Commodities

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

If you've ever wondered what the opposite of a "great-quarter-guys!" results call might sound like, the first question on United States Steel Corp.'s effort on Wednesday morning answered your prayers:

I think I've got a few questions, obviously. I think a lot of people do. The changes from last quarter to this quarter; it's a pretty big change. And it looks to me like, you know, you strip out, obviously, the accounting change and, I mean, you cut your guidance by 35 percent on the Ebitda line -- in a rising price environment.

The tenor of the Q&A did not improve noticeably after that opener from David Gagliano at BMO Capital Markets. At least, the market saw it that way. U.S. Steel's stock had already dropped by 13 percent in overnight trading -- the results were released late Tuesday -- by the time the call began. When it ended, just as the market was opening, that loss had widened to 22 percent. As of this writing, the stock was down by about 25 percent.

The company's cut to 2017 Ebitda guidance was bad (the actual first-quarter numbers missed estimates by a mile). Guidance looks even worse at the earnings level: U.S Steel originally envisioned $3.08 a share this year. It slashed that to $1.50.

However, that new number includes the benefit of an accounting change that cuts $175 million from operating costs. Taxed at 35 percent, that equates to a projected benefit of 65 cents per share. So adjusted guidance looks more like 85 cents of earnings per share -- a cut of 72 percent. In addition, the company dropped language about being "cash positive" for the year.

Timing compounds the problem.

U.S. Steel put the new guidance down largely to a strategic decision to accelerate upgrades at its plants, which involves costs and downtime, in order to reap benefits longer term. Which in theory is fine ... but does raise the thorny issue, as expressed throughout the call, as to why this decision came out of the blue, at a time when U.S. Steel could be capitalizing on higher prices:

Harvest Time
Benchmark U.S. steel prices are up 31 percent since the end of the third quarter
Source: Bloomberg
Note: Generic 1st future price for U.S. Midwest domestic hot-rolled coil steel.

U.S. Steel is now committed to a a multi-year investment project. The company said on Tuesday its accounting change will partly address the apparent gap between investment and depreciation, with new guidance implying capex will be 125 percent of depreciation in 2017. However, the revised earnings guidance on lower volume expectations, along with the historic numbers reinforces the sense U.S. Steel is indeed playing catch-up on investing in its plants:

Replacement Cost
The trend in U.S. Steel's capex versus its depreciation has been on a downward trend for the past 5 years
Source: Bloomberg
Note: Capital expenditure divided by depreciation, depletion and amortization, trailing 4 quarters.

U.S. Steel is confident markets will be strong in the future, meaning lower volume at a profitable point in the cycle is worth it. When asked whether it might adjust its plans if steel prices turn out to be weaker than anticipated, the company's answer was that its investment strategy required "a little bit of courage."

Yet, as Gordon Johnson of Axiom Capital -- the only one with a "sell" rating on the stock -- pointed out on the call, the hard data on important sectors such as vehicle sales and construction do not look especially bullish. The company disagreed, arguing, for example, that automotive sales would remain robust even if they don't necessarily grow from here. Meanwhile, the continuing recovery in onshore U.S. oil and gas drilling should mean more demand for tubular steel.

It was interesting, though, that the first half of Chief Executive Mario Longhi's opening statement on the call was taken up with his lauding the Trump administration's decision to investigate potential national security risks of steel imports. This is a rarely used tool that on previous occasions, most recently in 2001, hasn't led to restrictions on imports.

Clearly, Washington's climate has changed somewhat since 2001. Giving a speech at a Bloomberg New Energy Finance conference in New York on Tuesday, Energy Secretary Rick Perry made liberal use of the phrase "national security" when talking about the U.S. coal industry. So we can probably expect appeals to that politically charged concept to figure more prominently in trade policy.

Yet it would be risky indeed for investors to simply assume this will translate into a sustained boost to margins for America's steel-makers. For one thing, oil and pipeline companies, along with construction firms and automakers, aren't likely to stay quiet if U.S. steel prices -- which are already high, remember -- are lifted further by protectionist measures. Energy companies can also play the national-security card, and all of them can play the jobs card. As we approach the 100-day mark on the administration, it is fair to say that, so far, pronouncements from the White House should not be taken as gospel in terms of policy outcomes.

Indeed, this gets at a big reason why U.S. Steel's stock plunged so much on Wednesday: Investors had already put too much faith in the power of policy to address the industry's fundamental challenges:

Vote Winner
U.S. Steel's stock was swept up in the Trump rally
Source: Bloomberg

 

Now, they're confronted with U.S. Steel effectively saying "trust me" -- on strategy, investment and the market outlook -- in a manner virtually guaranteed to undermine it.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net