U.S. Steelmakers' Surprising Strength

Producers are enjoying remarkable pricing power due to a supply shortfall that can't be easily met with imports

Looking for a relatively safe bet in a volatile equities market? Some analysts think steel stocks might be worth a look.

Wall Street analysts are becoming more and more bullish on U.S. steel producers, either increasing their buy ratings or their earnings estimates with prices per ton climbing dramatically since October. The average price of one ton of steel jumped from $545 in December to $665 in February and is already being quoted as high as $800 for May orders.

Indeed, the Standard & Poor's Steel index was up nearly 4% year-to-date through mid-March, vs. a 12% decline in the S&P 500-stock index.

Some fund managers, too, are bulking up on more shares of companies such as U.S. Steel (X), Nucor (NUE), and Commercial Metals (CMC), whose gross margins are more than keeping pace with rising raw material costs due to price hikes.

That the industry is able to hike prices and boost its margins with the economy on the brink of recession seems counterintuitive, to say the least. What's wrong with this picture?

Nothing, say analysts. It's simply the law of supply and demand at work. The steel industry has structural capacity shortage in North America of about 30 million to 40 million tons a year. Imports from foreign steel producers are less likely to make up that shortfall, due to a weaker U.S. dollar and rising freight costs.

Inventories Aren't Climbing as Usual

Low-cost producers from Brazil, Russia, and India would typically be the most logical exporters, but there are multiple reasons why new capacity isn't being added there, from a scarcity of capital due to political risk in Brazil to government bureaucracy and local opposition in India.

Most steel imports are coming from China, which has excess production capacity, but those imports are down an estimated 50% in the past six months. Chinese producers, already burdened by freight costs that can reach more than $150 a ton, now have an added disincentive to export their steel—an export tax imposed by the government in December.

The drop in imports has given U.S. producers remarkable pricing power over the past several months, even in the face of accelerating weakness in demand, as automakers, construction companies, and other steel-consuming industries pull back amid economic contraction.

Falling inventory at suppliers and service centers, down to roughly 2.5 months' worth of supply from an average of 3.2 months over the past three years, have not only buoyed prices but have also extended lead times for steel mills' order books, to 12 from 3 weeks, says Aldo Mazzaferro, an analyst who covers steel stocks for Goldman Sachs (GS) Global Investment Research.

At this stage of the steel cycle, service center inventories would normally begin to climb, since service centers typically rebuild inventories when they drop below 2.7 months' worth of supply. Meanwhile, a more-than-40% hike in spot market prices would usually attract imports, which would then push service center inventories higher, analyst David Gagliano wrote in a Credit Suisse (CS) Equity Research report on Mar. 18. "But this isn't happening, and we are now heading into the seasonally strong second quarter demand period," he wrote.

Inventories at U.S. service centers could remain abnormally low for a prolonged period since global production is already operating near capacity, prices in other countries are still higher than in the U.S., and further depreciation in the dollar makes it even more expensive to ship steel to the U.S., the report said. Gagliano predicted the strong pricing will extend into 2009 and maybe beyond despite a weak end-demand in the U.S.

Weaker Dollar Is a Plus

While U.S. prices have tended to be below the average global price, steel imports have generally come in at discounts to U.S. prices, says Richard McLaughlin, a consultant to the steel industry and managing director of the strategy consulting division of Hatch Associates Consultants in Pittsburgh. That's partly because customers aren't confident about the quality of the steel and also because they are being compensated for taking on the added risk of owning the metal during the four to six months it takes to arrive from offshore suppliers, he says.

But it would be a mistake to think that U.S. producers are taking market share away from foreign producers in any material way, McLaughlin says. Domestic steel manufacturers are operating at about 87% capacity, he estimates.

Much of the supply shortfall in North America gets filled by exports from industrialized regions and countries such as Western Europe, Canada, and Japan, which come to about 10 million to 15 million tons a year. Another 5 million to 10 million tons of imports are supplied by foreign companies such as EvrazHolding Group, a Russian steel conglomerate. Evraz and other companies supply their U.S.-based subsidiaries with semi-finished and finished steel products, says McLaughlin.

Opportunistic exports to the U.S. account for the balance. Large quantities of a type of steel known as rebar come into the West Coast from Asia, for example, because the U.S. lacks ample capacity to make steel plate, which energy companies rely on for their oil wells and pipelines. "There are reasons for those imports. It's relatively stable and reflects longstanding relationships," McLaughlin says.

A lot of the credit for the slight decline in imports from overseas and the modest uptick in U.S. steel exports goes to the weaker dollar, which makes U.S. products cheaper for overseas buyers and makes foreign producers eager to sell to customers outside the U.S. who will pay in stronger currencies than the dollar.

The pricing power U.S. producers currently enjoy could only be dreamed of as recently as six years ago, when smaller producers such as LTV (LTVCQ) and National Steel were in fierce competition for small pieces of a fragmented pie.

M&A as Slump Protection

In the flat-rolled segment, which primarily supplies the automotive and appliance industries, U.S. Steel, Nucor, and Luxembourg-based Arcelor Mittal (MT), which has a big U.S. division, now control more than two-thirds of domestic production capacity, McLaughlin says. "When you have that kind of concentration, it's easier to be more disciplined about pricing. That's not going away."

Besides being a key driver of pricing power, industry consolidation has also been the favored tool for producers to position themselves for economic slumps. Being larger allows producers to more readily absorb excess capacity and cut production if necessary.

Another way that companies are insulating themselves from downturns is by buying some of their former customers, businesses that make paper clips and building materials that are closer to end-user demand. This is more common in so-called long products such as rebar, which is used for construction applications, as opposed to flat-rolled products that go into cars, appliances, and piping.

Nucor has been particularly aggressive in buying rebar fabricators, which make steel mesh used to strengthen concrete used in roads and bridges, as well as companies such as Vulcraft and Magnatrax, which make steel building systems, including siding and roofing products, McLaughlin says.

Commercial Metals is one of Craig Hodges' top holdings in the $780 million multi-cap Hodges Fund, which he co-manages. The company, which makes rebar for the construction industry using scrap steel, is well-run and very good at managing its cash, Hodges says. It saves money by using scrap instead of iron ore and earns extra margin on the scrap it buys through its trading department, he says.

Hodges has also been stocking up on U.S. Steel for the past few months, since seeing steel prices move up so dramatically. He expects "tremendous margins" when steel prices reach $800 a ton. Last week, JPMorgan Securities (JPM) raised its first-quarter profit estimates for the North American carbon steel producers by an average of 13%, betting that price hikes will help producers widen margins substantially.

Raising Second-Quarter Forecasts

Analyst Michael Gambardella at JPMorgan says that over the next several quarters he prefers mini-mills such as Nucor, which should face lighter energy costs than the integrated manufacturers. (JPMorgan or its affiliates received compensation for investment banking services from Nucor within the past year and expects to seek compensation for these services from Nucor in the next three months.)

The mini-mill portion of the industry, which includes Nucor, has always made a lot of money due to lower costs overall, says Eric Klenz, vice-president of institutional banking at KeyBanc Capital Markets in Cleveland. "They're newer, the plant layouts are better, and they have a more efficient process," he says. And because they use scrap metal, whose prices haven't risen as fast as those of iron ore and metallurgical coal, they do well when other raw material and natural gas prices are high.

And metal spreads could easily head even higher as mills have announced several price hikes for hot rolled sheet through May that will take them 63% above last August's lows, Gambardella wrote in his Mar. 17 note. He also expects all carbon steel companies to significantly raise their second-quarter profit forecasts when they report first-quarter results.

Nucor shares are up 19% since the beginning of the year, while Commercial Metals shares have stayed fairly flat year-to-date. U.S. Steel shares are up less than 1% since Jan. 2 but have recovered from a low of $92 in early February.

The U.S. steel industry faces a bigger potential threat over the longer term. It would make sense for China, whose main advantage is cheap labor, to shift over time from exporting steel products for manufacturers to exporting finished goods containing steel such as paper clips, nails, and cars, which contain more labor per unit, says McLaughlin. "That will erode our steel [finished goods] markets," but that won't happen in the next few years, he says.

Currently there's about 5 million tons of additional capacity being built in the U.S., but most of that will be in a finishing plant that the German manufacturer Thyssen is building in Alabama. That plant will have guaranteed supply of slab from Brazil, where Thyssen has a joint venture with Brazilian iron ore producer Vale (RIO).

If freight rates moderate and the dollar strengthens, you can expect to see exports from low-cost regions pick up. The extent to which additional capacity gets built in the U.S. will depend on how long the dollar stays weak and how high freight rates go, says McLaughlin.

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