Equity mispricing – further significant upgrades (& shareholder returns) ahead Since May, steel equities have largely looked through the earnings upgrades as investors have tried to avoid getting involved at the cyclical peak. This has left the sector on highly attractive valuation metrics, and although we don't disagree that steel prices are likely to come off (from historical highs), we expect several drivers to support margins materially above mid-cycle levels for the next 2-3 years. As a result, we still see further upgrade potential to our above-consensus scenario (DBe EBITDA 21/22E is 7-19% above the street on average), and we expect strong cash generation to amortise significant amounts of equity values. This should allow managements to set aside considerable capital for direct shareholder returns.

Top picks: MT (cyclical EU), X (cyclical US), tk (non-steel catalysts) & OUT1 (stainless) We continue to like tk, which has non-steel catalysts (value potential from AST sale & electrolyser business). In carbon steel, MT and X have the strongest cyclical leverage and relative FCF generation (31% and 44% average 21/22E FCF yield) and remain the best way to be exposed to the strong margin environment. We also upgrade SSAB to Buy; it has a similar FCF yield (24%) and is well positioned for European decarbonisation. In stainless, we upgrade OUT1 to Buy due to strong leverage to the EU price recovery, contract rollover, FeCr prices and 21% average FCF yield. All four companies could generate >50% of 2022E consensus numbers in Q1 22E.

Structural changes support a lasting above-mid-cycle environment Although prices are likely to soften in Western markets, the setup for the steel sector remains strong: 1) The post-pandemic recovery, stimulus and the auto sector should support demand over the next 2-3 years. 2) China (c58% of global production) is capping its output, maintaining a tight domestic market balance. 3) Both China and Russia have stepped away from the export market by imposing an export tax; as logistics costs have risen considerably, this is resulting in structural inflation in the RoW markets (and an additional Chinese export tax could be another catalyst). 4) Lastly, specific cost inflation for several input factors (e.g. scrap and Chinese domestic coal) should help Western blast furnace operators. We believe this should support a longer duration of the strong margin environment over the next few years, and we see the potential for multiple upgrade legs beyond our above-consensus numbers.