Renewed Strength at U.S. Steel

Capacity cuts, protective tariffs, rising prices, and increasing demand point to a rebound for this basic-industry old-timer

By Gene Marcial

With the crash of the new corporate icons that had become giants in just a few years -- such as WorldCom (WCOME ) and Tyco International (TYC ) -- some old names are becoming alluring once more as they recover at least part of their old turfs. One well known veteran that lost plenty of glory in recent years is U.S. Steel (X ), which is only a shadow of its old self -- and nowhere near its leadership in the stock market of moons ago.

Nonetheless, U.S. Steel is still the largest integrated steel company in the U.S. and the 10th-largest in the world, with about 17.8 million tons of annual capacity at its three American mills and one in the Slovak Republic. U.S. Steel was spun off at yearend 2001 from USX Corp., now known as Marathon Oil (MRO ).


  Now that basic-industry stocks are back on institutional investors' radar screen, U.S. Steel is among the old reliables that investors are starting to snap up. The stock has recovered from its 52-week low of 13, touched on Sept. 19, and climbed as high as 22 on June 5, 2002 -- when President Bush took the unusual step of imposing tariffs of as much as 30% on steel imports to protect a domestic industry that has been plagued with as many as 19 bankruptcies since the 1990s, mainly due to foreign competition.

The stock has since eased to 20, partly because of profit-taking. And many investors are still reluctant to believe that the old Steel is really back.

But some pros among the smart-money crowd now consider it a value play. Scott Kuensell, managing director at Brandywine Asset Management, has been accumulating its shares: "I know recent investor history in U.S. Steel has not been pleasant, but the risk-reward here is favorable," he says.


  The industry is facing two watershed events, he argues. For one, capacity is way down, because of plant shutdowns and bankruptcies, notes Kuensell. Producers including Bethlehem Steel (BS ), National Steel (NS ), and LTV (LTV ) have either filed for Chapter 11 bankruptcy protection or are in some stage of reorganization, says Kuensell. The other: President Bush's defensive tariffs.

Both events, he says, have caused a recent surge in prices, which have gone up $50 to $70 per ton, depending on grade, he notes. "This is a huge move, since every $10 rise boosts operating income by about $1 per share," estimates Kuensell. The tariffs will certainly boost prices for at last three years, when they're supposed to end.

Domestic steelmaking, he notes, went through a similar period in the early 1980s when tariffs were imposed at the height of an industry slump. The following two years produced a boom, he adds.


  Other analysts who have turned bullish on U.S. Steel include Peter Bures of HSBC, who rates the stock a buy, with a price trget of $32 a share, and Scott Morrison of Credit Suisse First Boston, which was the co-lead underwriter along with J.P. Morgan for U.S. Steel's secondary public offering in May, 2002, at $18.50 a share. Morrison also has a buy rating on Steel, with a price target of $30.

"The primary driver to the stock over the next 12 to 24 months is going to be the company's earnings leverage to a dramatically improving situation in the steel industry," says Morrison. He expects U.S. Steel to recover from an estimated loss of 25 cents a share in 2002 to a huge profit of $2.60 a share in 2003, and $3.75 in 2004.

His price target is based on an assumption that the stock will trade at 8 times his 2004 estimate. The shares peaked, he says, at a price-earnings ratio of 8.5 when steel prices were much higher in the 1980s.


  The prolonged and severe recent downturn in the domestic steel industry sparked a significant shrinkage in supply and capital spending. But now that will prompt a stronger and longer upturn than was seen in recent cycles, says Morrison.

This supply-side changes, he notes, have already allowed steelmakers to raise prices of some products by more than 60% and increase operating rates to 90% -- even without a major recovery in demand. U.S. Steel's leverage in such a case, he explains, is due to a combination: About 60% of its shipments are being sold into the spot markets, and some 50% of its operating costs are fixed, which in a rising-price environment means higher shipments contribute more quickly to the bottom line.

What could go wrong with this scenario? One would be if demand doesn't shoot up -- in pace with likely capacity increase. Morrison expects some 40% of idled flat-rolled steel capacity to be back on-line by yearend. The other possible risk: Imports are likely to increase starting in late in the third quarter, mainly because of the lure of higher U.S. prices. Plus, President Bush has put steelmakers on notice that he expects them to cut costs and overhaul their businesses or risk losing the tariff protection.


  Morrison, however, is convinced that these negatives will be more than offset by a stronger recovery in steel consumption and pricing in 2003. "We expect that about 50% of U.S. Steel's product mix is currently realizing significantly higher prices than prevailed at yearend," says the analyst.

Brandywine's Kuensell says U.S. Steel is reviewing assets that could be sold or spun off. One candidate, he thinks, is its coke and iron upstream business, which produces a relatively lower return. The company has already advertised its coal operation as for sale, he adds. Another possible sale is its transportation (barges) and tubular goods businesses. These could bring in some $2.7 billion, he figures.

With U.S. Steel's debt at only $1 billion -- thanks to the Marathon deal -- and a fully funded pension, U.S. Steel is stronger financially than before the separation from Marathon, says Kuensell. He says U.S. Steel is also talking with Bethlehem and National Steel about possibly buying some of their assets. Kuensell's price target is $30 per share.

With the economy apparently on track in its recovery and basic-industry companies on the rebound, these analysts make a nearly ironclad case for U.S. Steel, at least for now.

Marcial is BusinessWeek's Inside Wall Street columnist

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