United States Steel (X) just reported its earnings. As expected, the company suffered from a very weak global economy in its fourth quarter as earnings and margins were down across the board. The only good news is that earnings and sales were way above expectations. Immediately after the earnings release, the stock was up more than 7%. Unfortunately, this quickly turned into a loss shortly after the open as global markets continue to be pressured by coronavirus fears. I still expect a growth bottom in the first quarter of this year but think U.S. Steel is not the right stock right now. Volatility is high and flat-rolled steel exposure is only something you want if you are willing to take above-average risks.
Source: United States Steel
Here’s What Happened In Q4
As usual, I like to start by discussing earnings per share. In the fourth quarter, adjusted EPS fell to a loss of $0.64. This is the second consecutive quarter of losses and the third quarter with declining profits in 2019. That’s not everything, as the negative growth rates are accelerating from -69% in the second quarter to -135% in the just-released fourth quarter. There is no doubt that growth acceleration in 2016 and 2017 has turned into severe contraction. Note that growth peaked in Q4 of 2018. That’s exactly when the U.S. economy peaked as well, as I will show you in this article.
Before I go into any detail, I have to mention the good news. Even though earnings were weak, it’s safe to say analysts expected a much bigger decline as the average EPS target was at $1.14. This makes the fourth quarter one of the biggest earnings beats of the past few years.
With that said, let’s move over to the table below. The table below shows the income statement from sales to operating income. As you can see, trouble started all the way at the top as sales declined by 23.5%. This too is the worst rate of contraction of the current cycle and the result of weakness in all core segments. For example, the flat-rolled segment saw shipments drop from 2.7 million net tons to 2.5 million net tons. The average selling price also declined from $823 to $699 per net ton. Production was adjusted accordingly as total production fell by 23% to 2.6 million tons. According to U.S. Steel, weakness came from lower vehicle sales in North America – mainly impacted by the General Motors (NYSE:GM) strike. This is expected to improve in 2020 due to a low 57 days average dealer inventory level. Residential construction was a tailwind as business activity hit a 13-year high in the last month of the fourth quarter. Auto weakness was also the reason behind very weak U.S. Steel Europe shipments. In the EU, car production was down 4.7% in 2019 with a decline of 0.9% expected in 2020. As a result, steel shipments in this segment fell from 1.1 million net tons to just 760 thousand net tons.
When accounting for the cost of goods, we get an ugly gross profit decline of 91.2% erasing pretty much all prior-year quarter gains. Needless to say, gross margin also hit a multi-year low at 1.5%. When subtracting SG&A expenses, depreciation expenses and other operating expenses, U.S. Steel ends up with operating income of -$170,000. This is 167.5% below the prior-year quarter value and pushes operating margin to a new multi-year low of -6.0%.
With that said, let’s take a moment to discuss the slide of the Q4 earnings presentation below. Note that I added the red arrows. What we see could technically be a worst-case scenario of falling liquidity and rising debt on top of lower cash from operations. In other words, it looks like U.S. Steel is leveraging right into a slowdown. While it is generally bad to have high debt levels in an economic downturn, the slide below looks much worse than the actual situation.
The snapshot above is what has caused the green line in the graph below to inch up. In the fourth quarter, the ratio of liabilities/assets has risen from 61.5% to 65.0%. This is still a multi-year low as the company focused on deleveraging since the start of 2016. High debt levels were a major reason why U.S. Steel’s stock price got slaughtered in 2015. That said, I do not expect liabilities to continue to outperform assets in 2020. U.S. Steel significantly invested in 2019 to reduce fixed costs and de-risked pension liabilities.
2020 – The Pressure Is On
If there is any part of the fourth-quarter earnings release you should use going forward, it’s the part of the 2020 outlook I pasted below. 2020 is going to be extremely tough as we are starting the year in the midst of a growth slowing cycle. On top of that, we are dealing with a rapidly spreading virus in China, which has reached a global scale. At this point, one could write a 5,000 words essay on the risks of a virus. Unfortunately, nobody knows where this is headed. It could be really bad or start to linger in February. Either way, it causes uncertainty on top of an already weak economy.
One reason why I expect U.S. Steel to raise its outlook in either the first or second quarter of this year is the promising development of leading economic indicators like the ones below. Future business expectations have started to bottom three months ago and could further fuel upside momentum if this development continues.
Source: Author’s Spreadsheets (Raw Data: Regional Fed Manufacturing Surveys)
This matters because the ISM manufacturing index has been a major driver of cyclical stocks like U.S. Steel as you can see below. Not only is the ISM manufacturing index at a new multi-year low, but we also see that U.S. Steel is just $2 above its 2016 lows.
This is why I keep talking about leading indicators. If we are indeed able to get a growth bottom in Q1 of 2020, I think U.S. Steel is going to be a phenomenal investment.
U.S. Steel reported disastrous fourth-quarter results. Fortunately, the market already expected this as there is no way U.S. Steel is raising production in the current business environment. Unfortunately for investors, there continue to be a lot of uncertainties. On top of an already weak economy, we are dealing with increasing uncertainties that could weaken the global economy even further. Nonetheless, the company has a stronger balance sheet compared to the prior cycle and has presented an outlook that could be much worse. That’s why the stock was initially up more than 7% after earnings. At this point, the stock has fallen so much that investors are paying less than 3x earnings and 0.12x sales. Both are new cycle lows.
My advice is to stay on the sidelines for now. If you want to buy, start buying when the ISM manufacturing index is improving along with a better outlook regarding the coronavirus. If the growth bottom is for real, we could be facing a huge rebound to at least $20. However, keep in mind to keep your position small. U.S. Steel is volatile and could do a lot of damage to your portfolio.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.