U.S. Steel and Estee Lauder are stock-market microcosms. Shares of those dissimilar companies were scooped up by momentum-junkies in the fall. But last week, the two stocks diverged. Amid earnings reports, makeup and skin-care company Estee Lauder advanced 5.7 per cent while commodities company U.S. Steel tumbled 27 per cent. That deviation shows the latent danger, and opportunity, in stock-market darlings. Both are still attractive, but in different ways. Here's the breakdown.
This goliath-turned-David is what fictional Wall Street megalomaniac Gordon Gekko would call "a dog with fleas." Pittsburgh-based U.S. Steel, once a Dow Jones Industrial Average component, is now, by definition, a mid-cap stock. But everybody loves a comeback story. Perhaps that explains the optimism U.S. Steel enjoyed during the past few months. Its stock was upgraded by a gaggle of investment banks, most notably, Goldman Sachs.
The company's stock soared 90 per cent between Nov. 2 and Jan. 19, when it hit a 52-week high of $66.45 (U.S.). Then the surprise of the New Year: U.S. Steel swung to a fourth-quarter loss of $267-million, or $1.86 a share, from a profit of $290-million, or $2.50, a year earlier. It missed analysts' estimates for revenue and earnings, and remained unprofitable.
Fitch Ratings demoted U.S. Steel's debt to below investment grade, or junk. Then Goldman Sachs backpedaled, citing lower guidance as its motivation to downgrade the stock. The shares have now plummeted 28 per cent from their 2010 peak, burning investors who followed the crowd. Interestingly, U.S. Steel fared well in 2008, when most companies were writing in red ink. It achieved earnings per share growth in three of four quarters.
Deriving some overlooked economic truth from this performance is folly, since U.S. Steel is no longer large enough to justify bellwether status. And its peers, including AK Steel and Nucor , exceeded analysts' quarterly expectations. AK Steel shares posted a weekly gain amid the sell-off, even though the company enjoyed a LIFO credit (a method of valuing inventory) that could dampen sequential growth.
The U.S. Steel fiasco confirms a common theme of 2010 outlooks: We are in a stock-picker's market. This catch-phrase has weaseled its way into the Wall Street vernacular. And it's absurd -- every market is a stock-picker's market. But the steel industry is illustrating that theme.
Companies with opportunistic products, such as electrical steel, and mobility will justify their stock momentum in 2010. Those with systemic problems, such as U.S. Steel's 64 per cent utilization rate and idled facility costs, are likely to fall in market stature.
U.S. Steel still offers long-term value. Its shares are cheaper than those of metals peers based on projected earnings, book value and sales. But the near-term outlook is murky. Still, Bank of America and Deutsche Bank are maintaining "buy" ratings on the stock.
The New York-based cosmetics company posted a blow-out quarter. Net income soared 62 per cent to $256-million, or $1.28 a share, as revenue climbed 10 per cent to $2.3-billion. Estee Lauder's operating margin popped from 13 per cent to 20 per cent. Its restructuring plan generated around $83-million of savings and growth in Asia, as well as the launch of new high-margin products, enhanced profitability.
Of its operating segments, skin care and make-up performed best, growing 17 per cent and 12 per cent, respectively. Sales in Asia and the Europe, Middle East and Africa region each grew 18 per cent, including positive currency effects. In contrast, America sales inched up 1 per cent. Estee Lauder derived more than 59 per cent of its quarterly revenue from areas outside the U.S. If you're concerned about tepid domestic growth, this stock is an option.
Interestingly, management credits an advertising shift for a significant portion of the boost. Estee Lauder is evaluating its branding and funneling money out of inefficient advertising streams. In a stagnant global market, that strategy would be suicidal, but since Estee Lauder already enjoys a hefty market share in the U.S. and brand recognition in growth regions, it's increasing sales without exorbitant advertising expenditures.
Our equity model upgraded Estee Lauder to "buy" on Nov. 2, and the stock has appreciated 24 per cent since then. Still, we expect significant upside, with a price target of $70. Companies that used the recession to restructure and refocus are flourishing in the "new normal" economy. Estee Lauder offers exposure to the international consumer and is benefitting from operating leverage.
The company, which announced 2,000 job cuts and pay freezes last year, has rigidly implemented its four-year turnaround plan. So far, efficiency is a boon. Since last year's fiscal second quarter, Estee's cash balance has grown 68 per cent to $1.2-billion and debt has fallen by 15 per cent to $1.4-billion. A quick ratio of 1.4 and debt-to-equity ratio of 0.7 reflect a newfound fiscal prudence.
It's easy to criticize a company that has laid-off workers. But in a broader economic sense, efficiency has a positive redistributive effect. Estee Lauder is running lean and mean. With or without a robust U.S. economic recovery, the cosmetic king is going to outperform. Its stock has a PEG ratio, a measure of value relative to growth, of 0.2. By comparison, the personal-products industry average is 0.6, implying that Estee Lauder is grossly undervalued.