Steel stocks rode up into the start of 2012 on optimism in the fall of 2011 that there would be an improvement in non-residential construction and industrial demand to deliver sustainably higher prices and good shipment growth. That didn't really materialize as hoped, and the stocks of minimill operators Commercial Metals (NYSE:CMC), Steel Dynamics (Nasdaq:STLD) and Nucor (NYSE:NUE) all underperformed the S&P 500.

Now it's a new year and there's new optimism that the industry is past the worst. Will that optimism pay off a little better this year?

Top Investment Trends For 2013: We go over a few investment trends for you to think about for 2013.

An Encouraging Start to the Year
Commercial Metals got the year off to a good start, but even so there are a few yellow flags for investors to consider in the bigger picture.

Revenue fell 10% this quarter, and the company did miss the sell-side target for the top line. Shipments and pricing in the domestic mill operations were pretty good (relative to expectations), though revenue did decline 6%. The Americas' fabrication operations were actually the only ones to show top-line growth, with revenue up more than 11%.

Margins were nonetheless impressive. Gross margin improved about two full points, and the company saw an 89% growth in operating income. At that level of performance, the company's operating margin very nearly doubled the average expectation. Within the segments, domestic mill operations saw a 9% profit decline (better than expected), while recycling was down 78% (worse than expected).

Can the Optimism Last?
This recent down period in the steel industry has been a little different than prior cycles. Both minimill and traditional blast furnace operators were more rational about capacity, and the downturn wasn't as extreme as it has been. That said, even annualizing this quarter's performance leaves the company at about 60% of prior peaks, so there's certainly ample room for the climb back.

For Commercial Metals, the real question is the extent to which the non-residential construction market recovers. Commercial Metals is a top-four producer of steel bar products (Nucor and Gerdau (NYSE:GGB) are the largest), and the company is heavily exposed to not only non-residential construction but within that it depends on civil works projects like bridges and roads. Relative to, say, Steel Dynamics, Commercial Metals doesn't have as much upside to autos, appliances or scrap export.

What's more, the location of the company's plants makes it incrementally more sensitive to trends in the South/Southeast of the United States - a good place to be for the long term (given the need for roads, bridges and so on), but not the easiest operating environment at present. Likewise, the company's Polish mill could be in an attractive location for the long term, but this has been a disappointing asset for the most part.

Will Prices Go up In the Right Way?
The other factor that worries me a bit about Commercial Metals is the direction of steel and scrap prices. Like most minimill operators, it has its own scrap facilities, but these supply about one-third of its needs. On the other side, the company is not a price-setter in the market (that role often falls to Nucor). The risk, then, is that if the economy picks up (and the Chinese economy in particular) and scrap prices rise, Commercial Metals may not see all of the benefit of greater steel demand flow through to the bottom line on the income statement. That said, this is not a new risk for this company.

The Bottom Line
The ever-present problem with commodity stocks like Commercial Metals is that analysts (and investors) tend to miss the turns and usually end up scrambling to raise/lower estimates when things start getting better/worse. If investors look at the estimates for 2013 EBITDA coming out of this quarter and apply the historical six times average, fair value looks to be about $16.50 - which isn't very impressive, even with the stock hitting new highs.

Take the high end of expectations, though, and that target jumps up to about $18 and the stock is a bit more interesting (especially factoring in the technical picture). And if that high-end estimate goes up just another 5%, the price target moves to about $18.75 or $19.

At the risk of seeming to fall into the "valuations don't matter" trap, I will say this - if the non-residential construction market has turned (and management seemed cautiously optimistic on that point), this is a stock worth owning for the next 12 to 18 months. If this is another false dawn, though, then the difference of 5% plus or minus in EBITDA estimates doesn't really amount to much, and this is not a very compelling stock to own.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  4. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  5. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  6. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  7. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  8. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  9. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  10. Stock Analysis

    GoPro's Stock: Can it Fall Much Further? (GPRO)

    As a company that primarily sells discretionary products, GoPro and its potential falls right in line with consumer trends. Is that good or bad?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center