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2 Top Steel Stocks to Consider Buying Now -- and 2 to Avoid

Reuben Gregg Brewer, The Motley Fool

Steel is at the core of the world around us, supporting our buildings, protecting us in our cars, and helping us run our homes in the form of washing machines and refrigerators. Supply and demand play a big part in the price of steel, as with all commodity-driven industries, and that's been a headwind in recent years, largely thanks to China. But there are some steel stocks that managed to thrive even during those difficult times. The steel industry is actually on the upswing right now, lifting the shares of the weakest players along with the strongest. Don't lose sight of the big picture: Stick with leaders like Nucor Corp. (NYSE: NUE) and Steel Dynamics, Inc. (NASDAQ: STLD), but avoid United States Steel Corporation (NYSE: X) and AK Steel (NYSE: AKS)

A little background

Steel is an industrial commodity prized for its mixture of strength and cost. Although it's used throughout modern society, construction is a big piece of the demand equation. For example, you can see the exposed steel beams in some buildings and throughout the heavy construction machines that are used to put those beams in place.

A steel worker in a steel mill

Image source: Getty Images

The interesting thing is that steel's close tie to the construction market is one of the key reasons why supply and demand got out of balance in recent years. China had been growing at double-digit rates for years. Construction made up a huge portion of that growth as the giant nation built cities to accommodate a shift from rural to urban living.   

China had little choice but to ramp up the use of steel, which required an increase in its production capacity. With Chinese gross domestic product growth slowing from 14% in 2007 to less than half that total in 2016, demand for steel isn't what it used to be in that country. As a result, it has been selling steel to foreign markets at what some believe are below production costs. 

That, in turn, pushed steel prices lower in the United States. Much damage was done during a long steel industry downturn that started after the 2007 to 2009 recession. The U.S. government has been hitting various countries, including China, with steel tariffs to help protect U.S. producers from a glut of cheap steel imports. Getting these protective measures implemented, however, is a slow process. That said, steel prices have moved higher over the last year or so, partly because of the enactment of tariffs, lifting the results and outlook for U.S. steelmakers. (That said, the oversupply issue isn't going away, so you'll want to keep an eye on it.) 

Don't get lured in by old technology

To highlight what's been going on, take a look at United States Steel Corporation, an iconic name in the industry. The mill has lost money in nine of the last 10 years. But earnings were in the black in the second and third quarters of 2017, with industry watchers expecting a full-year profit. Earnings estimates call for another solid year in 2018 as well. 

That sounds great, but there are a couple of notable issues here. For example, U.S. Steel's business is built around blast furnaces. This is older technology that requires material rates of utilization to turn a profit because of high costs. Another downturn would hit the company harder than mills using electric arc furnaces, a newer technology that is simply easier to turn on and off with demand (Nucor and Steel Dynamics are built around electric arc technology).

Then there's the not-so-subtle issue of capital spending. The company reported a loss in the first quarter of 2017 that surprised investors. That was partly caused by capital spending, with then-CEO Mario Longhi explaining, "This remains a cyclical industry and we will not let favorable near-term business conditions distract us from taking the outages we need to revitalize our assets in order to achieve more reliable and consistent operations, improve quality and cost performance, and generate more consistent financial results." 

An overview of some of U.S. Steel's investment plans

An example of U.S. Steel's capital spending plans. Image source: United States Steel Corporation. 

Investors took the CEO's statement to mean that U.S. Steel hadn't invested enough during the downturn and was now playing catch-up. The stock sold off sharply and, shortly after the earnings release, Longhi announced his retirement. The problem is that the investments still need to be made, so despite a management shake-up, U.S. Steel will still be facing a capital investment headwind. Most investors should probably stay away here. 

Go with more innovative alternatives

This is where companies like Nucor and Steel Dynamics come in. Both of these mills use electric arc furnaces, which helped keep costs low and allowed them to have consistently higher and more stable EBITDA margins than U.S. Steel during the downturn. That's helped Nucor turn a profit in nine of the past 10 years, while Steel Dynamics was in the black in eight of those years. That's a much better showing than either U.S. Steel or similarly blast furnace-focused AK Steel (NYSE: AKS), which bled red ink for eight consecutive years through 2016, managed to make.  

Steel Dynamics is the smaller of the two companies, with an almost $9 billion market cap. Nucor's market cap is nearly twice that. Not surprisingly, Nucor is a far more diversified company. In fact, it's probably the most diversified U.S. steel mill. Diversification is a specific goal at Nucor, with a focus on moving up the value chain so it can use higher prices to protect margins and limit the impact of commodity-based steel imports. 

A series of pie charts showing Nucor to be more diversified than peers

Nucor is the most diversified steel mill in the U.S. market. Image source: Nucor Corp. 

Both companies, though, were actively building their businesses during the downturn. Nucor used the period to aggressively and opportunistically build new facilities, expand existing ones, and acquire new businesses. Steel Dynamics was doing a similar thing, with two recent acquisitions in 2017 intended to expand its portfolio of value-added products. These two steel mills aren't trying to play catch-up like U.S. Steel, instead focusing on further improving and expanding their businesses. They have been better able to take advantage of the current upturn.   

Financially speaking, Nucor and Steel Dynamics are also well situated. For example, long-term debt made up around 45% of Steel Dynamics' capital structure in September 2017, with a robust current ratio of 3.3 times. Nucor's long-term debt was roughly 30% of the capital structure with a current ratio of 2.1. Although Steel Dynamics' debt seems a little high, there's really no particular concerns on the balance sheet of either of these steelmakers. For reference, U.S. Steel's debt was around 50% of the capital structure with a current ratio of 1.9 and AK Steel's shareholder equity is negative, excluding noncontrolling interests, so debt is more than 100% of the capital structure. Its current ratio was 1.9 as well. Neither company is in as good a financial shape as Steel Dynamics and Nucor. 

Not all perfect

There is one problem: price. Steel is a cyclical industry that's experiencing an upturn right now. So all of the steel companies have advanced nicely off their early 2016 lows, with U.S. Steel and AK Steel posting larger advances than either Nucor or Steel Dynamics. Don't assume that means they are better long-term investment options, because they really aren't. Although I wouldn't say any steel stock is a buy at this point in the industry cycle, if you are looking to buy a steelmaker today, it's better to stick with the proven success and industry leadership of Nucor and Steel Dynamics. Between them, I prefer Nucor, which is why I bought it during the downturn. It's not cheap today, but I'd rather own a great company than a turnaround story in a cyclical industry. 

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Reuben Gregg Brewer owns shares of Nucor. The Motley Fool recommends Nucor. The Motley Fool has a disclosure policy.