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Cheap Iron Ore Is Here to Stay

But a differentiated production process at steelmakers Nucor and Ternium--both trading in 4-star territory--should better position them for the new environment.

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2014 was a turbulent year for companies involved in the supply chain for steel. Most notably, iron ore spot prices fell to $70 per metric ton after opening the year at $130 per metric ton.

In our view, cheap iron ore is here to stay, and lower iron ore prices will have profound implications on the steel industry. Iron ore's new normal will mean lower steel prices and a flatter cost curve for steel production.

Although cheaper iron ore will mean different things for different steelmakers, as a general rule, vertical integration will lose its strategic appeal, and conversion costs will increase in relative importance. Along these lines, Nucor and Ternium are now our top picks in the space. Both companies employ a differentiated production process, tapping into locally sourced, low-cost natural gas to establish favorable unit costs relative to their peers.

Even though we expect steel prices to decline further in the near term, both companies are trading at attractive valuations currently. Nucor, which is currently a best idea here at Morningstar, has established a narrow economic moat, stemming from low-cost production. Nucor shares are trading at a 20% discount to our fair value estimate of $62 per share.

Ternium's valuation also represents an attractive entry point, as shares of the Mexican steelmaker are trading at roughly a 45% discount to what we think the company is worth.

Healthy economic growth in North America should provide a macroeconomic tailwind for both companies as we expect robust automotive steel demand and improving nonresidential construction activity to support earnings growth for both companies.

Andrew Lane does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.