Steel Stocks: Still Sturdy

S&P likes the group's strong share-price performance and favorable fundamental outlook. Among its top picks: Allegheny Technologies

The trailing 12-month relative strength for the Standard & Poor's 1500 Steel subindustry index recently moved back above its 39-week moving average, and the moving average itself has begun to point upward, two favorable signals, in our opinion, for renewed market outperformance.

Regardless of the weakness in gold prices and the continued decline in new home construction, Leo Larkin, S&P's metals analyst, has a favorable outlook on the group and reminds me that steel's demand is primarily dependent on global nonresidential construction. Year-to-date through Apr. 25 the S&P Steel index rose 16.9%, vs. a 4.5% decline for the S&P 1500 index. During 2007, this subindustry index soared 32% compared with the broader market's climb of 3.6%.

Take a look at the accompanying chart. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's long-term mean relative strength.

There are eight large- and mid-cap companies in the S&P 1500 Steel index covered by S&P equity analysts. Three stocks have a favorable STARS ranking: Allegheny Technologies (ATI), Carpenter Technology (CRS), and Commercial Metals (CMC), all of which are ranked 4 STARS (buy). All others are ranked 3 STARS, or hold.

Larkin has a positive fundamental outlook for the steel industry in 2008. Following an 11% decline in net income in 2007 for the four companies that comprise our industry proxy, he looks for mid-single-digit percentage growth in sales and net income in 2008. In our view, most of the projected gain in sales and profits will reflect a combination of inventory rebuilding by distributors, a projected decline in imports, and a small uptick in demand from nonresidential construction.

In Demand Despite Weak Auto-Sales Forecast

For 2008, S&P projects gross domestic product growth of 1.1%, vs. GDP growth of 2.2% in 2007. Larkin sees higher shipments to the service center industry (steel distributors) in 2008 following extensive destocking of steel inventory in 2007. Demand from this key sector has been declining steadily since September, 2006. According to data compiled by the Metals Service Center Institute, steel inventories at service centers in February, 2008, represented 2.8 months of supply, below the three months that is considered the industry norm. In S&P's view, continued liquidation of inventory is unsustainable, and Larkin looks for service centers to begin to rebuild inventory before the end of 2008's second quarter.

Larkin believes the uptrend in nonresidential construction that followed a trough in 2003 will continue in 2008, albeit at a less robust rate, and be a source of demand.

Finally, S&P thinks the ongoing weakness in the U.S. dollar should enable domestic companies to gain market share at the expense of imports and thereby boost volume and prices this year. Partly offsetting these positive factors is Larkin's expectation for a decline in demand from the auto industry. This expectation is based on the S&P forecast for a decline in vehicle sales to 14.9 million units, from 16.1 million units in 2007.

However, Larkin believes the forecasted drop in auto demand won't be large enough to offset rising demand from service centers and construction markets and reduced imports.

Longer term, Larkin thinks the industry will benefit from greater pricing power, stemming from further expected consolidation, a lower cost structure, and a cyclical decline S&P sees in the U.S. dollar.

So there you have it. The group's strong relative strength and positive overall fundamental outlook supports S&P's favorable opinion for equity price outperformance in the coming six to 12 months.

Industry Momentum Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of 5 (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P STARS Rank Price (4/25/08)
Agricultural Products Corn Products International CPO 4 46
Coal & Consumable Fuels Peabody Energy BTU 3 64
Construction & Engineering Fluor FLR 4 161
Diversified Metals & Mining Freeport-McMoRan Copper & Gold FCX 3 117
Fertilizers & Agr. Chem. Monsanto MON 4 125
HyperMarkets & Super Centers Wal-Mart WMT 3 58
Industrial Gases Air Products & Chemicals APD 3 101
Integrated Oil & Gas Exxon Mobil XOM 5 92
Marine Kirby KEX 4 56
Oil & Gas Drilling Noble NE 5 60
Oil & Gas Equip. & Svcs. Baker Hughes BHI 4 82
Oil & Gas E&P Swift Energy SFY 5 53
Railroads CSX CSX 4 62
Steel Allegheny Technologies ATI 4 73

Source: Standard & Poor's Equity Research

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