Should You Buy Steel Stocks?

Should You Buy Steel Stocks?

ArcelorMittal , the world's largest steelmaker in terms of sales, released its quarterly results last week. The Luxembourg-based company reported a 23% increase in EBITDA for the fourth quarter. It also projected higher profit for 2014. ArcelorMittal's improved outlook for 2014 was based on an expected pick-up in steel demand from Europe, which would offset a slowdown in China. Certainly, the outlook for steelmakers is improving in the wake of an improved economic outlook for the U.S. and Europe. But does that make steel companies an attractive investment proposition, especially given the substantial gains in steel stocks in the past six months?

Improved outlook for steelmakers
Last week, ArcelorMittal reported a net loss of $1.2 billion for the fourth quarter of 2013, which was a significant improvement from a net loss of $3.8 billion reported for the same period in the previous year. The company's EBITDA for the quarter was $1.91 billion, compared to $1.56 billion reported for the same period in the previous year. For the full year, the company posted EBITDA of $6.9 billion, beating its own guidance of $6.5 billion. More importantly, the company expects higher profit for 2014, driven mainly by a pick-up in steel demand in Europe as the eurozone economy improves.

In October, the World Steel Association forecast that steel demand in the European Union would increase 2.1% in 2014. Although modest, the growth in a region that has struggled in the past few years is an encouraging sign for steelmakers, especially ArcelorMittal, which is based in the region. ArcelorMittal expects European steel demand to increase between 1.5% and 2.5%.

The improved outlook for Europe is driven by recent economic data from the region, which suggests a pick-up in manufacturing activity. The anticipated increase in demand in Europe is expected to offset a slowdown in China. In its October forecast, the World Steel Association had said that steel demand in China is likely to grow by just 3% due to the Chinese government's efforts to rebalance the economy. The manufacturing data from China since then certainly seems to validate the association's outlook.

Finally, in the U.S. steel demand is expected to increase by 3%, driven by the automotive, energy, and residential construction sectors. Overall, steel demand is forecast to grow 3.3% in 2014. ArcelorMittal is slightly more optimistic, predicting growth of 3.5% to 4%.

Are steel stocks worth buying?
Notwithstanding the slowdown in China and emerging market woes, the outlook for global economy has been improving. In such an environment, cyclicals such as steelmakers are almost always the best bet. But it seems the global economic recovery has already been priced into some steelmakers. In the past six months, AK Steel Holding Corporation has rallied more than 80%. U.S. Steel has gained more than 35% in the same period. ArcelorMittal is up nearly 21% in the last six months.

Given the substantial gains in AK Steel and U.S. Steel, I would be cautious in taking a long position. Both companies stand to benefit from improved steel demand in the U.S., but the gains in the past six months have already been priced in. More importantly, AK Steel and U.S. Steel could struggle if there is a surge in steel imports, which would hurt prices. That certainly is a possibility, given that Chinese hot-rolled coil has been trading at a substantial discount to U.S. prices.

Among U.S. steelmakers, Nucor Corporation looks to be the best bet. While anticipated lower pricing would also have a negative impact on Nucor, the company has a stronger balance sheet when compared to AK Steel and U.S. Steel. In fact, James Frias, Nucor's CFO, noted in a recent conference call that the company is the only steel producer in North America to enjoy an investment-grade credit rating. Considering the downturn in the steel industry, this is a remarkable achievement.

ArcelorMittal also looks attractive right now among global steel producers. The company is expected to benefit from its cost-optimization efforts going forward. In 2013, ArcelorMittal had $4.3 billion in cash flow from operations even as the company managed to bring down its capital expenditure to $3.5 billion. This allowed ArcelorMittal to lower its net debt by $5.7 billion last year. Apart from a stronger balance sheet, the company is also expected to benefit as the European steel market makes a recovery.

Overall, the outlook for global steel industry has improved significantly. However, investors will have to focus on the companies best positioned to benefit from the recovery.

Where should you be investing in 2014?
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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool recommends Nucor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published