U.S. Steel Stock Seems Cheap, Priced At 2x Free Cash Flow (NYSE:X)

Investment Thesis

United States Steel (X) has seen its shares start to move up as investors are starting to notice that this sector may now be too cheap relative to its underlying prospects.

The big question mark that remains outstanding in this investment thesis is, just how much of a decrease in revenues should investors expect in the second half of 2022?

That being said, at approximately 2x this year’s free cash flows, together with buybacks on the line being deployed right now, this is probably starting to look reasonably priced.

Investor Sentiment Perks Up

As you can see above, commodities have been on a tear in the past several months. On one hand, some are directly related to oil prices, while others are less so. Nevertheless, there’s no question that the market’s view of commodities right now is the best it’s been for a while.

U.S. Steel’s Revenue Growth Rates, The Big Uncertainty

Against its unimpressive 2020 performance, 2021 was able to shine strongly, as U.S. Steel finished Q4 2021 up meaningfully more than triple digits.

The big question hanging on investors’ minds right now is, we know that Q1 2022 will have very easy comparisons against Q1 of last year, but how will the remainder of the year fare as it comes up against those really tough comparisons made in the prior year?

As you can see above, analysts following the company presently expect that throughout 2022 U.S. Steel’s revenue growth rates should consistently move in the wrong direction, going from nearly 50% top-line growth all the way to exiting the year at an approximately 20% y/y decrease in revenues.

Clearly, this appears to indicate that in the near term, the best that U.S. Steel has to offer may, perhaps, already be in the rearview mirror. Thus, this forces the question, why U.S. Steel?

Why U.S. Steel? Why Now?

During its Q4 2021 earnings call, U.S. Steel management says,

We know about the risks, the Fed taking rates up too fast, unexpected changes to import restrictions, geopolitical risk, existential risks. The risks are many but we’ve seen it all before.

Furthermore, on the one hand, there are supply chain issues putting a lid on revenue growth rates, but on the other hand, there’s ample demand for steel in automotive, appliance, construction, container, transportation, and bridges, to name a few end markets.

After years of poor returns, investors have long ago given up being interested in deploying capital towards commodity business. The sector ended up starved of capital and underinvested, as investors sought out ”cleaner”, less carbon-intensive metals.

However, when it’s all said and done, profits are still growing and fast.

U.S. Steel’s Profits Are Growing, Fast

As you can see above, U.S. Steel’s adjusted EBITDA jumped meaningfully relative to the same period a year ago. For Q4 2021, adjusted EBITDA reached $1.7 billion compared with under $100 million in the same period a year ago.

However, as you know, adjusted EBITDA doesn’t always translate into free cash flow. So, we’ll soon turn to discuss its free cash flows.

But before discussing its free cash flows, let’s understand that U.S. Steel’s balance sheet has dramatically improved in 2021. At the end of Q4 2020, its balance sheet held a net debt position of $2.9 billion. Then, at the end of Q4 2021, it exited the year with a net debt position of $1.4 billion, a huge improvement.

As you can see above, U.S. Steel reported $3.2 billion of free cash flow in 2021. And unlike other ”asset-light” businesses, where the bulk of the free cash flow is stock-based compensation that gets added back as a ”non-cash cost”, this business in actuality generates strong free cash flows.

What’s more, looking further ahead, management guides for meaningful incremental free cash flow this year. This could translate into somewhere near $4 billion of free cash flow to be reported in 2022. Remember this figure of $4 billion free cash flow, as we’ll revisit it soon.

Consequently, management argues that in light of its balance sheet meaningfully improving, share repurchases make sense right now. Having deployed $150 million towards repurchases during Q4 2021, management has announced a new $500 million share repurchase plan to augment the remainder $150 million share repurchase plan previously announced.

Thus, altogether, there’s approximately $650 million worth of announced buybacks coming to shareholders over the medium term.

Independently, it’s worth noting that compared with other businesses that announce buybacks, but those repurchases rarely bring down the share count enough to offset management’s stock-based compensation, consider this following. At the end of Q3 2021, the total diluted share count was 287.5 million, whereas in Q4 2021, 285.3 million.

To which you may retort, ”big deal”, that’s less 1% of the share count. However, keep in mind, that this decrease in share count took place on the back of the $150 million share repurchase effected during Q3. And still, there’s a further $650 million to be deployed.

Now, let’s discuss its valuation.

United States Steel Stock Valuation – Attractively Priced

The big question mark that is difficult to get any visibility into is just how severe will the decline in revenues be towards the latter parts of 2022?

As of right now, there’s a lot of supply shock, which appears to indicate that at least the early parts of 2022 should be particularly strong.

However, how the second half of 2022 performs is anyone’s guess at this stage.

That being said, if we base valuation calculation on the assumption that U.S. Steel makes close to $4 billion of free cash flow this year, this puts the stock priced at approximately 2x free cash flow.

Given that its balance sheet, as we’ve discussed, is remarkably healthy, I am inclined to believe that the risk-reward looks enticing.

The Bottom Line

A lot of investors are thinking that given how much commodities have increased in the past few weeks, the rally is now done and dusted. Investors are price-anchoring to prices a few weeks ago, and making the argument that surely, given that this is a highly cyclical business, the good period is now in the rear-view.

I contend that this story is not finished. And that paying 2x free cash flow seems a reasonably good entry point for investors.