What to Buy: OneSteel Ltd (ASX: OST, OTC: OSTLF, ADR: OSTLY) at or below USD0.80

Why Now: OneSteel Ltd (ASX: OST, OTC: OSTLF, ADR: OSTLY) manufactures and distributes steel and related metals products in Australia, including structural steel, rail, rod, bar, wire, pipe and tube products. It also distributes sheet and coil, piping systems, plate and aluminum products. All are utilized in the country’s rapidly growing construction, mining and rail industries.

The dark side of Australia’s natural resource boom is a super strong Australian dollar. The aussie is now at USD1.07, up from only about USD0.94 in October and a low of just USD0.63 at the height of the financial crisis in November 2008. That’s made Australian steel manufacturing far less competitive versus competition from developing Asia, and OneSteel has suffered, sharply reducing its dividend since late 2008.

Most recently the company cut its final dividend (declared Aug. 16, 2011, and paid Oct. 13) by two-thirds from the year earlier. The stock is down more than 70 percent over the last 12 months in US dollar terms. And expectations are low for fiscal 2012 first-quarter results, which will be announced on Feb. 21. First half fiscal 2012 net at the company’s 50.3 percent owned New Zealand unit, for example, slipped 24 percent due to the same factors that have affected the core Australia operation.

OneSteel, however, does have four key advantages over foreign rivals. One is proximity to Australia’s resource riches, including the country’s immense reserves of iron ore and metallurgical coal that are essential elements of making steel. Two, its primary customers–those same mining and related industries–are also close by, minimizing transport costs in that direction as well.

Three, it makes its money in one of the world’s strongest currencies, the Australian dollar, and enjoys developed world financial and legal infrastructure. Finally, it has the explicit support of the Australian government itself, demonstrated by an AUD64 million grant dished out to the company under confidential terms to improve efficiency and environmental safety.

That’s part of an apparent AUD300 million rescue fund from the government to the domestic steel industry. It may not be enough to restore robust profit growth or to keep the dividend at its current level. But coupled with a recent streamlining asset sale that basically eliminated near-term debt maturities, OneSteel’s survival should be assured.

The play here is what happens when the company announces its earnings on Feb. 21. Given how low expectations are, it won’t take much to beat them and give the stock a lift. For those who can handle the risk and who have the discipline to sell in the next few months–either for a big gain or a large loss–OneSteel is a buy up to USD0.80.

The Story

As was the case in early 2011, investors are willing to seek out high yields. As a result there are far fewer stocks currently yielingd more than 10 percent in any of the Investing Daily coverage universes.

This has helped our previous Big Yield Hunting picks but made it a lot more difficult to find new ones offering high potential rewards in exchange for the higher risks.

This month’s pick comes from Down Under, a battered steel producer that’s set to announce another semi-annual dividend as well as earnings next week. Investors may not have to wait long to take a large profit, though they should be prepared for a dip into the red if the company fails to meet what are clearly very low expectations. This, incidentally is what happened to last month’s pick Inergy LP (NSDQ: NRGY), which we discuss below along with other previous picks.

David: Before we get to this month’s recommendation, I think we should discuss last month’s pick, which so far hasn’t turned out so well.

Roger: Absolutely. As I said last month, I really thought Inergy LP (NYSE: NRGY) units were already priced for a distribution cut. I still believe that was the case.

What they apparently weren’t priced for, however, was a wishy-washy statement from management a few days prior to the earnings announcement that it would be cutting its distribution by an unspecified amount.

And all we got from the conference call a few days later was they’d “likely be resetting our distribution.”

David: Sounds like lawyers are involved.

Roger: Right, and it sends the worst possible message to investors.

I guess management will have to make up their mind by Apr. 23, if only because that’s when they have to declare another distribution. But until they actually make a statement, I think the stock is going to suffer.

David: Which brings up a good question: What should readers who bought it last month do? You’ll recall Alaska Communications (NSDQ: ALSK). That one we recommended getting out of when management warned it was cutting dividends but refused to set a specific amount. Then, not a week later, management cut the dividend by far more than anyone expected–from 21.5 cents all the way to a nickel.

We took a loss from our entry point but saved another 50 percent in downside. Why shouldn’t we bail out of this one?

Roger: I can always count on you to ask the hard questions.

Look, we’re talking about speculations here. Stocks don’t have yields this high unless there’s risk. So we’re constantly betting that the underlying business will beat expectations and overcome those risks. Sometimes it works out really well, as it did with PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)–and you get to take a big profit.

Sometimes, as with Alaska, it doesn’t, and you have to get out at a loss to avoid an even bigger one.

Other times, though, it’s shades of grey, and your best choice is just to be patient and see how it turns out.

David: So your advice is, what exactly?

Roger: Well, we’re going to stick with Inergy LP for now, as a speculation. That’s really the same premise as when we entered the trade.

In fact, one of the last lines in our discussion last month was when you said anyone owning Inergy should have the understanding a dividend cut is possible “in the very near future.”

I’m still dead-set against anyone averaging down in this stock. Also, anyone who is in this stock for conservative income should immediately switch to Inergy Midstream LP (NYSE: NRGM). The yield is less than NRGY’s at 37 cents per quarter, or a little over 7 percent. But they’re going to grow NRGM’s distribution 8 to 10 percent a year, and these are Inergy’s best assets.

David: So stick with Inergy LP if you’re a speculator, but switch to Inergy Midstream if you’re in it for income and growth. And above all, don’t average this trade down.

Roger: I think you’ve got it. Meanwhile, we’ll keep an eye on this one every month. And I should point out that Inergy LP is tracked regularly in another advisory I co-edit with Elliott Gue, MLP Profits.

David: Speaking of past positions, is there anything we should discuss about what’s still open on the list that’s always at the bottom of the report?

Roger: Starting with the energy stocks, AvenEx Energy Corp (TSX: AVF, OTC: AVNDF) has kind of flat-lined here between USD5.50 and USD6. I kind of suspect it will stay in that range until the end of March, when we get a chance to see its operating numbers again. But in the meantime, I’m happy to say we’re back in the black by about 20 percent.

BreitBurn Energy Partners LP (NSDQ: BBEP) last month raised its distribution for the seventh consecutive quarter, though most people seemed more interested in what sort of dilution its equity offering would trigger. We’ve seen again and again master limited partnerships get taken down on equity offerings, only to rise to new highs after it proved the proceeds would be deployed in an accretive way.

That’s definitely the case here. We’re still up about 13 percent on this trade, but I’d like to raise the buy target to USD19. Earnings come out Feb. 28.

Finally, PetroBakken has come back a little since our recommendation to take partial profits. But it’s still digesting recent gains, so let’s keep that one effectively a hold for now.

David: Those picks have obviously been helped by strong oil prices.

Roger: Don’t forget that natural gas prices have generally crashed over the time we’ve been in them.

But let’s move on to some that haven’t done as well. We’re still down a little more than 8 percent including dividends on Capital Product Partners LP (NSDQ: CPLP). We’ve been right on so far about the company’s ability to maintain its distribution, and fourth-quarter results as well as management’s comments certainly support the payout for 2012 as well.

As CEO Ioannis Lazaridis pointed out with the fourth-quarter results, the company now has only one crude tanker vessel currently operating on the spot market. The rest are fixed to long-term contracts. There’s still the perception in the marketplace that all tankers are doomed, and that’s still weighing on the stock.

But this is what Big Yield Hunting stocks are all about–situations where management is proving the market wrong. So long as they do that, it’s only a matter of time before we get a big gain out of this one. Capital Products is still a buy up to 9 for anyone who hasn’t already bought in.

David: What about Superior Plus Corp (TSX: SPB, OTC: SUIFF)? That one’s down more than 40 percent from when we get in and it looks stuck in a rut.

Shouldn’t investors move on here?

Roger: Unfortunately, virtually all of our loss in this one came pretty much right after we got in last year, when management indicated a dividend cut at the same time the overall market was collapsing.

I’m inclined to stick with it at this point, even though the propane business is obviously not in the pink of health right now. That’s mainly because it’s set guidance so conservatively for both cash flow and the distribution. I do want to officially change our recommendation on Superior Plus to hold, however, at least until the propane business perks up.

One thing that’s easy to forget when a stock drops is that the situation doesn’t have to be permanent, so long as a company’s underlying business stays solid. That much should be clear to anyone who owns Data Group Inc (TSX: DGI, OTC: DGPIF), which has more than doubled off its October low.

We’re still down on it by about 14 percent. But the market is obviously feeling a lot better about the dividend. Again, I don’t think anyone should be doubling up here, and earnings in early March may tell a different story. But yielding over 13 percent, Data Group still looks OK up to USD6. We track it regularly in Canadian Edge.

David: Which brings us to the three communications companies–Otelco (NYSE: OTT), France Telecom (France: FTE, NYSE: FTE) and Telefonica (Spain: TEF, NYSE: TEF).

None of them have cut dividends since our recommendation, but all three are losers so far, mainly because of the perception they will be forced to do so at some point in the not-too-distant future. Is there any hope for them?

Roger: This past week at the Orlando MoneyShow an investor asked me what essential-service sector would I “over weight” for 2012. My first answer was, of course, that I don’t “over weight” any one sector but rather always recommend a diversified mix.

But when I got to thinking about it, I kept coming back to communications stocks. This is a sector that’s really not feeling any love from investors, despite continuing to put up very good numbers. I blame some of that on what happened to Alaska Communications.

But sooner or later, you’ve got to figure value will be rewarded. Let’s take Otelco, which believe it or not is actually in the black since we recommended it in October 2010. It’s still down a little less than 30 percent from the high point it reached last summer, despite a nice rally this month. Investors have clearly lumped it in with Alaska Communications, as a fellow rural telecom.

But the company has never weakened as a business over that time and isn’t likely to when it announces earnings on Feb. 21. I still like the stock as a buy up to 20, though again I would not average down.

France Telecom and Telefonica are probably more victims of investors’ fears about Europe than anything else. We’re down about 25 percent in France Telecom, though again we’re actually up about 2 percent on the Telefonica trade. Both of these stocks are real bull-bear battlefields in the analyst community.

Of the 44 firms covering Telefonica, 20 rate the stock “buy,” 10 “sell” and 14 “hold.” The same numbers for the France Telecom are 17 “buys,” 15 “holds” and nine “sells.”

Ultimately, how they do this year probably comes down to how bad things get in Europe. But come what may, these companies are going to be there at the end of the day. And expectations are so low that it’s hard to see them not beating them. Again, we’re taking calculated risks here. but I think we should stick.

David: The bottom line being, buy France Telecom up to USD16 and Telefonica up to USD20, for those who don’t already have positions?

Roger: Actually, I would leave France Telecom as a hold at this point. They’ve just bought out their partner in Egypt for about USD2 billion, and it remains to be seen what impact on earnings that will have.

Let’s revisit it next month, when we have more numbers. But Telefonica up to USD20, yes.

David: Which finally brings us to this month’s pick. I’m finding that outside of what we’re already recommending, there’s not much worth holding in the 10 percent and up category. I even started looking at some of the positions we’ve sold over the past year.

Roger: I know what you mean. A reader at the Orlando Money Show asked me if we were still recommending Cellcom Israel Ltd (Israel: CEL, NYSE: CEL). I had to tell him we’ve been out since mid-August and that since then the stock is down by a third and the dividend has been cut another 27 percent.

Telstra Corp Ltd (ASX: TLS, OTC: TLSYY) is tempting but now well above the buy target and yielding well below 10 percent. It’s great as a cornerstone holding in our Australian Edge advisory, but not a speculation anymore–not really Big Yield Hunting material.

David: It really does feel a lot like early 2011, when people were bidding up all these high-yielding stocks. And if you look at our recommendations, those were the hardest comparisons.

We really did recommend them right before investors started fleeing for the very safest part of the market.

Roger: Just as a warning to people, that may wind up happening this time around. The high-yield stock market doesn’t move up and down with interest rates but with perceptions about dividend risk.

The lower these perceptions are, the lower yields are generally, and the further stocks can decline if the market mood shifts. I am willing, however, to jump onto a company in our Australian Edge universe that you’ve been quite high on, OneSteel Ltd (ASX: OST, OSTLF).

David: Well, no one could accuse you of bandwagon jumping with that one. I do like it heckuva lot better than its rivals like BlueScope Steel Ltd (ASX: BSL, OTC: BLSFF). It’s a little bit gutsy buying before they report their next set of numbers, which is for the first half of fiscal 2011-12 on Feb. 21. But the dividend has actually been relatively stable since they eviscerated it in 2009.

I think a halfway decent report could provide a big bounce. As for the dividend, demands on cash flow have been severe, particularly late last year. But they’re a lot less so now, which is good for the current dividend’s safety. I really think 13.7 percent is pricing in too much risk.

Roger: I think what caught my eye was a line you wrote in Australian Edge about the Australian government literally giving it AUD64 million to improve its efficiency and comply with environmental regulations. Isn’t that pretty much a tacit admission that having functioning steel companies is a matter of national security?

David: If nothing else it’s a nice chunk of change to help make their operations more efficient.

Keep in mind though that this company competes with neighboring Asian steel companies. And that high Australian dollar makes it a lot easier for its major customers–construction, mining, rail and other manufacturing industries–to meet their steel needs elsewhere.

Roger: There’s also the problem of very high prices for iron ore and metallurgical coal, which are the key inputs for making steel. And those prices are somewhat ironically being driven by demand from those same Asian steel producers they’re competing with.

David: OneSteel and its in-country rival BlueScope do have one very big advantage I think most people overlook. That’s proximity.

They operate in Australia, so they’re geographically a lot closer to those massive iron ore and metallurgical coal mines operated by BHP Billiton Ltd (NYSE: BHP) and others. And the same factories that make the structural steel, bar, rail, road, wire, pipe and tube products are also proximate to the country’s mining and energy companies, which are using huge amounts of steel.

Granted, transportation is only one input cost. But it’s a big one, particularly since the Australian government has apparently decided to provide financial support.

Roger: It looks like the dividend has been pretty consistent, though I see the “final” payout made in mid-October was only AUD0.04, down from a final dividend of AUD0.06 a year ago. It looks like the consensus is for a AUD0.06 per share “interim” dividend the next time they declare, which should be any day now.

But I would expect that amount to be more in line with the last final dividend. That still leaves a total dividend of about AUD0.08, which still makes for a yield of 11 percent.

David: As you know, Australian stocks pay just twice annually, so it’s important to time your purchases.

The important date here is the next ex-dividend date, which is on or about Feb. 27. You want to be in the stock before that date or you won’t get the April dividend–and that means you’ll have to wait until October to get paid.

Roger: While we’re on that subject, maybe we should share with readers how best to buy Australian stocks.

David: There are basically three ways for US-based investors to buy Australian stocks.

You can buy on the Australian Securities Exchange (ASX) if your broker has direct access. ASX symbols, the first one listed when we first name a company in an article, generally comprise three letters. You should be paying in the mid-USD30s range as commission for such services.

Some firms require direct consultation with a specialist via telephone to place an order, a practical measure that at least one shop takes just to make sure you know that, in general, the order you enter during normal trading hours stateside may not be executed until the ASX opens for its next trading day in Sydney, which is 15 hours ahead of the East Coast of the United States.

You can also buy what is essentially the same share traded on the ASX on a US over-the-counter (OTC) market. These OTC symbols, typically listed second when we mention a company, consist of five letters, the last being “F.” Ask your broker if it charges a “foreign stock fee” for trading in OTC F-shares; some do, while others treat them as domestic securities for fee-and-commission purposes.

The third way to own publicly traded Australian equities is via an American Depositary Receipt (ADR), which can be either “sponsored,” which means the company itself has initiated the listing as part of concerted effort to raise capital in the US, or “unsponsored,” in which case a bank has enabled the listing. ADRs trade on the New York Stock Exchange (NYSE) as well as on US OTC markets. Shares traded on the latter are denoted by five-letter symbols ending in the letter “Y.”

Your broker should charge the same fees and commissions for ADRs he charges you to buy and sell a typical American stock.

But trading directly on the ASX affords you the deepest liquidity and could actually save you in terms of costs over the long term

Roger: This one shouldn’t be too hard to pick up, as it has a market capitalization of over USD1 billion. Moreover, it shouldn’t be too difficult to get information on it either.

I count 13 firms currently tracking OneSteel, including JP Morgan, RBS, Credit Suisse and Goldman Sachs. That’s a lot of focus on this company. I also count nine “buys,” four “holds” and zero “sell” recommendations in that group. And there have been three upgraded recommendations since the beginning of the year. That’s fairly extraordinary, considering the stock is down nearly 70 percent over the past 12 months, including dividends paid.

David: As we’ve mentioned above, we’re going to get some fresh numbers pretty soon. I noticed New Zealand’s Steel & Tube, of which OneSteel owns 50.3 percent, posted a 24 percent drop in net income for its fiscal first half, which ended Dec. 31. That triggered some selling in OneSteel the day the news was announced, as I guess investors anticipated the same thing was happening at the mother ship.

Roger: Well, that makes a certain amount of sense. Higher iron ore costs are clobbering all these companies, and metallurgical coal prices aren’t helping much either.

OneSteel late last year sold what it called a non-core asset in piping systems. They got cash and were able to cut into their debt, and speculation is they can do more. The board has since then stated it’s not considering equity offerings, which would seem to indicate they’re in line with debt covenants now.

David: I’m seeing a couple of credit lines that have to be rolled over in the first six months of this year that seem to have a total of AUD41 million drawn on them. Then there are five tranches that mature at various times in 2013 that don’t appear to have anything drawn on them, and five more that mature in 2014 that also appear untapped at this time.

Overall, debt-to-assets is just 22.6 percent as of the last set of numbers, and management has hinted debt-to-equity is only around 30 percent. Those are pretty low numbers. Even cash generated to cash required is at a 1.2-to-1 ratio, which means they’re generating free cash flow. And dividends as of last count were covered by profits by a 1.72-to-1 margin.

Roger: That looks like a pretty conservative balance sheet to be sure. Of course, the numbers are through the last fiscal year, which ended Jun. 30, 2011.

What we’ll see next Tuesday are going to cover a lot of ground that I don’t believe has been as kind to steel companies.

David: That’s true. Like I said, we’re taking a risk buying before earnings come out. And investors may want to take a page from what happened at Inergy and hold off until we do get those numbers.

Roger: You did have to bring that up. But I’ll say the same thing I said then. Expectations are very low for OneSteel. At a yield of nearly 14 percent, they’re most definitely pricing in a dividend cut right now.

What we’re going to see over the next week or two will either beat those very low expectations or it won’t. If it does, and I think the odds favor it, we’re going to make some money here. If not, we could be underwater in a hurry.

That’s what taking a calculated risk is all about, and it’s the essence of a speculation, which this is just like every other Big Yield Hunting pick.

David: I should also mention takeover rumors for this company, though they appear to have fizzled.

Roger: I presume you’re talking about the possibility of an offer from the Korean giant Posco (Korea: 005490, NYSE: PKX).

Well, OneSteel is trading at just 21 percent of book value and 13 percent of sales, which is very cheap. Given the Australian government’s support of OneSteel, however, it may not be so willing to let a foreign company in, but it’s always a possibility.

I think we should also mention the Australian dollar, which has really been off to the races this year. A pullback would certainly help OneSteel’s competitiveness, but there’s a direct relationship with the value of dividends paid by the company to US investors.

I think it’s a good trade and thank you for locating this company in a market like this.

David: I hope you still have the same opinion of me after Tuesday. In the meantime, it’s time to restate our standard disclaimer about this sort of speculative trade.

Roger: By all means.

• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–Buy < USD6
• October 22, 2010: Otelco (NYSE: OTT)–Buy < USD20
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Hold
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–Buy < USD6
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Hold
• October 21, 2011: PetroBakken Energy (TSX: PBN, OTC: PBKEF)–Buy < CAD10.30, USD10, SELL half
  
• November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD19
• December 16, 2011: Telefonica SA (NYSE: TEF)–Buy < USD20
• January 23, 2012: Inergy LP (NYSE: NRGY)–Buy < USD25
• February 16, 2012: OneSteel Ltd (ASX: OST, OTC: OSTLF, ADR: OSTLY)–Buy < USD0.80
  

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–SELL (12/16/11)
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–SELL (12/16/11)
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–SELL (12/16/11)
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–SELL (12/16/11)