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About the Industry
The steel industry can well be termed the backbone of modern society considering steel’s 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 (GM - Analyst Report), Ford Motor Company (F - Analyst Report), Toyota Motor Corporation and Honda Motor Company (HMC - Analyst Report).
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 America’s 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, 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 China’s 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 will likely be a long time before the industry’s 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.
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 (MT - Analyst Report), AK Steel Holding Corporation (AKS - Analyst Report) and Nucor Corporation (NUE - Analyst Report) -- we find revenues increasing across the board due to higher average steel prices and increase in shipments.
ArcelorMittal, the world’s largest steel producing company, belched out 91.9 Mt in fiscal 2011, representing 6% of the world's steel output. ArcelorMittal’s 2011 sales increased 10% to $94 billion while AK Steel’s 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. ArcelorMittal’s 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 (X - Analyst Report), 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 company’s 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 rate has 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 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 relatively weak 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 China’s 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.
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 (VALE - Analyst Report), Rio Tinto (RTP) and BHP Billiton (BHP - Analyst Report) 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 China’s 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 world’s largest spot iron ore market. With the involvement of major foreign miners, the trading platform’s position can have more influence over the price of the raw material.
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 Steel’s 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.
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 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 world’s biggest miner, hinted at flattening iron ore demand as well as steel growth in China triggering concerns. However, the company believes the steel industry’s long-term story in the country remains intact, underpinned by China’s urbanization and industrialization programs. The company forecasts that the country's annual steel output will still rise by around 60% by 2025.
There are signs of cooling in China’s 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 vast capital outlay on infrastructural development. In this game, its neighbor India is not behind and will likely be a major consumer driving the steel industry.