This Just In: U.S. Steel Upgraded

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...

2019 has not been kind to U.S. Steel (NYSE: X) shareholders.

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So far, the stock is down 36% from its highs in February on fears a trade war with China is sapping steel demand -- at the same time as a trade truce with Mexico and Canada will remove the protective tariffs that enabled the company to nearly triple its profits last year. On Wall Street, Citigroup this month cut its price target on U.S. Steel (to $15, says StreetInsider.com), while Goldman Sachs downgraded it to sell.

Yesterday, U.S. Steel moved to address these fears by idling three of its blast furnaces -- and immediately won an upgrade from a completely different analyst: Vertical Group.

Why Vertical Group likes U.S. Steel

According to U.S. Steel's latest 10-K filing with the SEC, the company currently operates 14 blast furnaces spread across the United States, as well as an integrated production facility in Kosice, Slovakia. So U.S. Steel's move to idle three of its furnaces could potentially cut its steel output by as much as 21%.

In its note this morning, Vertical Group calls this move "unthinkable" -- but apparently in a good way. In fact, the analyst has swung all the way from a sell rating on U.S. Steel to a buy and hiked its price target to $17 per share.

But was this move really good news?

What U.S. Steel said yesterday

Perhaps. Falling demand for steel among manufacturers, combined with a 35% decline in the price of hot-rolled coil over the past year, has significantly dinged U.S. Steel's profitability. In last night's Q2 2019 earnings preannouncement, which contained the news about the furnace closings, the company warned that "second quarter 2019 adjusted diluted earnings per share [will] be approximately $0.40" -- 23% below the $0.52 per share that Wall Street had been forecasting.

In addition to "decreasing steel prices and softening end market demand," management blamed the weak profits forecast on "flooding in the southern United States, which has limited the availability of barges and our ability to ship finished product," as well as "market headwinds" and "lower selling prices" in Europe.

Given the soft demand for its product, and even weaker prices it's able to command for the steel it does sell, U.S. Steel's decision to idle its "Great Lakes B2 blast furnace" and "south blast furnace at ... Gary Works," as well as the "#2 blast furnace" in Kosice may make sense. (Why flood an already oversupplied market with additional production that's only going to drive down prices even further?)

According to management, idling the three furnaces will remove "approximately" 325,000 to 350,000 tons of steel supply from the market monthly -- or as much as 4.2 million tons annually, depending on how long these idlings last. That still leaves U.S. Steel shipping about 14.6 million tons of steel this year, but it's a significant reduction nonetheless.

What it means to investors

It could also be mean a significant reduction in U.S. Steel's annual capital spending budget -- maybe even significant enough to return this company to free-cash-flow positive despite the reductions in steel pricing (and the planned reduction in production).

Consider: With $1.15 billion in trailing earnings, U.S. Steel stock currently sells for an ultra-low valuation of just 2.3 times profit. Granted, management just warned us that profits are slumping, and that's part of the reason analyst forecasts show that the shares are trading at 10.5 times what the company is expected to earn next year. But even so -- 2.3 times trailing earnings is a valuation almost too enticing to resist.

What really worries me about U.S. Steel stock, though, is the fact that after generating positive free cash flow in 2017, a number not too far short of its reported earnings (it reported $387 million in GAAP profit in 2017, and FCF of $321 million), the company's free cash flow dropped to negative $63 million last year, and remains in the red (negative $29 million) over the past 12 months. Without cash coming in to support its $2 billion net debt, I see a lot of balance sheet risk.

However, by lowering production and idling facilities, not only will U.S. Steel be doing its bit to support global steel prices going forward, it should also be able to reduce capital expenditures on maintaining and upgrading those furnaces that are no longer operating. If this permits U.S. Steel to reduce its capital spending budget to the $500 million-ish level that was more the norm over the past five years, I could see the company generating positive free cash flow even if operating cash flow falls by half over the next year.

So is that good enough news to justify an upgrade on U.S. Steel stock? Yes, I think it just might be.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.