Sector Watch: Sizing Up the Steel Stocks

Steel stocks fell from record highs Wednesday amid a broad sell-off in the US stock market. As the Dow Jones Industrial Average () tumbled 140 points in midday trading, the SIG Steel Sector Index () was down 6 points to 600 and change. The steel index tracks the performance of shares of fifteen different steel companies. Prior to Wednesday, however, the group had performed well amid a recent wave of merger activity along with expectations for higher steel prices. Now, however, the sector appears to be facing an important test heading into the third quarter earnings-reporting season.   

The steel industry is cyclical in nature and, for that reason; shares of steel companies are often volatile. When steel prices are rising, the profits and share prices of companies in the industry tend to do well. However, during periods of slower demand and falling steel prices, profits suffer and the share prices of the major steel companies sometimes fall.

Recently, the trends in the steel industry have been bullish for steel companies. On the one hand, recent merger and acquisition activity is helping to support higher prices. Big mergers, including US Steel’s () takeover of Lone Star Technologies and Sweden’s SSAB’s acquisition of Ipsco, are reducing the number of players in the industry. The wave of merger activity is expected to continue, as players in the industry attempt to get bigger and more efficient through acquisitions.  AK Steel (), US steel, Allegheny Tech (), and Steel Dynamics () have all been mentioned as takeover plays at one point or another. As a result, some of the share prices in the industry are probably trading at a bit of a premium due to merger expectations.

Meanwhile, the companies in the industry are very profitable. The price of the metal has been pushed higher by strong demand, especially from emerging markets such as China. Table 1 shows the expected earnings per share for the components of the SIG Steel Sector Index. All are expected to post solid earnings for the quarter. Indeed, the share prices have been performing well amid expectations that the recent period of profitability will continue. During the past two years, the SIG Steel Sector Index is up from 210 to a recent high near 605, or 188%!

Yet, while the steel companies are expected to post strong earnings for the third quarter of 2007, some concerns are beginning to surface. For example, a recent article in the Wall Street Journal (Rising Costs Could Sap Steelmakers’ Profits by Robert Guy Mathews, September 25, 2007) notes that, “The world’s steelmakers could face significantly higher costs next year as raw-materials prices rise, threatening the industry’s string of big profits.”

According to the article, big producers of iron ore, an essential ingredient for that steelmakers, are expected to demand a 50 percent increase in prices next year, and well above a 9.5% increase last year. The industry is already coping with higher prices for coke and coal, which are also used in the steelmaking process.

Steelmakers are not expected to pass the entire cost of higher material prices to customers. Instead, the higher costs of iron ore, coke, and coal will dent profit margins instead. Some of the companies are better prepared than others. For example, US Steel owns its own iron ore and coke supplies for its US steel plants. However, others are not so fortunate and the rising costs of raw materials are expected to have a meaningful impact on 2008 earnings in the industry.

Meanwhile, the SIG Steel Index is testing an important technical level heading into the third quarter earnings reporting season. Most of these companies are due to report earnings over the next few weeks (see table 1) and could provide forward-looking guidance when releasing the third quarter numbers. The comments could be key because, as we can see from figure 1, the SIG Steel Sector Index is in the process of testing its record highs near 605 set back in July. The net result appears the possible development of a double top, or a bearish pattern that sometimes results in trend reversal (also note that Relative Strength Index [RSI] is not confirming the new highs in the steel index). 

Figure 1: SIG Steel Sector Index Weekly Chart

So, the outlook for the steel sector is a cautious one heading into the third quarter earnings reports. While the results are expected to be mostly positive, there are concerns that the pace of profit growth might begin to slow in 2008 due to rising material costs. However, the wave of merger activity is a positive for the sector that should not be overlooked. Nevertheless, for investors with an interest in the sector, the short-term performance STQ is worth watching. If it continues to break down as it did on Wednesday, it could be a sign that index is set to retrace some of the 188% gain that it has tallied over the past two years.    

Frederic Ruffy
Senior Writer
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