US Steel - Lower Entry Points for Bonds Ahead

US Steel (X - Ba2/BB) results:

US Steel's Q3 '10 earnings reflected sequential declines in production, shipments and average realized prices (more of the same expected in Q4 '10).  The company ran negative working capital of over $500MM, leading to continued negative free cash flow of nearly $1B.  X is the most recent to provide a somewhat weaker outlook for the industry and we should not expect the company's credit fundamentals to improve in the near to intermediate term.  Should the company continue to be a net consumer of cash, I believe that their current ratings are at risk for downgrade.  I am underweight the sector.

Bottom line stats:
FCF:  -$926MM
Total Debt:  $3,659MM up $300MM this year.
CFO YTD:  -$478MM
CFO Capex coverage:  N/A (cash USED in operations)
Debt/Capitalization:  +300bps from 12/09 to 44.7%


Headline Numbers:

• Net sales of $4.5 billion -4% from Q2 '10;
• Loss from operations of $138MM;
  
• Net loss of $51MM for Q3, down $26MM sequentiall and up $252MM YOY.  Net income was propped up by currency gains of $139MM (second quarter loss was due to currency losses);
• Cash used in operations:  -$478MM (9mo), capex: $426MM, dividends: $22MM.  Negative free cash flow of $926MM.
• U. S. Steel had $643MM of cash and $2.2B of total liquidity as compared to $947MM of cash and $2.5B of total liquidity at June 30, 2010. 

Segment Results:

• Flat Rolled:  Q3 loss of $174MM, down $272MM sequentially and up $204MM YOY.
• Loss due to decreased shipments (-6% to 3.8mm tons) and production volumes, decreased average realized prices ($688/net ton, -$12 from Q2), increased costs for facility repair and maintenance, and consumption of higher cost coal, coke and iron ore purchased to support earlier facility restarts. Capacity stood at 77% (down from 82%).
• USS Europe:  Q3 loss of $25MM, down $44MM sequentially and down $32MM YOY
• Favorable currency transactions offset by higher raw materials costs and increased facility repair and maintenance costs. Realized prices increased $61 to $748 but shipments decreased 4% to 1.3mm tons.  Capacity stood at 77% (down from 89%).
• Tubular:  Q3 income of $112MM, up $12MM sequentially and up $132MM YOY
• Income up due to higher average realized prices (+$63 to $1,559/ton). and decreased costs for steel substrate, which were only partially offset by slightly lower shipments (-3% to 422k tons)
• Other:Q3 income of $7MM, down $21MM sequentially and up $2MM YOY
• Down primarily due to real estate sales in Q2.
  

Outlook:

"Our current order entry rates reflect the uncertain economic situation in North America and Europe, with spot customers reducing inventory levels in light of short lead times, while our contractual customers' order rates are consistent with traditional downtime taken late in the fourth quarter."

Outlook By Segment:

• Flat-rolled are expected to be in line with the third quarter, expects to operate at an overall lower raw steel capability utilization rate due to lower expected shipments and realized prices;
• USSE expected to be comparable to the third quarter as lower raw materials costs and reduced spending on facility repair and maintenance are offset by lower shipments;
• Tubular segment expects to remain profitable in the fourth quarter, but expect lower results as compared to the third quarter.  Customer inventory levels are at the high end of the normal range.

Value:

X       7.375  4/20      (Ba2/BB)       +400/10yr

MT    5.250  8/20      (Baa3/BBB)    +250/10yr

NUE 4.125  9/22        (A2/A)             +132/10yr

While X presents some value to HY accounts at +400, I believe it is going lower and will have better entry spots.  This sentiment can be extrapolated to the entire sector.  NUE and MT have widened as well, but there should be lower entry spots.  Underweight the sector.