its New Economy brethren have napped.
The relatively healthy global economy certainly has helped. The International Iron and Steel Institute sees worldwide steel consumption climbing by nearly 6% in 2004, after a similar rise last year. With the increased demand has come higher steel prices. Meanwhile, a soft dollar has bolstered exports. Finally, difficult industry conditions over the past several years have forced the surviving companies to improve operating efficiencies by reducing work forces and trimming costs.
The combination of increased demand, higher prices, a weak dollar and leaner operations has resulted in an industrywide earnings boom. And nothing attracts investor interest like skyrocketing earnings.
Though many of the stocks in the group have enjoyed spectacular gains over the past 52 weeks -- the average gain of the 12 stocks listed below is a stunning 115% -- favorable industry conditions, relatively cheap valuations and strong price momentum suggest that the steel industry will continue to flex its muscles in the months to come.
Of course not all steel stocks are alike. In fact, the industry comprises three subgroups.- Raw ore processors: Integrated steel companies are the ones that make metal from scratch by using blast furnaces on raw materials such as coal and iron ore. High equipment costs and unionized labor forces traditionally translate into very narrow margins. However, the group benefits most directly from increased pricing conditions. Included in this subgroup are AK Steel (AKS, news, msgs), Allegheny Technologies (ATI, news, msgs), International Steel Group (ISG, news, msgs) and U.S. Steel (X, news, msgs).
- Scrap metal recyclers: Then there are the mini-mills, led by Nucor (NUE, news, msgs). These companies use scrap and recycle it into new steel. As a general rule, these are nonunion outfits with higher margins and cleaner balance sheets. A couple of smaller players in the group include Commercial Metals (CMC, news, msgs), Schnitzer Steel Industries (SCHN, news, msgs) and Steel Dynamics (STLD, news, msgs).
- Steel servicers and processors: Finally, there are the service centers and steel processors that dont make steel but rather coat, slit or temper for end-users. Given the service rather than commodity nature of the business, these firms tend to enjoy more stable profit growth. Among the players are Worthington Industries (WOR, news, msgs), Steel Technologies (STTX, news, msgs), Gibraltar Steel (ROCK, news, msgs) and Olympic Steel (ZEUS, news, msgs).
Now we can take the next step and determine which, if any, of these stocks are positioned to outperform the market in the future.
Big producers could struggle
Though industry conditions and momentum might propel a number of the integrated steel companies to new heights, they have a history of contentious labor conditions, inconsistent profitability and generally high debt burdens. That suggests that with share prices already up anywhere from 30% to 155% over the past year, the best days are behind this group.
Investors should also note that the industry is in the midst of ramping up production -- a seemingly shortsighted decision given the cyclical nature of the industry. A material increase in production could easily turn the current steel shortage into a glut and send the industry back into the doldrums from which it has just recently emerged. Any turn in the industry would hit the integrated steel companies the hardest.
Schnitzer gleams among the mini-mills
Turning our attention on the mini-mills and the processors, there are a handful of stocks that stand out as good near- to intermediate-term investment options.
Among the mini-mills, you have to be impressed by the performance of Schnitzer Industries. The companys operating margins and return on equity are the highest in the group. Schnitzer also has little to no debt and a modest dividend yield of 0.20%. At 2.8 times book value and 10.3 times estimated earnings for fiscal year 2004, the stock sports some of the highest valuations in its group. But its superior operating performance suggests that the premium is warranted. And though the price/earnings multiple might be high by industry standards, its still a bargain relative to the S&P 500 ($INX).
The other player in this subgroup that looks promising is Steel Dynamics. Its return on equity of 11% might not match Schnitzers 29%, but its still among the best in the industry. Meanwhile, the stock trades at only 7.3 times projected fiscal year 2004 earnings of $3.98 per share. And the stocks PEG, or P/E to long-term growth rate, of 0.32 is well below the industry and the market.
Nucor, the giant of the mini-mill group, has delivered spectacular earnings growth over the past year. However, its margins are well below those enjoyed by Schnitzer and Steel Dynamics, as is its return on equity. In addition, earnings are projected to drop sharply in fiscal year 2005. Even though Nucor trades at only 11.7 times 2005 estimated earnings, the scope of the potential earnings drop is apt to keep the stock from experiencing outsized gains.
Gibraltar looks rock-solid
That leaves us with a review of the service and processing stocks, and in this group the best combination of value, earnings growth and solid financials belongs to Gibraltar Steel. Relatively small, with a market capitalization of only $628 million, Gibraltar stands tall among its peers with operating margins of 8.2% and a return on equity of 9.1%. Additionally, its debt/equity ratio of 0.58 is below the industry average. Toss in a nice little dividend yield of 0.62% and projected earnings growth over the next two years of 46% and 12% and theres a lot to like. Best of all, you dont have to pay a premium for the growth. Gibraltar Steel trades at a modest 13.3 times and 11.8 times estimated fiscal year 2004 and 2005 earnings.
Worthington Industries is my other pick in this group because of the companys relatively consistent earnings growth, its low debt burden, a healthy dividend yield of 3.2% and a group best return on equity of 9.9%. At 13.7 times fiscal 2004 estimated earnings of $1.45 per share the stock isnt cheap, but its also not expensive. As long as industry conditions remain solid, Worthington should continue to outperform the overall market.
Steel may not be the sexiest of industries, but it sure has delivered some beautiful returns over the past month. Firm pricing conditions, robust demand, improved operating efficiencies and impressive earnings growth suggest that this Old Economy stalwart will continue to pound out better-than-market gains for the remainder of the year. As such, its time to add a little iron to your portfolios diet.
At the time of publication, Robert Walberg owned none of the securities mentioned in this article.
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