4 Reasons Why This Industry Is A Value Trap

Tim Begany's picture

Monday, February 16, 2015 - 1:30pm

by Tim Begany

 

Steel stocks have fallen deeply out of favor with the group losing about 25% of its value over the past year, according to Morningstar. The industry's biggest players, U.S. Steel Corp. (NYSE: X) and ArcelorMittal (NYSE: MT) have fallen 60% or more from their cyclical peaks.

 

For bargain hunters, a decline of this magnitude might be seen as an opportunity to hunt for deep values. You can't blame investors for such a reaction.

 

We saw a similar pullback in energy stocks in recent months, yet many key energy stocks and ETFs have now made rapid rebounds from their recent lows. For example, the Energy Select Sector SPDR (NYSE: XLE), an ETF that provides broad exposure to energy stocks, has spiked almost 9% already after apparently hitting bottom a month ago.

 

However, I'm not so keen on a similar rebound in steel stocks or ETFs.

 

Steel and oil are subject to distinct economic variables. Many experts believe that energy prices will regain much of their lost value by next year, albeit with a high degree of near-term volatility.

However, there are a number of reasons why the steel industry could be a perilous value trap with negligible pricing power and limited earnings upside.

 

Enormous Overcapacity
Currently, global steel consumption is nearly 1.7 billion tons annually, according to the World Steel Association. Yet it is the stockpiled steel that should give you pause. There are an estimated 300-to-600 million tons of steel piled up in warehouses, which is 35% more than is needed.

 

Much of the overcapacity is coming from China, by far the world's largest steel source with about 780 million tons of annual production. That's seven times the 111 million tons a year generated by the number-two producer, Japan.

 

Underused Assets
The steel industry capacity utilization rate is currently about 74%, meaning steel mills are overproducing while operating at barely three-fourths capacity. This utilization rate is the lowest in several years.

 

This doesn't bode well for profits. You see, steel companies typically only start to gain pricing power once capacity utilization rates are at least 80%. So the current rate suggests demand will have to pick up substantially for steel to become more of a seller's market.

 

But with the global economy in the midst of a slowdown, this doesn't seem likely anytime soon. Thus, some analysts project that current levels of steel industry capacity under-utilization will persist throughout 2015 at least.

 

Currency-related headwinds
Extreme overcapacity tends to push down prices and crimp margins, regardless of the product. This issue is especially severe for steel firms in the United States, where the surging dollar can sabotage pricing power, especially compared to lower-cost imports.

 

Indeed a flood of cheap imports from foreign countries is seen as the industry's biggest threat. Because its economy is slowing, China now has a record-high 47 million tons of annual steel surplus and much of it is being unloaded on the United States.

 

Energy & Automotive
The plunge in oil prices has led to a rapid drop in energy exploration and drilling. For example, energy giant ConocoPhillips (NYSE: COP) recently announced a 20% reduction in its capex budget. Industry wide, the number of drilling rigs in service has begun to fall sharply and recently hit a three-year low, according to Reuters.

 

Falling budgets means reduced demand for steel used in drilling rigs, pipelines and other exploration equipment. The energy sector accounts for 10% of all domestic steel consumption.

 

The auto industry has been a notable bright spot for steel producers, thanks to high vehicle sales volumes. But demand could progressively erode over the next decade as auto makers increasingly replace steel with aluminum in vehicle construction to improve fuel efficiency.

 

The shift will boost aluminum use in new vehicles to about 3.5 million tons in 2015, a 28% increase from 2012 levels, projects market research firm Ducker Worldwide. In the decade ahead, the proportion of vehicles with bodies constructed entirely from aluminum will rise to as much as 18%, compared with just 1% currently, Ducker also estimates.

 

Risks To Consider: A lot rides on the Eurozone because it's the world's second-largest steel consumer, after China. If current attempts stimulate the region's fragile economy fall short, then demand for steel is sure to suffer.

 

Action To Take --> With capacity utilization well off the all-important 80% level, steel industry profits may remain elusive for an extended period. Simply put, this industry is more of a value trap than a value play these days. Short sellers may want to target the industry through a broadly diversified investment like the Market Vectors Steel ETF (NYSE: SLX).

 

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Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.