Steel's Renewed Strength


By Sam Stovall The return of the Standard & Poor's Steel subindustry index to the industry momentum list this week couldn't be more timely. Just recently, S&P Steel & Precious Metals analyst Leo Larkin upgraded his investment outlook for the group to positive, from neutral, based on valuation and a more optimistic view for steel prices and earnings per share in 2005.

That's especially noteworthy considering the group's remarkable surge in 2004. The subindex rose 61.5% for the year, vs. a 10% advance for the S&P 1500. This subindex consists of 12 companies from the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes.

RISING SUPPLY. Larkin notes that operating results in 2004 for the four leading concerns that comprise S&P's proxy for industry performance -- AK Steel Holding (AKS

; recent price: $16), International Steel Group (ISG

; $41), Nucor Corp. (NUE

; $57), and U.S. Steel (X

; $53) -- improved significantly over 2003, as increased volume and higher capacity-utilization rates offset rising costs for raw materials. Larkin believes the improvement reflected stronger industry fundamentals as well as acquisitions.

Aggregate sales rose 72%, on a 43% increase in revenue per ton and a 20% climb in shipments. Aided by higher margins, per-ton profit was $76, vs. a per-ton loss of $6 in 2003. According to data compiled by the American Iron & Steel Institute, industry shipments rose 7.6% in 2004's first 11 months, and consumption (domestic shipments, plus imports minus exports) increased 21%.

What about 2005? Assuming 3.7% GDP growth for the year, vs. 4.5% projected for 2004, Larkin believes industry conditions won't be as robust as in 2004 and that spot steel prices will decline from what he views as 2004's unusually high levels. Increased imports, along with higher domestic production, should add to supply and place downward pressure on spot prices. Also, steel inventories at distributors and end users at the beginning of 2004 were abnormally low, contributing, S&P believes, to the high prices.

HEAD OF THE CLASS. However, Larkin thinks the average realized price (revenues divided by shipments) for S&P's proxy companies should equal or possibly exceed 2004's levels despite spot prices that likely peaked in 2004's third quarter. The average realized price reported by the proxy companies is a blend of spot and contract prices.

To the extent that the businesses successfully negotiated large increases in contract prices for 2005, this could offset the impact of lower spot prices and enable steel outfits to achieve higher average prices compared to 2004. In turn, with costs rising less rapidly than in 2004, this should permit higher profits in 2005.

Longer term, Larkin thinks the industry will benefit from greater pricing power as a result of recent consolidation, a lower cost structure, and the cyclical decline S&P sees in the U.S. dollar.

So there you have it. Favorable fundamentals and momentum are encouraging, in S&P's opinion, for this high-performance subindustry index. Larkin's top pick in the group is Carpenter Technology (CRS

; recent price: $64), ranked 5 STARS (strong buy). He also likes Nucor, Allegheny Technologies (ATI

; $23), Commercial Metals (CMC

; $31), and Quanex (NX

; $54), each ranked 4 STARS (buy). The rest of the companies in the subindex are ranked 3 STARS (hold).

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the industries in the S&P 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), their proxies (the highest STARS-ranked companies in the sub-industry index -- tie goes to the largest market value) as of February 11, 2005.

Industry

Company

Ticker

S&P STARS Rank

Recent Price

Agricultural Products

Archer-Daniels-Midland

ADM

3

$24

Commodity Chemicals

Lyondell Chemical

LYO

3

$31

Consumer Electronics

Harman International

HAR

3

$113

Fertilizers & Agr. Chemicals

Scotts Co.

SMG

4

$69

Home Ent. Software

Electronic Arts

ERTS

4

$63

Homebuilding

Standard Pacific

SPF

5

$74

Internet Software & Svcs.

Yahoo!

YHOO

4

$34

Managed Health Care

PacifiCare

PHS

5

$65

Oil & Gas Drilling

Nabors Industries

NBR

5

$55

Oil & Gas E&P

Devon Energy

DVN

5

$42

Oil & Gas Refg., Mktg. & Trans.

Valero Energy

VLO

4

$67

Steel

Carpenter Technology

CRS

5

$64

Stovall is chief investment strategist for Standard & Poor's


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