Olympic Steel (NASDAQ:ZEUS), a steel service center based in Ohio, joins the list of other steel companies that are pumping iron and bench-pressing record results. In its second quarter, Olympic Steel produced $1.82 in earnings per share (EPS) from $18.5 million in net income, giving the company its greatest quarterly net income result in its 50-year history. Compare these record numbers with the $554,000 in net income loss in second quarter of 2003, and it is safe to say that the steel business is booming.
Ispat International (NYSE:IST), Reliance Steel and Aluminum (NYSE:RS), Steel Dynamics (NASDAQ:STLD), Novamerican Steel (NASDAQ:TONS), Nucor (NYSE:NUE), and Steel Technologies (NASDAQ:STTX) are all experiencing record results. But before prospective investors decide to dive into the cyclical steel industry, remember that picking up red hot steel can result in searing and scorching -- only those knowledgeable of the ups and downs of this business should dare tread these waters.
The reason the steel industry is booming is that steel prices are soaring. In fact, over the past two years the price of steel has nearly doubled. Skyrocketing prices are primarily a result of China's booming economy. The cheap steel imports that were once imported to the United States are now being consumed by China, and with the shortage of raw materials, prices are rapidly increasing.
A question to ask is, "How do steel producers profit from higher prices given the high cost of raw materials?" What Olympic Steel and many others have done is purchased as much raw material as possible when the prices were low, and then, when the projected shortage came, they were able to increase prices on cheaply purchased inventory -- thus, higher profit margins. But, as the cheaply purchased inventory depletes, steel producers will again feel the crunch on profit margins.
We can see this effect with Olympic Steel. In 2003 it managed -$0.34 in EPS. Compare the dismal 2003 results with the eye-popping $5.75 in earnings per share expected in 2004. What have these earnings done to its stock price? A year ago this stock traded for as low as $3.80, and it recently hit a high of $24.90. Looking ahead in 2005, it is projected to earn $4.65 per share. So we can see that Olympic Steel is currently tapping into higher profit margins, which is allowing it to produce record earnings. But, as the cheap inventory begins to deplete, profit margins will tighten, resulting in fewer earnings per share in 2005 and beyond. As its EPS begins to level off and eventually contract, so too will its stock price.
With a negligible cash position, $90.3 million in debt, and its sporadic free cash flow history in addition to the market conditions discussed above, I would not be an eager investor in Olympic Steel or any other steel producer unless I am very comfortable with the complexities of this business and aware of the risks associated with such cyclical industries.
Fool contributor Jeremy MacNealy does not own shares of any companies mentioned.
