Why Investors Shouldn’t Ignore the Steel Industry (SLX)

While most investors are focused on precious metals, I prefer to look for investment opportunities in markets less traveled. Sure, precious metals are still wildly popular – or not popular enough – depending on who you ask. And they’re always in the mainstream consciousness. Either the dollar is going to be worthless and gold and silver will be the only true stores of value, or precious metals are in a bubble and will correct to more reasonable levels. Again, it depends who you ask.

But there’s another type of metal that I have my eye on. It’s one that hasn’t enjoyed the kind of run-up that gold and silver had recently.

Steel, and the companies that make the industrial metal, have been sinking like a piece of iron in a swimming pool. And this decline is likely to continue, here’s why…

Steel Industry Faces Weakening Demand and Price Erosion

Last week, Steel Dynamics (Nasdaq:STLD) tanked after issuing an earnings warning. The company said second-quarter earnings per share would be $0.35 to $0.40 rather than the $0.57 Wall Street was expecting. The lower-than-expected guidance was due to a slump in orders in April and increasing costs.

Other companies within the steel industry, including Arcelor Mittal (NYSE:MT) and Nucor (NYSE:NUE), have also been weak as more investors question the economic recovery.

  • The International Monetary Fund recently cut its U.S. 2011 GDP estimate to 2.5 percent from 2.8 percent as more evidence of a slowdown emerges.
  • Last month, 28 states lost construction jobs versus the 22 that added them.

Should the recovery falter, it’ll be particularly painful for steel companies, as construction is a bellwether of economic activity, particularly new homes.

And the folks who are buying steel are losing their optimism. The Steel Market Update’s Steel Buyer’s Sentiment Index, while still positive, is at its lowest level of the year due to concerns about price erosion and weakening demand.

“Even those involved in segments of the steel industry which have been doing relatively well since the beginning of the year – such as automotive – were displaying signs of concern about lack of strength in the overall U.S. economy,” said John Packard, Publisher of The Steel Market Update.

Responses from the survey included:

  • “Still not fully recovered and manufacturing does not exist in a lot of markets to aid in any recovery.”
  • “Still no significant uptick in the backlog. Extended commitments are not happening.”

Citigroup Expecting Steel Industry to Have Negative EVA

And Citigroup is not a big fan of the sector, expecting steel companies to have negative EVA (economic value added) in 2011 through 2013. EVA is a measure of profitability over cost of capital. Citi expects aluminum and uranium companies to also have negative EVA during that period.

The weakening of the entire steel sector is analogous to the following chart of Market Vectors Steel Index ETF (NYSE:SLX)…

Market Vector Steel Index ETF (NYSE: SLX) Analogous to Whole Sector Decline

Allegheny Technologies: A Vulnerable Steel Company

One steel company that I think looks particularly vulnerable is Allegheny Technologies (NYSE:ATI).

  • The company trades at 53 times earnings, higher than the industry average of 41.
  • Yet, at the same time, its return on equity is lower than its average peer.
  • It generates a significant portion of its revenue from the aerospace and defense sectors, which up until now have been healthy. In fact, on Monday, companies announced more than $20-billion worth of airplane orders at the Paris Air Show.

However, those robust assumptions are baked into the share price. Allegheny’s stock jumped yesterday on the news. Any slowdown in orders from those customers would have a profound effect on Allegheny’s top and bottom lines.

And with the budget deficit a political football, I wouldn’t be surprised to see some defense funds cut, particularly for things like new expensive planes.

Allegheny Technologies (NYSE:ATI) Chart

When Allegheny popped yesterday on the news, it rose above a key resistance level. If it drops back below $60, it looks like a great shorting opportunity, or a spot for longs to cut their losses.

I think Allegheny has risk to $49, which would put it more in line with its peers on a price-to-earnings basis.

  • For speculators, shorting steel companies looks like an interesting short- to intermediate-term opportunity.
  • Those who want to get long should wait a few months to pick shares up on the cheap.

Good investing,

by Marc Lichtenfeld, Senior Analyst, Investment U

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