WHY THESE CLUNKY STEEL STOCKS, DOWN 9% IN '95, CAN REBOUND 50% IN '96
(MONEY Magazine) – FORGET THAT THE DOW, LATELY AROUND 5100, rose an awesome 33% last year. Or that the Federal Reserve recently trimmed interest rates to perk up the economy. My friends only want to know whether the market's long-overdue correction is near. My answer? A sell-off is inevitable. Instead of worrying about when, focus on how best to ride out a pullback and still be positioned to profit once stock prices turn up again. I think I've found the ideal vehicles in battered steel stocks. They're among the market's biggest clunkers, down 9% overall in 1995, partly because earnings grew only 8%, half the pace of the S&P 500 companies. If I'm right, steel shares could rise roughly 50% this year. If I'm wrong, I don't see much downside left in a stock group whose market values typically have tanked to 30% to 40% of annual sales, vs. nearly 100% for the S&P 500.
Skeptical? Ugly steel stocks have caught the eye of some big-time bargain hunters. Before John Neff retired from managing Vanguard Windsor at year-end, he and successor Charles Freeman socked almost 5% of the fund's $13.6 billion portfolio in such major steelmakers as $5 billion (annual sales) Bethlehem, $4.9 billion Inland, $4.3 billion LTV and $1.4 billion WHX (formerly Wheeling Pittsburgh). Tony Orphanos, manager of $1.1 billion Warburg Pincus Growth & Income, has an even heftier 8% of his fund bet on the foursome plus $6.5 billion U.S. Steel. "Investors have shunned such stocks in expectation of weaker economic growth and commodity prices in '96," he says. "But I think my steel companies will impress Wall Street with their resilience." In fact, Neff, Orphanos and other value-minded sources of mine believe their steel holdings could appreciate 50% or more this year even if real GDP growth, around 3% in '95, slows to between 2% and 2.5%. If the economy stalls, consider:
American mills are humming again. Few investors realize how superefficient U.S. steelmakers have become in the wake of an agonizing decade of downsizing. Since the early '80s, closings of obsolete mills have cut U.S. steel production by a quarter to 97 million tons, resulting in today's flat-out factory utilization rate of 90%. At the same time, payrolls shrank 57%, and the industry pumped $28 billion into modernization. The payoff? Operating profits per ton of steel, which averaged $8 in '93, soared to $39 last year. That trounces the $15 a ton cleared by Japan's mills, with 8% of world capacity. So, barring an unexpected spike in the dollar's value, at least 8% of the world's steel isn't competitive in the U.S. In response, steel imports last year fell an estimated 20% as U.S. exports shot up roughly 84%.
Steel prices could rebound as much as 10%. That would be news to most Wall Street steel analysts. They see industry profits dropping 8% this year in step with continuing weakness in steel prices, down 12% since mid '95. Soft prices are blamed mostly on distributors slashing inventories that swelled to 8 million tons last May. Moreover, new mills opening in '96 will raise industry capacity about 4%. My sources disagree. They say inventory reductions are largely finished and initial output from new mills will be amply absorbed by a projected 1% to 2% pickup in auto sales. They also expect further erosion of imported steel's U.S. market share, from 20% to 15%. Remember, American mills are operating at close to full throttle. So even the modest 3% to 4% rise in orders envisioned in '96 by my sources could bump up steel prices. How much? "I can see market prices 10% higher in an economy growing 2% to 2.5%," says John Neff. If he's right, steel company profits would rise sharply and stoke investors' ardor for the stocks.
Buy Bethlehem, Inland and WHX. My sources think these three stocks have the potential to exceed their group's projected 50% appreciation this year with gains averaging 67%. The three trade on the New York Stock Exchange.
Bethlehem (ticker symbol: BS; lately $14), the nation's No. 2 producer after U.S. Steel, is paring its 19,000-worker payroll and $1 billion in unfunded pension liabilities. Yet John Maack, a portfolio manager at the $4.2 billion Crabbe Huson Group in Portland, Ore., estimates the company can cut costs 12% more by 2000. This year Maack believes productivity and production gains will lift bs' earnings per share 48% to $2. That's 23% above the median $1.62 forecast of other analysts. And the stock? Says Maack: "We're aiming for $24 this year," a possible 71% profit.
Inland (IAD; $26), the fifth largest producer, is noted for its fully funded pension fund and environment-friendly management, says Jerry Dodson of socially responsible Parnassus Investment in San Francisco. But many investors overlook the fact that Inland, unique among major mills, derives 40% of earnings from its perennially profitable $2.4 billion network of steel distributors. Dodson figures the network is worth $20 a share as an independent business. What about the whole company? His target this year is $42 a share, or 62% more.
WHX Corp. (WHX; $11), No. 9, focuses on high-margin products like galvanized steel. WHX does have $416 million in unfunded retiree medical benefits. But that's largely offset by $370 million of cash in the till, notes Merrill Lynch's Robert Costos, a prominent Baltimore broker who has long followed the company. He says that WHX's improving prospects recently prompted Merrill Lynch to raise its '96 earnings estimate for the stock upwards of 30% to $1.95 a share. That's 54% above Wall Street's median $1.27 forecast. "Even if WHX earns only $1.75," says Costos, "its stock should sell for $18, or 64% more, by year-end."
ALL STOCK DATA AS OF JAN. 2