United States Steel Outlook Turns Positive After A Wild 2018

United States Steel (X) is showing signs of bouncing back after a wild run in the second half of 2018. The stock shed more than 40% in market value, as the trade war between the U.S and China intensified, steel prices declined, and the China economy showed signs of slowing.

The stock got off to a solid start in 2018, reaching $47 in the first quarter, before the first of three big drops throughout the year. Then a change in sentiment in the market – caused to some extent by the above-mentioned factors – appears to have a triggered a series of sell-off waves. The stock eventually almost touched $16 before recently recovering to $21.

The price of steel went through a similar trend. After initially peaking at record highs of $920 a ton, steel prices started on a downward trend starting mid last year and recently touched $721.

With the trade spat still unresolved and the China economy showing evidence of slowing, it seems counterintuitive to consider investing in US Steel (X) but the valuation is too compelling and the company is going through a revitalization plan that should drive operating efficiency and long-term growth.

United States Steel Overview

Pittsburgh-based United States Steel is one of the leading steel manufacturers in the world. The company is engaged in the business of producing and selling steel mill products in North America and Europe. It has annual production of over 22 million tons of raw steel. The company operates under four main segments: Flat-Rolled Product, U.S Steel Europe, Tubular Products and Other businesses.

The Flat-Rolled products segment accounts for more than 60% of the company’s total shipments. The unit produces sheet plates and tin mill products used in the automotive industry as well as appliances and construction markets. The segments annual raw steel production stands at about 17 million tons.

The U.S Steel Europe segment accounts for about 30% of the company’s total steel production. The unit sells sheets, plates, as well as tin mills precision tubes, and tubular. Most of these steel products are used in end markets such as construction, conversion appliance and transportation in Europe.

The tubular product segment accounts for about 5% of the total steel production mostly made up of domestic tubular production facilities. The unit specializes in electric resistance welded tubular products used in oil, gas and petrochemical markets. The unit produces about 2.8 million tons of tubular products annually.

The other business segment specializes in the production and sale of iron-bearing taconite pellets. The unit also offers transportation services as well as consultation services in the management and development of real estate and engineering.

United States Steel 2018 Underperformance

The company underperformed the overall steel industry in 2018. Its share price dropped by more than 47% while industry peers lost anywhere between 15% and 29%. The only company amongst its peers with worse performance was Alcoa (AA), which declined over 50%. The company’s net income was also down by 18% in the final quarter of the year compared to the previous year, putting further pressure on the stock.

Operational issues remained the most significant headwind. The company warned of the potential impact of planned and unplanned outages at some of its facilities. A planned four-week outage at the furnace in Gary Works in Indiana led to a reduction in production levels and the increased outage time, as well as higher maintenance costs, are some of the issues that continued to affect the company’s Flat-rolled division.

The company also appears to have spooked investors by lowering its full year EBITDA estimates. The company expects earnings to come in at $1.8 billion from an initial guidance of between $1.85 billion and $1.90 billion.

It didn’t help that ongoing talks between the US and China could potentially result in the elimination of the current import tariffs on steel. The scrapping of the import tariffs could create some headwinds to what seems like the beginning of a turnaround for steel. The tariffs have helped curtail an influx of cheap steel imports into the U.S, something that has helped drive prices upwards allowing domestic producers to enjoy the potential for higher profits.

United States Steel Balancing Act

The company has sought to assuage investors’ concerns about its long-term prospects and ability to generate shareholder value. For starters, the board of directors has approved a $300 million share buyback program. The approval is part of the company’s effort to support its commitment and willingness to return value to shareholders. The steel producer intends to execute the program over the next two years.

Amidst a considerable cash allocation into the buyback program, the steel producer has also found ways to increase its Capex budget by about $50 million to $1 billion. The increase provides the company with additional funds to pursue mergers and acquisitions.

The capex increase underlines the fact that 2019 will mark a peak for the Asset Revitalization Program (ARP). The company intends to spend an additional $2 billion under the program for the modernization of its operations. As much as $750 million of the amount is to go towards the modernization of the Gary Works plant.  Modernization of the plant should help strengthen steel production levels allowing the company to take advantage of high steel prices in the market.

The management team is pursuing other initiatives beyond the ARP. For starters, completion of the advanced Fairfield electric arc furnace in Alabama is near. The company has already invested an additional $150 million to accelerate completion of the steelmaking facility. The investments should help strengthen the company’s steel production capacity.

The company has also established a new revolving credit facility for its wholly owned subsidiary the United States Steel Kosice. The new $527 million revolving credit facility should strengthen its capital structure as it replaces an existing $230 million facility.

Earnings Report

United States Steel did deliver a positive earnings report for its third quarter. In the quarter, the company reported a profit of $291 million or $1.62 a share. Q3 earnings represented a 98% increase in earnings from $147 million reported a year ago. The higher profits were mostly because of an increase in earnings in the Flat-Rolled unit and higher steel prices.

The Flat-Rolled segment delivered an 89% increase in profits that came in at $305 million. Total steel shipments in the segment were up 5% to 2.7 million tons at an average price of $859, representing an 18% increase.

The USSE segment, on the other hand, delivered a profit of $72 million – a slight drop from a profit of $73 million reported a year ago. In contrast, total shipments in the segment were up 3% to $1.1 million tons at an average price of $669, representing 5% increase from a year ago.

The Tubular segment, on the other hand, registered a profit of $7 million compared to net loss of -$7 million reported a year ago. Shipments in the segment remained flat coming in at 184,000 tons at an average annualized price of $1,602, which was a 12% increase.

Revenues in the quarter were up 15% to $3.73 billion beating consensus estimates of $3.7 billion. United States Steel exited Q3 with cash and cash equivalent of $1.3 billion a drop of 21% from a year ago same quarter. However long-term debt dropped by 14% to $2.4 billion.

United States Steel Outlook

The  company has reported a positive outlook for 2019, in response to expected capacity growth. Capacity growth should allow the company to generate an EBITDA of $2,051 million in 2019.

The positive outlook for Q4 was buoyed by strong market conditions helped by high steel prices and higher steel demand  – especially in the automotive industry – which points to an increase in sales in the quarter. The company expects EBITDA in Q4 of about $575 million. Full year EBITDA, on the other hand, should come in at around $1.8 billion – below initial guidance of between $1.85 billion and $1.9 billion.

The Flat-rolled segment, the company’s largest, should continue to post impressive numbers helped by higher shipments as well as reduced maintenance and lower outage costs.

Results should also improve within the Tubular segment helped by higher shipments. While the European segment could take a hit because of inventory revaluation adjustments compounded by volatility in raw material prices.

Industry Analysis

The steel industry faces a lot of uncertainty given the impact of the ongoing trade war between the U.S and China. Tensions have already triggered a ripple effect depicted by steel prices taking a hit to $725 a ton after surging to record highs of $920 a ton in July.

China’s economy has slowed noticeably despite the government’s effort to stimulate activity by lowering bank reserves again. Given the stringent tariffs imposed on $200 billion worth of goods from the country by the Trump administration, the retaliation by China is a concern for steel producers that rely heavily on selling to one of the largest consumer of steel in the world – even if that demand is slowing.

Weakness in some U.S steel end-use markets has also emerged as significant headwinds. For example, while the auto industry seems to be performing well, demand for steel from the housing industry could decline, amidst a slowdown in the construction sector – as homes sales have declined due to affordability issues and lack of supply.

However, the 25% tariff on steel imports to the US has fueled a resurgence for US Steel producers.  Raw steel production in the overall industry, for the week ending December 29 was up on a year-over-year basis to 1.9 million tons from 1.7 million tons a year ago .Most steel producers operated at 80% of capacity utilization, from just 71.9% a year ago.  Data released by AISI also Indicates that raw steel production rose to 1.9 million tons representing a 12.3% increase.

If the tariffs remain in place, they are likely set to continue driving production capacity as steel producers continue to take advantage of a reduction in cheap imports.  US Steel , for instance, restarted two blast furnaces last year at one of its integrated steelmaking plants. The company restarted the furnaces as it sought to address the expected demand for steel from Granite City Works in Illinois.

Competitors has also increased investment in expanding capacity. Nucor Corp has started investing in expansion programs as it seeks to beef up its own capacity. The company intends to spend $650 million on the expansion of its flat-rolled sheet steel mill in Kentucky. This expansion should boost the plant’s production capacity to 3 million tons from the current 1.6 million tons.

Industry Outlook

Chinese steel prices took a hit as Trump administration imposed stringent tariffs that made it impossible for Chinese steel producers to make shipments into the U.S. while prices declined in China due to a glut in supply as local producers could not export to the U.S.

However, prices have bounced back, an indication that things could turn positive in the first half of 2019. Chinese steel prices have stabilized in response to production cuts in the country. In the US, steel prices have also shown signs of stabilization as a slide in Chinese’s prices were the initial trigger – and with Chinese prices recovering – US prices have followed suit.

The fact that U.S steel demand tends to pick up in the first quarter of the year supported by high levels of inventory restocking should help support prices in the quarter as well. And because of the higher steel prices in Q4 compared to the previous year, we expect the company to report better results for the quarter.

The Risks

The Federal Reserves move to increase interest rates late last year has brought about significant risks. Higher interest rates threaten to affect housing affordability – something that could affect demand. Investments in nonresidential construction have declined in response to the higher interest rates and their impact on affordability.

Steel consumers in the U.S are still paying 17.2% more for hot rolled and cold rolled steel compared to their counterparts in other countries, which still poses a significant risk to domestic producers. Import tariffs on cheap steel from China, while a good thing for local steel producers, could trigger a change in the flow through the supply chain.  For starters, buyers of steel may be forced to import finished products from other suppliers rather than buy expensive raw materials at home.

The steel industry also risks overcapacity as companies continue to ramp up production in response to the import tariffs. Demand in the U.S alone may not be sufficient to absorb the expected output. Oversupply in the market could once again hurt steel prices should demand fail to tick higher. The result could be lower revenues, which would not be good on the back of recent lowering of its EBITDA earnings forecast.

What Next For United States Steel

United States Steel has bottomed out form one year lows after underperforming for the better part of the second half of last year.  Renewed investor interest in the stock comes on the back of import tariffs, strong demand in autos, and cost reductions.

Improvements in the manufacturing processes have already contributed positively as the company continues to modernize its operations and logistics. The company has also inked a strategic partnership with Japan’s Kobe Steel for the construction of a new galvanizing line at its subsidiaries. The new line will help the company better address the expected demand for advanced high-strengthened steel from the auto industry.

From a balance sheet perspective, the company has started deleveraging its balance sheet as it seeks it to improve its liquidity profile. The efforts have resulted in a 13% reduction in debt to $1.5 billion.

Our Take

In recent years, steel stocks have traded with steel prices. With prices showing signs of climbing higher after correcting from record highs recorded in June, a bounce back could be in play in the broader industry. After a wild ride last year, stability is finally creeping into the steel sector. United States Steel has already bottomed out from last year’s lows.

U.S steel price looks set to continue climbing as demand for the raw material continues to tick higher especially in the automotive industry. The trade tariffs also seem configured to prevent an influx of cheap imports into the country something that should work to the advantage of U.S steel producers. The fact that United States Steel trades at a 50% discount, in response to the recent drop in steel prices, points to further movements on the upside as steel prices recover.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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