Jefferies: Can Steel Equities Work Even as Prices Peak?

 

Key Takeaway

Trade policy uncertainty has sparked a meaningful de-rating of US steel equities even as prices recently surged. Now, with momentum fading and a summer inflection likely, we question if steel stocks can work even as prices peak? While historical analysis highlights the strong correlation between steel equities/prices in a down-cycle, with bad news largely “priced-in” post de-rating we continue to see attractive risk-reward for top US picks STLD, NUE, X and CMC.

 

How correlated are steel equities, prices and spreads? While correlation does not always translate to causality, the relationship can nonetheless be illuminating. While integrated and mini-mill equities were highly correlated pre-global financial crisis (GFC) this relationship has completely broken down post-GFC, falling from 95% to 3%, reflecting the unique operating challenges faced by integrateds and a more adept reading of mini-mills’ uniquely flexible cost structure. Over this time, mini-mills’ correlation to the steel price has fallen dramatically (from 67% to 28%) while correlation to metal spreads has grown modestly (from 51% to 65%). Notably, integrateds remain most correlated to the US HRC price (63%), only slightly above Chinese HRC (60%), which has grown markedly post-GFC. (See Exhibits 1-2)
Are equities a leading indicator for steel prices or vice versa? Reviewing 18 years of steel cycles we identify four periods in which prices rallied in similar scale-speed to that seen in 2017-18 (See Exhibit 3). But in assessing if equities serve as a reasonable leading indicator for steel prices, we come to mixed conclusions. Steel equities correctly anticipated forthcoming declines in US HRC during 2002 and 2010, but equities meaningfully lagged steel prices in 2004 and moved coincidentally with prices during 2015. 2004 is perhaps particularly notable as steel prices fell by ~$120/t before equities began to crack, and while equities pulled back meaningfully thereafter the correction proved short-lived with rising confidence that steel prices could remain at sustainably higher levels than in cycles past.
Bad news priced in post de-rating? While equities have at times been leading indicators for steel prices, it is unique to see equities lead to the extent witnessed over recent weeks with integrated mills -26% and mini-mills -6% at a time of upward earnings revisions. The de-rating of steel mills reflects expectation for an imminent downturn in steel prices and distrust for trade policy that remains hard to read. But has it gone too far? While caution is warranted at this point of the pricing cycle, the current de-rating appears overdone with multiples at the bottom end of their post-2010 trading range. Integrated mills trade at 4.7x forward EV/EBITDA vs March peak of 6.3x and post-GFC average of 6.0x while mini-mills trade at 6.0x vs March peak of 7.7x and post-GFC average of 7.3x. While we recognize the risk of owning steel equities as prices potentially inflect lower, recent valuation trends imply much of the bad news is already priced in.
Trade policy uncertainty contributed to de-rating, but implementation could surprise to the upside. Continued flip-flop trade policy has contributed greatly to equity volatility raising fears that poor implementation actually leads to higher imports or a trade war weighs on demand. While the pivot from tariff to quota-based Section 232 policy has been horribly communicated, we feel quotas could ultimately be more sustainable and help support higher domestic production/prices. Global demand conditions are far from where they were in the supercycle, but our belief that supply-side reform leads to “higher lows” through-cycle strikes a notable parallel for the sustainability of what are admittedly super-normal margins. With steel equities looking cheap, even while forecasting notable price-margin compression, we see potential for steel equities to break their historic correlation with prices and outperform in months ahead.
 

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