Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
The new tariffs, signed into law on Thursday and going into effect about 10 days from now, impose a broad 25% tariff on steel imported from almost anywhere on the globe (and 10% tariffs on aluminum, too). They're almost certainly the reason that shares of U.S. Steel (NYSE: X) are up 15% over the last 30 days, why AK Steel stock has gained 10%, and probably explain why Alcoa has notched a 6% jump as well -- but not everyone is impressed.
This morning, analysts at Vertical Group announced they're downgrading shares of U.S. Steel. Here's what you need to know.
U.S. Steel gets a thumbs-down
Vertical Group announced a big downgrade of U.S. Steel stock from hold to sell this morning, reports StreetInsider.com (subscription required). What's more, the analyst assigned it a lowly price target of just $23 -- implying there's as much as 45% downside risk in the stock despite its apparent win in the recent tariffs debate.
That doesn't quite jibe with how other investors have been reacting to the Trump administration's imposition of tariffs designed to raise steel industry utilization to 80% or better, boost domestic steel sales, and grow steel industry profits. So what is it, exactly, that Vertical Group doesn't like about the tariffs story?
Buy the rumor, sell the news
As Vertical explains in its note, most of the gains in steel stocks to date came during a period of "uncertainty" about the level of tariff that would be imposed on steel imports -- and whether it would be imposed at all. Now that the number is known -- 25% -- Vertical says investors are "shifting" their focus to the fine print. What they're seeing there, though, may be worrisome for steel stock bulls.
For one thing, Vertical notes that the list of countries and products being exempted from the tariffs is "growing." Already, Mexico, Canada, and Australia have been assured their steel exports will not be hit with the new 25% tariff. Vertical notes that similar tariffs on steel imposed by President Bush on imports under Section 201 of the Trade Expansion Act in 2002 ultimately exempted more than 700 different steel products from their effect, "prompting a resurgence in imports" after an initial slump.
If President Trump's Section 232 tariffs follow the same path that President Bush's Section 201 tariffs did, the new tariffs regime could end up gutted, and reduced to "a watered-down talking point" -- useful on campaign stumps, but of little use in boosting U.S. steelmakers' profits.
What it means for investors
This would not be good news for investors who piled into steel stocks over the past month, hoping to reap windfall profits from an industry sheltering under the protection of Trump-imposed tariffs. Flipping through its history book, Vertical notes that during the time of the 2002 tariffs, U.S. Steel stock actually achieved its highest valuation (expressed in terms of enterprise value-to-earnings before interest, taxes, depreciation, and amortization, or EV/EBITDA) in the quarter before the tariffs were set in place.
In contrast, during the entire time those Section 201 tariffs were in place, and while investors watched their effectiveness continually eroded, U.S. Steel stock's valuation declined, bottoming in Q2 2003 -- about 15 months after the tariffs were announced. Again, should the trend following imposition of Section 232 tariffs mimic that of the trend seen with the Section 201 tariffs before, this would imply that U.S. Steel's current 8.6 EV/EBITDA ratio will shrink over time, and its stock decline in price.
And this actually looks like a reasonable scenario to me. Currently priced at 18.8 times earnings, most analysts have U.S. Steel stock pegged for only mid-single-digits profits growth over the next five years -- about 5.5% compounded, according to data from S&P Global Market Intelligence. Suffice it to say that's not a lot of growth to support a P/E ratio in the high teens.
Granted, other stocks aren't quite so richly priced, and not so likely to suffer -- AK Steel stock, for example, sells for only an EV/EBITDA ratio of about 7, and Alcoa lands at 4. To my Foolish eye, though, that still leaves U.S. Steel stock looking like the most expensive stock in a highly valued metals sector -- and the one most vulnerable to a fall.
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