The Solid Steel Sector


By Sam Stovall After a long period of underperformance, the S&P steel subindustry index has forged a place for itself on S&P's industry momentum list. The subindex has gained 5.8% thus far in 2004 (through Feb. 28) after a 57.4% rise in 2003. S&P analyst Leo Larkin, who follows the group, projects solid improvement in industry operating performance in 2004, and he believes the subindex will outperform the S&P 1500 index (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes) for the year.

Although imports may rebound in 2004 with the removal of the Bush Administration's tariffs on December 4, 2003, Larkin believes the impact will be minimal. To the extent that imports put any downward pressure on prices, he believes that will force the shutdown of marginal capacity now operated by companies under Chapter 11 bankruptcy protection.

Operating results deteriorated in 2003, as sharply higher raw material costs outweighed increased sales and higher volume. Another negative factor for the industry was a decline in North American auto production. One bright spot, though: Despite the negative comparisons with 2002, it appears that prices may have bottomed in 2003's second quarter.

CARS RAMP UP. According to preliminary data compiled by the American Iron & Steel Institute, industry shipments in 2003 rose to 105.6 million tons, from 99.2 million tons in 2002. Imports declined to 23.0 million tons, from 32.7 million tons in 2002. Larkin believes the gain in shipments reflected stronger economic growth, market-share gains at the expense of imports, and some rebuilding of inventories by distributors and end users.

Based on S&P's forecast of 4.5% real GDP growth in 2004, vs. 3.2% estimated for 2003, Larkin says sales and operating results should improve. Other positive factors for the industry in 2004 will likely be a forecasted rise in North American auto production and expected continued weakening of the U.S. dollar relative to most currencies.

Also, Larkin notes that nearly every domestic steel producer has instituted a raw material surcharge to offset sharply rising costs for raw materials such as scrap, iron ore, and coke. The surcharges should lift margins and help the industry return to profitability in 2004. If the surcharges don't take hold, Larkin anticipates that some producers will be forced to curtail output, which should result in lower supply and higher prices.

Longer term, the analyst thinks the industry will benefit from greater pricing power as a result of recent consolidation, a lower cost structure, and a cyclical decline in the U.S. dollar. His top pick in the group is Nucor (NUE), which carries a 5-STARS (buy) opinion. Based on its price-earnings multiple -- and his forecast for free cash flow -- Larkin views Nucor as attractive compared with other base-metals companies he follows.

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 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) as of February 27, 2004.

Industry/Sector

Company

S&P STARS* Rank

Aluminum/Materials

Alcoa (AA)

4 STARS

Casinos & Gaming/Consumer Discretionary

Harrah's (HET)

5 STARS

Catalog Retail/Consumer Discretionary

Insight Enterprises (NSIT)

Not Ranked

Consumer Electronics/Consumer Discretionary

Harman International (HAR)

5 STARS

Consumer Finance/Financials

MBNA Corp. (KRB)

5 STARS

Diversified Metals & Mining/Materials

Phelps Dodge (PD)

4 STARS

Electronic Equipment Manufacturers/Info. Tech

Vishay (VSH)

5 STARS

Homebuilding/Consumer Discretionary

D.R. Horton (DHI)

5 STARS

Internet Software & Services/Info. Tech.

Yahoo! (YHOO)

3 STARS

Steel/Materials

Nucor (NUE)

5 STARS

Wireless Telecom Svcs./Telecom Svcs.

Nextel Communications (NXTL)

5 STARS

* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief investment strategist for Standard & Poor's


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