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Steel Stocks Are Crashing: Buy or Sell?

By Jason Hall – Oct 6, 2019 at 3:15AM

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Top steel stocks have lost between 24% and 64% of their value over the past year.

Almost exactly one year ago, the S&P 500 reached its 2018 high, and then promptly spent the next three months falling by 20%. Steel stocks took an even bigger beating. Betwen Oct. 3 and Dec. 24, 2019, AK Steel (AKS) lost 56% of its value, and even a stalwart like Nucor (NUE 2.60%) saw its stock price fall more than 23%, with peers including Commercial Metals Co., Steel Dynamics (STLD 3.62%), and U.S. Steel (X 3.92%) falling somewhere in between.

A year removed and the S&P 500 has more than made up for the crash that ended last year, while steel stocks have continued to underperform; several have seen their share prices fall even further than where they were on Christmas Eve.

A worker in a steel plant, sparks flying in front of him.

Image source: Getty Images.

On the one hand, investors may look at the sharp decline and see opportunity. After all, two of the most-famous investing quotes, "Be greedy when others are fearful and fearful when others are greedy" and "buy when there's blood in the streets," point to steel stocks as buy-worthy today. On the other hand, the steel industry is notoriously cyclical and a hard place to make a profit, and fears of a global recession are part of what has investors wary of the sector today.

Are there any steel stocks investors should put on their buy lists? AK Steel and U.S. Steel continue to demonstrate why most investors should avoid them across every part of the steel cycle, while Steel Dynamics and Nucor continue to be the best-run steelmakers with the best assets and operations. Whether they're buy-worthy depends on a few factors.

Why have steel stocks fallen so much?

In short, it's a product of worries about the global economy, compounded by tariffs and the ongoing trade war between the U.S. and China. This has caused investors to either avoid or flee many cyclical stocks, including steelmakers, which can find themselves exposed to big losses when steel demand swings from demand growth to contraction. And over the past year, investors have continued to fear that steel demand could be at -- or very near -- a cyclical peak.

So steel stocks have fallen, even as steelmakers have been profitable and cash flows have remained relatively strong:

AKS EPS Diluted (TTM) Chart

AKS EPS Diluted (TTM) data by YCharts.

So while steelmakers have managed to operate profitably over the past couple of years, investors aren't optimistic that will continue. Over the past few weeks we have already seen multiple analysts downgrade U.S. Steel, and AK Steel also got a downgrade as a number of concerns weigh on the sector.

Steel car frame in an auto assembly line.

Image source: Getty Images.

In addition to worries about the global economy, North American steelmakers have launched a significant round of capacity expansion over the past couple of years. Considering that there has been a substantial global oversupply of steel -- mainly from Chinese expansion of its steelmaking capacity in recent decades -- for years this added capacity had many observers fearing that the steel industry was setting itself up for struggles.

A good example of this potentially bad capital allocation is U.S. Steel. The company has committed to major investments -- including a recent $700 million acquisition it will fund entirely with debt -- that will increase its capacity. Unfortunately, many of those expansions will also expand the company's expense structure. If a protracted downturn in steel demand happens after those facilities are brought online, the company would likely take substantial operating losses from those assets before it could even start to monetize them.

Why investors should avoid these two steelmakers

U.S. Steel and AK Steel are continually at the top of my list of steel stocks to avoid. First, their cost structures and operating assets don't generate anywhere near the operating profitability of Steel Dynamics or Nucor:

X Operating Margin (TTM) Chart

X Operating Margin (TTM) data by YCharts.

In addition to lower-margin operations, U.S. Steel and AK Steel would also have a harder time adapting quickly to lower demand. Their operations are underpinned by blast furnaces, which can produce a lot of steel profitably at high output, but also come with very high fixed operating expenses that make them unprofitable at lower volumes. Nucor and Steel Dynamics, on the other hand, use electric-arc mini mills for most of their steel production. Without getting too deep in the weeds, mini mills can be operated profitably at a variable range of output.

Next, both are substantially more leveraged -- both as a factor of their cash flows/earnings and assets -- than Nucor or Steel Dynamics:

X Financial Debt to EBITDA (TTM) Chart

X Financial Debt to EBITDA (TTM) data by YCharts.

Put it together and AK Steel and U.S. Steel have the dubious combination of less-profitable operations that can't adapt very quickly to a downturn, and lots of debt that already costs them more to service. That's a perfect recipe for a high-risk investment.

Two steelmakers worth owning long term (with a caveat)

Bridge under construction.

Infrastructure spending bodes well for steel demand over the long term. Image source: Getty Images.

Nucor and Steel Dynamics still have their warts. Yes, they have superior operating assets that give them more flexibility to adapt to changes in the steel market, but a drop in steel demand, pricing, or -- likely if we see a recession -- both would still take a bite out of their cash flows and earnings. And that would almost certainly see Mr. Market send shares of both down even further.

The difference is, while U.S. Steel and AK Steel might struggle to survive a protracted downturn, Nucor and Steel Dynamics have a history of taking advantage of downturns to get bigger and better, buying high-value assets from struggling competitors at fire-sale prices.

Lastly, both are very cheap, based on the earnings they can generate during a healthy steel market:

STLD PE Ratio (TTM) Chart

STLD PE Ratio (TTM) data by YCharts.

That's not to say their share prices won't fall from here. To the contrary, if we do see a steel downturn, I'd expect both would fall from here. But because of their superior operations, strong balance sheets, and history of seizing the opportunities to grow market share during downturns, I'd view a further sell-off as an opportunity to buy both.

The caveat? Investors need to take a long-term approach, and be willing to add to their position during a downturn in order to profit when the steel cycle recovers. If you're not willing or able to make a multiyear commitment and take on the risk that a downturn sends shares falling from here, you may be best off staying away from steel stocks -- even top picks like Nucor and Steel Dynamics.

Jason Hall owns shares of Nucor. The Motley Fool recommends Nucor. The Motley Fool has a disclosure policy.

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