As goes China, so goes the steel and iron sector.
News last week indicated that all five contributing factors to China's PMI, a measure of manufacturing growth, signaled contraction. But we have to remember that China, assuming it can ease its monetary policies and level off this decline in manufacturing, will still be growing GDP by about 7.5% in 2012, according to China Premier Wen Jiabao, which is likely a conservative estimate. It does bear watching that China's GDP has more or less been on a steady decline for the past eight quarters, but 7.5% growth from the world's second-largest economy should be enough to keep resource and manufacturing companies rolling in the dough.
Today, I want to take a look at two steel and iron companies that could benefit from Chinese and domestic demand while also taking note of one that could be a snake-oil salesman in disguise.
One thing you'll rarely find in the steel and iron sector is a consistent dividend, but that guideline can be thrown out the window when we're talking about Nucor.
Through thick and thin, Nucor has paid a dividend for 39 straight years. Note, I didn't say it went up every year, but just the fact that a cyclical company has managed to give back to its shareholders for nearly four full decades is impressive. Also, as I noted last week, a happy workforce will generally lead to great results. Nucor offers one of the most generous 401(k) benefit plans I've seen and it's a testament to management's willingness to spread its wealth among its workers as well as its shareholders.
A slowdown in China is already having an effect on Nucor's bottom line. The company just last week guided first-quarter EPS to $0.30-$0.35, which is at the low end of its previous guidance. Weak iron ore pricing and increased domestic competition (probably caused from those low iron ore prices) are hampering its results. Yet, for 11 times forward earnings, you can own a company currently yielding 3.4% that has been profitable in every year over the past decade, save for 2009. With the company continuing to see strength in borderline necessity sectors, energy and heavy equipment, I feel this is a dividend stock you can safely tuck away in your portfolio and forget about for years.
Steel Dynamics may not have a long history of paying dividends, but it more than makes up for that in other areas.
Like Nucor, Steel Dynamics is feeling its margins pressured by lower prices and a general decrease in worldwide demand for steel, which caused it to guide its first-quarter EPS to about half of what Wall Street was expecting. Although this isn't good news by any means, it's just another opportunity to look beyond the short-term weakness in steel pricing and focus on the long-term aspects that make Steel Dynamics a smart play.
For starters, the company's metal recycling segment has the potential to become a cash-flow monster for the company. Just as I described when touting Waste Management a few weeks back, there's almost an endless supply of garbage and, therefore, a continuous need for recycling -- which includes metals recycling. Steel Dynamics' railroad market share showed a nice increase year over year as well. The company produces rails for the industry and it more than doubled the amount of tons shipped in 2011 versus 2010 (117,000 vs. 55,000).
Then there's that little bit about cash flow that just might be important! Steel Dynamics and Nucor remain two of very few U.S. steelmakers that are currently cash flow positive. AK Steel
At just eight times forward earnings and seven times cash flow and with a dividend yield of 2.7%, Steel Dynamics more than makes up for its brief dividend history and gives you an income stream you can trust over the long term.
I am indeed advocating not buying into a steel company that has paid dividends each year since 1939. Harsco survived the recession better than most steel producers but has been suffering from a perfect storm of negative news lately that causes me to slap the "avoid it" sticker on this company.
The first warning flag comes from its financial statement. Harsco has been safely cash flow positive in every year over the past decade except for 2011, when there was actually a $14 million cash outflow. In addition, Harsco CEO Salvatore Fazzolari unexpectedly resigned in late February after spending 32 years with the company (four as CEO). Trust me, I'd love to stop there and that'd be that, but there's actually one more ominous warning sign.
Just two weeks ago, Moody's downgraded Harsco's debt to Baa3 and lowered the company's outlook to negative. We all know the ratings agencies are far from perfect, so I do take their ratings with a grain of salt, but they may indeed have a point with Harsco, which has a net debt position of $787 million and was cash flow negative last year. The short-term outlook for steel doesn't look very appealing and the company is currently paying out $66 million in dividend payments annually. To me, that just doesn't seem sustainable.
A management shakeup, negative cash flow, and a debt downgrade mean three strikes, you're out, Harsco!
This cyclical industry definitely requires some long-term thinking, but Nucor and Steel Dynamics give investors the opportunity for healthy and uninterrupted dividends from companies that are currently cash flow positive and trading at reasonable valuations. Remember, it's not always about the yield, but the growth supporting that payout.
Disagree with me? Let me know about it in the comments section below and consider adding these three companies to your free and personalized watchlist.
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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. He successfully avoided using the cliche "Steel of a deal." You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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