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, etc. 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, and 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 Co. (F - Analyst Report), Toyota Motor Corporation (TM - Analyst Report) and Honda Motor Co. Ltd. (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, the U.S. 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. In the first quarter of the current fiscal year, world crude steel production was 377.3 Mt, which improved to 388.6 Mt in the second quarter.
China retained its status as the largest steel producing country, yielding almost half of the global output at 47%, growing 1.7% year over year in the second quarter. Japan, the second largest producer, posted a 4.3% increase. The United States held the third position, producing 23 Mt of crude steel in the quarter, 7.5% higher than second quarter of 2011 and comprising 6% of the total global output. Asia improved 2.3% to 251.9 Mt, while Europe dipped 5.4%.
Performance: Before & After
After enjoying a sturdy growth for most of the past decade, the steel industry suffered a setback 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 the global economic recovery.
The growth witnessed in 2011 was noteworthy considering the widespread headwinds facing the industry: the ongoing Eurozone sovereign debt crisis, earthquakes in Japan, the political unrest in the Middle East resulting in a surge in oil prices, and the tightening of government monetary measures in many emerging nations.
Demand for steel has benefited from 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.
The automotive and construction markets have historically been the largest consumers of steel. The automotive sector is showing significant promise. In February 2012, total motor vehicle sales reached their highest level in the past 4 years at 15.1 million SAAR (Seasonally Adjusted Annual Rate). In May, many auto manufacturers made their best Memorial Day sales in over five years.
In June, total motor vehicle sales were at 14.1 million, improving from 13.8 million in May. Domestic sales rose from 10.6 million SAAR in May to 11.1 million SAAR in June, almost close to the highest level of 11.4 million attained in February.
The outperformance was somewhat helped by lower gasoline prices, which made domestic trucks more attractive and increased from 5.92 million SAAR in May to 6.14 million SAAR in June, the highest number of domestic trucks sold since March 2008. For the first half of 2012, sales averaged 14.3 million SAAR. We believe these upbeat numbers bode well for the steel industry.
On the contrary, the construction sector has been a drag on the steel companies’ earnings. 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 48.4 in April 2012, dipping further to 45.8 in May and 45.9 in June.
As a reminder, the March reading of 50.4 was significant, as any score above 50 indicates an increase in billings. After hovering above 50 for five consecutive months, the index dipped to negative territory from April. This points to a potential weakness in non-residential construction, with little hope of a near-term recovery.
As per the U.S. Department of Commerce, housing starts increased 6.9% to a seasonally adjusted annual rate of 760,000 in June 2012 from the revised rate of 711,000 in May 2012 and 23.6% above June 2011. Though the June results have been the strongest since October 2008, it is approximately half the 1.5 million annual pace that economists consider normal.
Building permits in June were at a seasonally adjusted annual rate of 755,000, though 3.7% lower than the May figure of 784,000, 19.3% above the June 2011 number. In fact, building permits issued in May jumped to the highest level in the past four years.
To surmise, record-low mortgage rates, rising rents and reduced prices of properties are luring buyers. 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.
How Well Did Steel Stocks Fare?
Reflecting on the first quarter results of the steel companies in our coverage – ArcelorMittal (MT - Analyst Report), United States Steel Corp. (X - Analyst Report), Nucor Corporation (NUE - Analyst Report) and AK Steel Holding Corporation (AKS - Analyst Report) – we see revenues benefitting from higher average steel prices. On the volume front it was a mixed bag as ArcelorMittal and U.S. Steel witnessed a rise, while Nucor and AK Steel suffered declines. Revenues increased at all the companies except AK Steel. However, we note margin compression across the board.
As we look into second-quarter results, Nucor’s volumes saw a lift but a fall in average prices constrained its revenues. Profit was affected considerably by an oversupply in the industry and a gloomy European market. The rest of the companies have yet to release their second quarter numbers.
Let’s have a preview of what the companies are expecting in the second quarter. Arcelor Mittal expects steel shipments in the second quarter of 2012 to be at similar levels with the first quarter. The Mining segment is expected to benefit from seasonally higher iron ore shipments. The company forecasts that all of its segments will demonstrate improved underlying profitability in the second quarter. It expects that EBITDA for the first half of 2012 will be higher than the first half of 2011. ArcelorMittal anticipates its own iron ore and coal production to increase by approximately 10% in 2012.
U.S. Steel expects all three of its segments to report positive results in the second quarter with total segment results in line with the first quarter. Improvement in average realized prices is expected to show in the next quarter with its European segment expected to report positive income.
AK Steel has provided a muted guidance for the quarter in a range of 4–6 cents per share, well below last year’s earnings of 32 cents in the wake of macroeconomic weakness and falling spot prices. The company expects shipments to be slightly higher than the first quarter of 2012 while average prices are expected to remain flat with the first quarter.
Now, what will be the exact picture in the upcoming results? The U.S. steel market is plagued by oversupply and increased imports. Although Chinese steel production, which was responsible for causing the glut to some extent, has somewhat slowed down, supply in the steel market still overshadows demand, primarily driven by weakness in the construction industry.
Increasing domestic imports along with oversupply in the industry due to a ramp-up of operations by other steelmakers, is putting pressure on prices. A recent fall in scrap prices has further put pressure on steel pricing. We expect weak pricing to weigh on second quarter results. Furthermore, the European debt crisis and its potential global impact remain an overhang on the steel industry.
Given the scenario in Europe, ArcelorMittal, the world's largest steelmaker by volume and Europe's largest steelmaker, decided to idle five of its 25 blast furnaces in Europe and announced the extended idling of a number of facilities. The company will continue to align its steel growth projects to match demand situations.
In addition, the company’s focus on its mining business given its more attractive returns has resulted in some planned steel investments being deferred. To reduce its exposure to Europe, the company has also sold its 24% share in European energy company Enovos International.
Industry Capacity & Demand/Consumption Dynamics
World crude steel capacity utilization ratio inched up to 80.4% in June 2012 from 79.7% in May, but dipped 2.5 percentage points from June 2011.
As per the data released by the U.S Department of Commerce, U.S. capacity utilization ratio in April 2012 was at 80.9%, 9% above the April 2011 level and the highest rate since September 2008. Though the capacity utilization rate has increased significantly by 98% from the lows seen in April 2009, it still remains below historical averages.
In the U.S., apparent consumption, which is used to measure domestic demand for steel, stood at 8.7 Mt in April 2012, up 0.4% from the sequentially preceding month. When we compare it with the trough experienced in April 2009, demand was up a considerable 110%.
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 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 in the automotive, appliance and other industrial segments while construction still 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.
Despite the price improvement in first-quarter 2012, there has been a slump in pricing in the second quarter due to a glut in imports, oversupply in the market from zealous steelmakers, weak demand in Europe and tempering growth in Asia. A resumed downturn in steel prices would materially and adversely affect the margins for the second quarter. 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 necessitate 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 that 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 U.S. 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 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 S.A. (VALE - Analyst Report), Rio Tinto Plc (RIO) and BHP Billiton Ltd. (BHP - Analyst Report), having significant pricing power. The risk lies in further consolidation among raw material suppliers.
In March, Vale, Rio Tinto and BHP Billiton signed agreements to sell iron ore through China’s new spot trading platform. The platform 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.
Recently, Nucor completed the acquisition of Skyline Steel, a steel-foundation manufacturing and distribution subsidiary of ArcelorMittal, for approximately $605 million.
Skyline Steel has been distributing Nucor’s piling products for over 20 years and has been a key customer of H-piling and hot rolled sheet piling from Nucor-Yamato Steel. Through the acquisition, Nucor aims to integrate Skyline into its system and make it a more valuable downstream customer of coiled plate and sheet products. In addition, the company expects the technological know-how of both the companies to help them with innovative solutions for the construction industry.
Skyline has an impressive distribution network serving the U.S., Canada, Mexico and the Caribbean markets, providing solutions for application in heavy civil construction, marine construction, underground commercial parking, storm protection, bridge and highway construction and environment containment projects in the infrastructure and construction industries. This is a smart move for Nucor towards inorganic growth since Skyline’s excellent network will enable it to expand in North America.
Going forward, the abatement of the Eurozone crisis, recovery in the U.S. 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&A.
Steel Usage Forecasts
The World Steel Association projects global steel usage to rise 3.6% in 2012, a sharp deceleration from 2011’s 5.6% growth. This reflects continuing slowdown of Chinese steel demand and Eurozone debt crisis uncertainties. Questions about the U.S. growth outlook also loom on the horizon.
China’s steel use in 2012 is estimated to grow 4% to 648.8 Mt, following 6.2% growth in 2011. The slackening is due to the economy entering a less steel-intensive growth phase as a result of the government’s efforts to rebalance the economy and restrain the real estate bubble. After a weak performance in 2011, India is expected to grow by 6.9% to reach 72.5 Mt.
Apparent steel use in the U.S. is forecast to grow 5.7% in 2012. In Central and South America, apparent steel use will attain a historical high of 49.1 Mt, up 6.8% in 2012. Brazil is expected to return to positive growth. Japan’s steel use is expected to drop 0.6% to 63.7 Mt in 2012 due to the impact of exchange rate appreciation in spite of the reconstruction efforts following the March 2011 earthquake. Steel usage in the European Union is expected to decline by 1.2% to 150.9 Mt in 2012 as sovereign debt problems persist.
In 2013, world steel demand is expected to increase 4.5% to approximately 1,486 Mt. China’s steel usage is expected to grow at 4% to 674.8 Mt from 2012 projections. India is expected to pick up pace and grow 9.4%, triggered by urbanization and surging infrastructure investment. In 2013, the steel use in the U.S. is envisioned at 99.5 Mt, recording 5.6% growth. Brazil is expected to grow 6.7% to reach 52.5 Mt in 2013. Japan is expected to decline further by 2.2% to 62.3 Mt, comprising 77% of the 2007 level. Europe is however expected to record a modest recovery of 3.3% to 155.8 Mt in 2013.
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 been further exacerbated 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 U.S. 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.
However, there are signs of moderation in China’s real estate sector, which accounts for almost half of the total steel demand in the country. China has 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. However, we believe the steel industry’s long-term story in the country remains intact, underpinned by China’s urbanization and industrialization programs.
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 construction 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.
However, second quarter results will face headwinds in the form of low prices due to overcapacity and surge of imports. Slowing growth in China, the largest steel producer, and the sticky situation in Europe will add to near-term headwinds.