Only two days in, this first full week of March is turning into a nice one for steel investors, with two of the biggest names winning upgrades -- and a third winning an honorable mention.
Yesterday, as you may have heard, analysts at Jefferies & Co. upgraded shares of the world's largest steelmaker, Arcelor Mittal (MT -2.03%), from underperform to hold, arguing that the company's issuance of $4 billion worth of new shares will raise enough cash to "assuage our concerns over the co's ability to withstand future years of poor market conditions." StreetInsider.com reports that Jefferies is still worried that "negative FCF may eat into liquidity" at Arcelor Mittal. But the analyst is also now saying that "the steel market environment is perhaps better than feared," and believes that with the additional cash in hand, Arcelor Mittal can buy enough time to survive, and perhaps even thrive, in the recovery.
Which brings us to today, and a second upgrade, and one that's even more positive for investors than yesterday's was. Here are three things you need to know about Berenberg's decision to upgrade Steel Dynamics (STLD -1.48%) shares -- all the way to buy.
Thing No. 1: China is a mess
For years, investors have worried about the Dumpster fire that is the Chinese economy, and its effect on global commodities demand -- demand for steel in particular. As scores of skyscrapers loom over the Chinese countryside, uninhabited and unneeded, investors have worried that China will need to take a breather from its construction binge, and ramp down steel consumption while the economy absorbs past excesses.
China accounts for roughly 50% of global steel production. Yet as recently as just this past fall, CNBC was reporting that weak demand for Chinese steel had pushed iron ore prices (a key steel component) down to $43.40 per ton, "levels not seen since [the] 2008" financial crisis.
Thing No. 2: But it's getting better
But there's good news at last. As Jefferies pointed out above, the steel market does appear to be improving, and Berenberg agrees. Writing this morning, the analyst notes that a new report out of China shows "Chinese steel prices rising stronger than we expected – up USD67/mt this week alone."
And as steel prices revive in China, the cost of imported steel rises in the U.S. -- taking some of the pressure off of U.S. producers such as Steel Dynamics.
Thing No. 3: Events don't happen in isolation
A peppier Chinese economy isn't just good news for steel stocks. Berenberg takes its analysis one step further, and notes that if China's economy improves, this could "support oil prices" as well. And this, in turn, could create even more good news for Steel Dynamics.
Says Berenberg: "The lower risk of a hard landing for the Chinese economy may support oil prices and underpin a volume recovery at Steel Dynamics' Columbus mill in Mississippi, which is largely exposed to the energy market," producing tubes and pipes for oil drilling and oil transport, for example. Thus, "just as steel imports to the US reduce" (because Chinese steel is getting more expensive), steel demand in the U.S. could perk up.
More sales, at higher prices -- that's good news all around.
And one more thing...
So far, so good. Berenberg's (and Jefferies') arguments show logical consistency, and make sense. But what about the ultimate conclusions they draw? Are Berenberg and Jefferies picking the right steel stocks to benefit from these trends?
Well, let's see here. According to data from S&P Global Market Intelligence, Steel Dynamics and its archrival, fellow minimill operator Nucor (NUE -1.61%), are both firmly free cash flow-positive in their businesses, even before the trends the analysts have spotlighted begin to benefit the steelmakers. Steel Dynamics may have reported a GAAP net "loss" last year, but free cash flow data for the past 12 months belie that assessment -- and show that in fact, Steel Dynamics generated positive cash profits of $924 million.
Nucor, by the way, is doing even better than Steel Dynamics. S&P Global data show this steel company to be both profitable under GAAP and generating roughly twice as much cash profit as Steel Dynamics. Last year, Nucor produced $1.8 billion in free cash flow. (And in a side note, Berenberg mentioned that it likes Nucor nearly as much as it likes Steel Dynamics).
Valuation-wise, Steel Dynamics is the cheaper of the two minimill operators, selling for 5.3 times free cash flow versus Nucor's 7.9 P/FCF ratio. Both companies are pegged for 7.5% long-term growth rates on S&P Global. Both pay respectable dividends. While I think both stocks look attractive at today's prices, I agree with Berenberg that right now, today, Steel Dynamics is the better bargain.
As for Arcelor Mittal, I agree with Jefferies that the cash infusion is a good thing for the company. Furthermore, a turnaround in steel prices could be just the thing Arcelor needs to return itself to free cash flow-profitability. Until it gets there, though, I'm inclined to agree with Berenberg: Nucor and Steel Dynamics are still the stocks to beat.