Steel Industry Stock Outlook - March 2012 - Yahoo! Finance

8/13/2019 Steel Industry Stock Outlook - March 2012 - Yahoo! Finance

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Steel Industry Stock Outlook - March 2012

By Zacks Equity Research | Zacks Wed, Mar 28, 2012 4:49 PM EDT

About the Industry

The steel industry can well be termed the backbone of modern society considering steels varied uses, be it in

construction, transport, electrical appliances, food packaging and the like. In terms of its composition, steel is an alloy of

iron and carbon containing less than 2% carbon and 1% manganese and small amounts of silicon, phosphorus, sulfur and

oxygen.

Steel products are classified into four broad categories: flat steel products, long steel products, scrap and semi-finished

products. Flat products include plates, hot-rolled strip and sheets, and cold-rolled strip and sheets. The long steel product

category includes wire rods, beams, reinforced bars and merchant bars. The products under both these categories are

rolled from steel slabs, which are considered as unfinished or semi-finished products that are generally not sold.

The world steel industry is a large one. According to the World Steel Association, world crude steel production was a

record 1,527 million tons (Mt) in 2011. However, despite its size, the steel industry remains relatively fragmented. The

industry is highly cyclical and intensely competitive.

A Look into Major Consumer Markets

Historically, the automotive and construction markets have remained the largest consumers of steel, absorbing more than

half of the total steel produced. The industry caters to large automakers such as General Motors Company(NYSE:GM

- News), Ford Motor Company(NYSE:F- News), Toyota Motor Corporation(NYSE:TM- News) and Honda

Motor Company(NYSE:HMC- News).

Houses, buildings, skyscrapers and bridges rely on steel for their strength. Other steel consuming industries include

appliances, agricultural implements, converters, containers, energy, electrical equipment and industrial machinery.

Over the last few years, China has emerged as the major consumer of steel. Ranked on the basis of consumption, United

States follows next with Japan, India and South Korea in tow.

Global Production Numbers

As mentioned above, world crude steel production was a record 1,527 Mt in 2011, outperforming the 2010 record of 1,414

Mt, a 6.8% jump. China continues to be the largest steel producing country, generating almost half of the global output at

46%, and growing 8.9% year over year. Japan posted a 1.8% decline affected by last year's earthquake. The United States

enjoyed the third position, producing 86.2 Mt of crude steel, 7.1% higher than 2010 and comprising 6% of the total global

output.

North Americas crude steel production was 118.9 Mt, an increase of 6.8% on 2010. Asian production grew 7.9% to 988

Mt and Europe rose 4.6% to 329 Mt. Among the top 10 steel producing countries, as per the World Steel Association,

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Turkey outperformed the rest on the basis of year-over-year growth with a 17% surge in production to 34 Mt. South Korea

followed with a 16% clip to 68.5 Mt.

January figures from the ongoing fiscal show a downtrend of 7.8% year over year aggregating to steel production of 117 Mt

but consistent with December 2010 levels. Chinese production dropped 13% to 52 Mt while Japan posted an 11% drop to

8.6 Mt. In Asia, overall decline was noted at 11.4% to 73.8 Mt and Europe dipped 2.7% to 17.3 Mt. The United States fared

better with an annual climb of 5.7% to 7.6 Mt.

Performance: Before & After

After enjoying a sturdy growth for most of the past decade, the steel industry suffered a decline in 2008 due to the

recession, as consumers utilized existing inventories rather than buying new stock. However, the industry turned around

in late 2009 and continued to grow in 2010 and 2011, in tandem with global economic activity.

The growth witnessed in 2011 was noteworthy considering the widespread headwinds facing the industry: the ongoing

euro area sovereign debt crisis, earthquakes in Japan, the political unrest in the Middle East which resulted in a surge in

oil prices, and the tightening of government monetary measures in many emerging nations.

Demand for steel has benefited from the spurt of growth witnessed in the developing economies that helped counter the

sluggishness in developed economies. Asia, particularly China, continued to be the principal driver of growth. Demand for

steel products nonetheless remains below pre-recession levels. Questions about Chinas growth going forward also add an

element of uncertainly to the outlook.

In 2010, the automotive industry began to recover from the effects of the recession. The automotive sector is showing

significant promise. In February 2012, total motor vehicle sales reached the highest level since February 2008, at 15.1

million SAAR (Seasonally Adjusted Annual Rate). For the first two months of 2012, sales have averaged 14.6 million

SAAR, outperforming the Street expectations. We believe these upbeat numbers bode well for the steel industry.

The construction sector has been a drag on the steel companies earnings. Unlike the automotive sector, the housing

industry struggled in 2011 and continues to be severely impacted by the after effects of the recession. Housing starts in

the United States in 2011 remained near historically low levels for the third consecutive year compared to pre-recession

activity.

According to the data released by the U.S. Department of Housing and Urban Development, housing starts increased

34.7% to a seasonally adjusted annual rate of 698,000 in February 2012 from February 2011. Building permits in

February were at a seasonally adjusted annual rate of 717,000, 34.3% above the February 2011 figure of 534,000.

These figures provide a glimmer of hope that U.S. residential construction is finally on the road to recovery. But it willlikely be a long time before the industrys conditions can be called normal again.

We also see some early signs of recovery in non-residential construction. According to the American Institute of

Architects, the architecture billings index, an economic indicator that provides an approximately nine to twelve month

glimpse into the future of non-residential construction spending activity, was 51.0 in February 2012.

The index has remained over 50 for the fourth consecutive month, a sure indicator of an overall rise in demand in the

construction industry. The optimism is seen across most regions of the country and the major construction sectors.


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However, given the uncertainty in the markets, we are still a little skeptical about the sustainability of the momentum. We

thus expect soft-to-very-moderate near-term growth in demand in this sector as clients exercise caution in pursuing new

projects and face difficulty in accessing financing for projects.

How Well Did the Steel Stocks in Our Coverage Fare?

Reflecting on the 2011 results of the steel companies in our coverage --ArcelorMittal (NYSE:MT- News),AK Steel

Holding Corporation (NYSE:AKS- News) and Nucor Corporation(NYSE:NUE- News) -- we find revenuesincreasing across the board due to higher average steel prices and increase in shipments.

ArcelorMittal, the worlds largest steel producing company, belched out 91.9 Mt in fiscal 2011, representing 6% of the

world's steel output. ArcelorMittals 2011 sales increased 10% to $94 billion while AK Steels sales climbed 8% to $6.5

billion. Nucor recorded sales increase of 21% to reach $20 billion.

In terms of profitability, Nucor stood tall with its fiscal 2011 EPS of $2.45, almost six fold the 42 cents earned in 2010.

ArcelorMittals EPS in fiscal 2011 plummeted 31% to $1.19. AK Steel reversed its year-ago loss to earn 9 cents (excluding

special items) in 2011. United States Steel Corp(NYSE:X- News), though still in red, narrowed its fiscal 2011 loss per

share to 47 cents from the year-ago loss of $3.36.

The steel companies expect volumes to improve in 2012 on recovering demand from improving end-markets, backed by a

recuperating global economy. They expect operating results to significantly improve from 2011 levels mainly driven by

improved average realized prices and higher shipments. Steel consumption is expected to grow in the automotive,

transportation, energy, industrial and the agricultural sectors.

However, the European debt crisis and its potential global impact remain an overhang on the steel industry. ArcelorMittal

has idled 5 of its 25 blast furnaces in Europe. The company will continue to align its steel growth projects to match

demand situations. Furthermore, the companys focus on its mining business given its more attractive returns has

resulted in some planned steel investments being deferred.

Currently, Nucor, United Steel and AK Steel retain a Zacks #3 Rank (Hold) for the short term (1 to 3 months) that

corresponds with our Neutral recommendations in the long term. ArcelorMittal retains a Zacks #4 Rank (Sell) and we

have recently downgraded our long-term recommendation from Neutral to Underperform.

Industry Capacity & Demand/Consumption Dynamics

World crude steel capacity utilization ratio inched up 0.5 percentage point to 71.3% in January 2012 from December 2011

but dipped 9.6 percentage points from January 2011. U.S. capacity utilization ratio in January 2012 was a forty-month

record high at 77.6%, an increase from the December 2011 utilization rate of 75.2%. Though the capacity utilization ratehas increased significantly from the April 2009 low level, it still remains below the historical averages.

In the United States, apparent consumption, which is used to measure domestic demand for steel, stood at 8.6 Mt in

January 2012, up 15.6% year over year and 11.6% from the sequentially preceding month. When we compare it with the

trough experienced in April 2009, demand was up a considerable 86.1%.

Price Trends Seen So Far

Steel prices are generally volatile, in line with the highly cyclical nature of the global steel industry. Following an extended


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period of rising prices, steel prices plunged during the financial and economic crisis of 2008 due to the sudden drop in

demand. This was further intensified by massive industry destocking as customers cleared their steel inventories. Steel

producers in their turn suffered the worst casualties, recording lower revenues and margins, and even had to write down

finished steel and raw material inventories.

Steel prices saw a recovery in late 2009 that followed into 2010 but remained below the pre-financial crisis level. In 2011,

steel prices remained volatile, increasing in the first half on the back of strong demand, higher raw material costs,

improved activity for the automotive, appliance and other industrial segments though construction remained relativelyweak in many regions.

Prices fell in the second half as demand decreased due to uncertainty surrounding the Euro-zone sovereign debt crisis.

The fourth quarter particularly exhibited weakness due to a sharp drop in iron ore prices in October and as customers

renewed destocking considering the uncertain economic environment.

So far in 2012, the steel industry is seeing some price hikes. We feel that the recovery in pricing momentum will be driven

by a reviving economy, no further crisis in the Euro-zone and a rebound in construction activity in the developing

countries, in particular China, India and South Korea.

A Closer Look at the Factors Affecting Steel Prices

Rising raw material prices:The steel industry consumes substantial amounts of raw materials including iron ore, coking

coal and coke besides requiring a lot of energy. Increases in raw material prices necessitates a corresponding increase in

steel selling prices.

However, the situation gets tricky in the wake of lower demand, when it becomes increasingly challenging to pass on raw

material price hikes to consumers. Historically, energy prices have varied significantly. This trend is expected to continue

due to market conditions and other factors beyond the control of steel companies.

Overcapacity and fluctuation in steel imports-exports: The steel industry has always suffered from overcapacity. Steel

consumption in China and other developing economies has increased at a rapid pace. In response, steel companies have

ramped up their steel production capability with scope for increasing further capacity.

Steel production capability, particularly in China, appears to be in excess of Chinas domestic market demand.

Considering China is the largest steel producer, the export of the surplus steel at subsidized prices to other markets casts

a major impact on world steel trade and prices. Consumers in the United States are importing cheaper steel from China,

forcing domestic steel producers to sell at lower prices, and sometimes even at a loss. The U.S. government has thus been

imposing anti-dumping duties on Chinese steel imports.

Economic recovery: Steel prices are generally sensitive to changes in global and local demand, which are in turn

governed by worldwide and country-specific economic conditions and available production capacity. Although the steel

industry has been recovering since the 2008 recession, the recent Euro-zone sovereign debt crisis added to the still-

tentative recovery in the developed world has again created a lot of uncertainty in the market. This has resulted in many

countries suspending investment in infrastructure and other industries, impacting steel prices.

Threat from substitutes:Steel has many substitutes like aluminum, cement, composites, glass, plastic and wood. A shift

toward these or other substitutes, whether due to lower costs or government mandates on the basis of environmental or

other reasons, would significantly impact prices and demand for steel products.


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Raw Material Trends

The primary inputs for the steel industry are iron ore and coking coal, along with coke, scrap, alloys and base metal. The

industry also uses large volumes of natural gas, electricity and oxygen in its steel manufacturing operations.

Iron ore prices have remained relatively high in 2009, which continued in the first half of 2010. However, prices fell in

the second half of 2010. In 2011, iron prices were up most of the year before prices fell in October.

The iron ore industry is highly concentrated with only three major players:Vale(NYSE:VALE- News), Rio Tinto

(:RTP) and BHP Billiton(NYSE:BHP- News) having significant pricing power. The risk lies in further consolidation

among raw material suppliers.

In a recent development, VALE, Rio Tinto and BHP Billiton will soon sign agreements to sell iron ore through Chinas new

spot trading platform. The platform will officially start operating in the first half of the year and has been set to strengthen

pricing power and improve transparency.

China is the largest iron ore importer, and also has the worlds largest spot iron ore market. With the involvement ofmajor foreign miners, the trading platforms position can have more influence over the price of the raw material.

Consolidation

Mergers and acquisitions (M&A) have remained an important growth strategy in the steel industry. M&A activities

prevent additional steel capacity, providing production efficiency and economies of scale. The biggest example is Mittal

Steels acquisition of Arcelor in 2006. The Tata Steel and Corus merger in 2008 is another instance of industry

consolidation.

After a lull during the global economic downturn of 2008-2009, M&A activity of various steel and mining players,including Chinese and Indian companies, has quickly picked up.

Consolidation has been primarily driven by the urge to increase global scale and operations, and access new markets. The

industry is likely to see more M&A activity in the coming years as the industry players prepare themselves for a recovery

in the long run. Further, steel makers are now focused on acquiring or are considering acquiring mines or stakes in mines

to secure raw materials at more competitive prices.

Going forward, the abatement of the Euro-zone crisis, recovery in the US economy and developments in the Chinese real

estate and construction sector will determine the fate of such deals. However, given the prevailing uncertainty, we expect

moderate growth in M&As.

Challenges Ahead

Overcapacity:Even though demand has increased overall in the past two years, growth in steelmaking capacity is still

ahead of demand and remains a significant challenge for the industry. This has further worsened by the European

sovereign debt crisis which has put a bar on investments in large scale projects in Europe and reduced capital for growth.

The uncertain global economy:The steel industry was significantly affected by the global economic crisis in 2008. Even

though it is recovering, demand has still not reached pre-recession levels. The debt crisis in Europe remains a concern


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and the United States has had to resort to quantitative easing to thwart sluggish demand.

The saving grace is the spurt of growth witnessed in the developing economies that helped counter the sluggishness in the

developed economies. Asia and particularly China continued to make up for the stalemate in Europe and North America.

Earlier this month, BHP Billiton, the worlds biggest miner, hinted at flattening iron ore demand as well as steel growth in

China triggering concerns. However, the company believes the steel industrys long-term story in the country remains

intact, underpinned by Chinas urbanization and industrialization programs. The company forecasts that the country'sannual steel output will still rise by around 60% by 2025.

There are signs of cooling in Chinas real estate sector, which accounts for almost half of the total steel demand in China.

Earlier this month, China cut its 2012 growth target to an eight-year low of 7.5%. A slowing Chinese economy will have a

negative impact on infrastructure and construction spending and on the steel industry as well.

Dependence of Margins on Raw Material Prices:The steel companies margins are dependent on the extent to which

changes in raw material prices are passed through to steel selling prices. The time lag between the raw material price

change and the steel selling price change, and the date of the raw material purchase and the actual sale of the steel

product in which the raw material was used are also important factors affecting margins.

To Sum Up

All said, we believe growth in the industry will be tempered by concerns regarding the continued financial uncertainty

and volatility and the quintessential issue of overcapacity. Global steel demand will improve gradually in line with the

recovery in the user industries, automotive and residential construction. While the automotive sector holds promise, we

have yet to see a sustained recovery in the residential sector, to enforce a more positive outlook.

Emerging and developing economies will continue to drive growth while recovery of steel demand in the developed world

will be slow. Despite concerns regarding a slowing economy, demand in China will grow in the long term given the vastcapital outlay on infrastructural development. In this game, its neighbor India is not behind and will likely be a major

consumer driving the steel industry.

Read the analyst report on GM

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Read the analyst report on TM

Read the analyst report on HMC

Read the analyst report on MT

Read the analyst report on AKS

Read the analyst report on NUE

Read the analyst report on X

Read the analyst report on VALE

Read the analyst report on RIO

Read the analyst report on BHP

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Steel Industry Stock Outlook - March 2012 - Yahoo! Finance