KeyBanc Urges 'Selective Bias' On Carbon Steel Stocks

Investors should continue holding a "selective bias" on carbon and steel stocks despite an increase in 2018 and 2019 hot rolled coil steel, or HRC, estimates, according to KeyBanc Capital Markets. 

The Analyst

KeyBanc's Philip Gibbs downgraded Steel Dynamics, Inc. (NASDAQ: STLD) from Overweight to Sector Weight with no assigned price target. The analyst maintained an Overweight on Reliance Steel & Aluminum Co (NYSE: RS) with a price target lifted from $97 to $100.

The Thesis

An analysis of the commodities sector that included surveys with C-level carbon sheet product distributors led KeyBanc to lift its 2018 HRC pricing estimate from $750/ton to $800/ton. 

The firm also lifted its 2019 HRC pricing estimate from $660 to $675, which on a dollar basis is a smaller uptick compared to 2018 and reflects the "eventual easing" of tariff effects, a higher 2019 U.S. sheet supply and stronger year-end import supply potential, Gibbs said in a report. 

The 20 C-level executives surveyed by KeyBanc reported above-average seasonal shipment and volume momentum in the second quarter with strength across all markets, especially construction, industrial and energy, the analyst said. The survey also found a "modest amount" of customer hedge buying in the second quarter, in contrast with the first quarter, when nearly 50 percent of respondents pointed to some customer hedge buying.

Despite what appear to be encouraging industrywide fundamentals, investors need to be selective in their carbon steel equities for valuation reasons, Gibbs said. Many names in the group are modeled to report "stellar" near-term results due to tariffs, but face the potential for tougher 2019 year-over-year EPS comparisons, he said. 

Related Link: Analyst: For US Steel, Tariffs Are A Sell-The-News Event

Aggressive On Reliance Steel, Not Steel Dynamics

Among the entire sector, investors should prioritize "free cash flow-rich" companies that are building long-term earnings per share power, like Reliance Steel, Gibbs said. The stock boasts exposure to potential infrastructure spending projects; "unpredictable" M&A activity; and a higher return on invested capital due to tax reform, the analyst said. 

Steel Dynamics' stock has gained around 30 percent since mid-October, and the valuation of 6.5x and 8.6x EV/EBITDA on 2018 and 2019 estimates implies minimal upside potential, Gibbs said. Expectations for "excessive" profitability in the second and third quarter will normalize into 2019 amid a sheet supply-side recovery, he said. 

Price Action

Steel Dynamics shares were trading down 0.14 percent off the open Thursday, while Reliance Steel shares were trading nearly flat. 

Related Link: After Trump's Announcement Of Steel, Aluminum Tariffs, The Sell-Side Reacts