Sexy Steel Stocks? Don't Laugh

Steel stocks may not have the allure of high-tech shares, but an obscure segment known as steel processing might be worth a look. Despite troubles last year, the sector's growth has Wall Street excited. "There are real opportunities, but the sector is poorly tracked," says Michelle Galanter Applebaum, managing director of Salomon Smith Barney in Highland Park, Ill.

The growing prominence of these so-called metals-service centers reflects the steel industry's increasing specialization. Service centers distribute commodity steel, but lately several have moved into the more profitable business of making highly finished steel for use mostly in cars, appliances, and construction. They are taking over these higher-profit-margin functions from steelmakers, which prefer to avoid the outlays associated with capital-intensive, advanced processing. So while the processing segment has enjoyed strong sales growth for many years, its profit margin has lately been rising as well--to the 8% region, from the typical 4% for distributors, analysts say.

At least 14 processors with a market capitalization in excess of $5 billion now trade publicly compared with two just 10 years ago, says Kenneth Hoffman, an analyst at Prudential Securities. Of the 14, nine have grown an average of 20% annually in the past three years--and are trading at an average price-earnings ratio of about 12, well below the Standard & Poor's 600 SmallCap Index average of 23.

Analysts recommend that investors choose top-tier companies that have good records of profitability--and savvy expansion plans (table). Two on Wall Street's pick lists are Reliance Steel & Aluminum and Gibraltar Steel. Reliance, a Los Angeles processor and distributor with annual sales gains of 20% to 30% and a record of smart acquisitions--10 since its 1994 IPO--has convinced many of its growth potential.

Gibraltar's recent investments, like those of Reliance, have won praise from analysts. A leader in cold-rolled steel, it invested last year in a rolling mill in Cleveland that it says will boost annual revenues, now at $450 million, as much as $85 million in three years.

Investors should remember, however, that the business is highly sensitive to commodity-steel price fluctuations. Indeed, last year the industry saw a high-profile slump when Olympic Steel, a Cleveland distributor that supplies General Motors, was caught off guard by a surge in cheaper imports when it had a lot of high-priced steel in its inventory.

ROUGH PATCH. Bargain hunters might find that Worthington Industries merits a gander. Worthington, the first processor to go public, in 1971, ran into a rough patch in the early 1990s after aborting plans to invest in a steel mill. It recently invested in a galvanizing facility and a processing plant. "They're putting a lot of money into new plants.... If they can turn that into profitability, their stock will have plenty of room to grow," says Ralph Wanger, chief investment officer at Acorn Trust, a $3.7 billion fund in Chicago that holds $23.3 million of Worthington's stock. And growth--at a reasonable price--is what makes processors promising.

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