Metals and Mining Review - Sept. 2010

Overview

The Metals & Mining Industry encompasses the extraction (mining), as well as the primary and secondary processing of metals and minerals such as aluminum, gold, precious metals, coal and steel. The industry is oligarchic in structure, with a few producers accounting for the lion’s share of the output. The largest segment of the global metals market is iron and steel, followed by aluminum.

The iron and steel segment comprises more than half the industry in terms of volume. This industry includes metal ore exploration and mining services, iron and steel foundries for smelting, rolling, forging, spinning, recycling, stamping, polishing and plating of iron and steel products such as pipes, tubes, wire, spring, rolls and bars. Luxembourg-based ArcelorMittal (MT), the world’s largest steel producing company, produced 73.2 million tons in 2009, representing 6% of the world's steel output.

The precious metal and mineral industry consists of companies engaged in the extraction and primary processing of gold, silver, platinum, diamond, semi-precious stones, uranium and other rare minerals and ores, along with the cultivation of pearls. Anglo American Plc., the largest gold producer by market capitalization, dominates the gold industry.

Historically, the automotive and construction markets have been the largest consumers of metals, accounting for more than 50% of total demand. Other metal consumers include energy, electrical equipment, agricultural, domestic and commercial equipment and industrial machinery. Large automakers such as General Motors Corporation ( GM - Analyst Report ) , Ford Motor Company (F), Toyota Motor Corporation (TM) and Honda Motor Company (HMC) are big consumers of metals, chiefly steel and aluminum.

Outlook

The global metal industry is cyclical, highly competitive and has historically been characterized by overcapacity (excess of supply over demand). Metal producers are subject to cyclical fluctuations in London Metal Exchange prices, general economic conditions and end-use markets. Individual company profitability depends on volume and operating efficiency. Large producers with huge resources are able to discover, develop new deposits and boost reserves, while smaller ones own few mines and concentrate on them.

Mergers and acquisitions (M&A) has historically been a critically important growth strategy for metal companies. While the slow economic recovery is a significant factor in short-term decisions regarding M&A activity, mining companies expect to make acquisitions over the next three years. The M&A activity is also supported by higher metal prices that have strengthened the financial positions of many mining giants.

Geographically, the Asia-Pacific region is witnessing higher production and consumption of metals, especially China and India. Per capita consumption levels in both these countries are calibrating to U.S./European levels, which could -- theoretically, at least -- double metal demand in the longer term. In recent years, capacity growth in China has significantly exceeded the growth in market demand. A continuation of this unbalanced growth trend or a significant decrease in China’s rate of economic expansion could result in the country increasing its metal exports.

Yet, we expect global metal demand to improve in the long term with the recovery of user industries. Developed regions such as the US and Europe are showing signs of recovery. Despite some concerns about its sustainability, China is expected to remain the largest consumer of metals in the future.

Metals in Detail:

Steel

As the major shareholder (about 60%) in the metals market, the steel industry was strongly affected by the global economic downturn. Massive over-capacity is one of the major headwinds for steel, which continues to weigh on prices. Moreover, the industry has witnessed a number of trade disputes involving the U.S., in particular, the imposition of tariffs of up to 30% on imported steel. Rising raw material prices -- iron ore and coal (metallurgical) -- are also a major concern for the steel industry. AK Steel Holding Corporation (AKS), for instance, expects a 65% rise in benchmark iron ore prices in the near term.

Demand in key metal consuming industries such as autos, shipbuilding and construction, continues to remain weak, forcing global metal producers to slacken output levels. While utilization levels have improved recently, steel makers were operating at less than 50% capacity last year. U.S. Steel Corporation ( X - Analyst Report ) -- the eighth largest steel producer in the world, the largest integrated steel producer headquartered in North America and one of the largest integrated flat-rolled producers in Central Europe -- slashed production by almost 37% in 2009, while Korean steel maker POSCO ( PKX - Analyst Report ) had to scale down output by about 10.9%.

Steel demand is reviving slowly, with improving end-markets on the back of a recovering global economy. Steel giant ArcelorMittal and U.S. Steel are restarting furnaces or are planning to in the near future. Industry steel mill utilization rates have increased to above 70%. The current high in steel demand helped reverse losses for the third largest steel maker Steel Dynamics Inc. ( STLD - Snapshot Report ) and the largest recycler of steel scrap in the U.S., Nucor Corporation ( NUE - Analyst Report ) .

Steel Dynamics’ second-quarter earnings of 22 cents reversed losses of 8 cents recorded in the year-ago quarter. Similarly, Nucor reported a profit of 29 cents per share in the second quarter of 2010, in contrast to a net loss of 43 cents per share in the same quarter of 2009. The World Steel Association expects a 10.7% increase in global steel demand this year and a further 5.3% gain in 2011 compared to 2010 level. The impetus is mostly expected from a surge in Chinese steel demand, which is likely to grow 6.7% to 579 million tons in 2010.

But despite these improving trends, average selling prices are still struggling, as the pace of recovery in the U.S. and global markets is slow at best. The ongoing slowdown has marred prospects in the housing and construction sectors in the near term. AK Steel Holding Corporation (AKS), Nucor and Steel Dynamics have provided a bleak overall near-term price outlook, although they expect end-markets to stabilize.

Collectively, AK Steel, Nucor and ArcelorMittal have a Zacks #4 Rank (Sell) for the short-term (1 to 3 months), while we maintain our Neutral recommendation in the long term for all three, given the outlook for steel. However, Steel Dynamics holds a Zacks #5 Rank (Strong Sell) and has a long-term Underperform recommendation driven by a very weak earnings outlook.

Gold

The outlook for investment is positive overall, with absolute levels of demand likely to remain well supported by continued economic and currency uncertainty, inflation concerns and the search for diversification. In 2009, global gold supply exceeded demand by 15%, reflecting favorable gold prices. However, based on the marginal improvement in the economic environment in 2010, the World Gold Council expects an increase in demand for jewelry, which in turn will help global gold demand. A potential shot in the arm for the precious metal is the expected increase in central bank gold holdings, primarily as a diversification play.

The value and wealth preservation attributes of gold continue to attract investors and consumers. Jewelry and investment demand in non-western markets continues to rebound from the low levels in 2009, while industrial demand has started to recover in response to an improvement in economic conditions. India, which alone consumes nearly 45%−50% of the world gold production, should drive demand for gold along with China in the next half of 2010. Chinese gold demand is expected to double in 10 years. Concerns over the recent European debt crisis have also led to strong buying of gold coins, bars and gold exchange traded funds in particular.

We saw gold demand and prices strengthen in the first six months of 2010, a trend that is likely to remain in place in the rest of the year. Higher prices bode well for gold producers, which should benefit giants such as Barrick Gold ( ABX - Analyst Report ) , Agnico-Eagle (AEM) and Goldcorp Inc. ( GG - Analyst Report ) . However, gold producers Newmont Mining ( NEM - Analyst Report ) and Kinross Gold Corporation ( KGC - Analyst Report ) suffer from lower ore grades that subdue production levels, increase mining costs and offset the benefits of rising gold prices. Overall, the stock prices of gold producers are not expected to benefit much from this overall favorable commodity-price backdrop. This is reflected in our overall neutral view on the space.

Aluminum

The aluminum industry is highly cyclical, with prices subject to worldwide supply and demand forces along with other influences. Aluminum prices at the LME have plunged around 20% from their April highs to $1,969 per ton. The greatest risk for aluminum producers would be a further decline in aluminum prices.

However, we expect aluminum demand to increase in the long term, outstripping supply growth with the improving end-markets. Leading aluminum producers such as Alcoa Inc. ( AA - Analyst Report ) , Paramount Gold and Silver Corporation (PZG) and Aluminum Corporation of China (ACH) should benefit from the improving demand outlook.

In the medium to long term, Alcoa expects aluminum consumption to improve globally with improving automotive and packaging industries, one of the key consumer markets. Aluminum is widely used for packaging, beverage cans, food containers and foil products. The automobile market is also becoming increasingly aluminum intensive, benefiting from the recyclability and the light weight of the metal.

Alcoa now expects demand to grow about 10% to 12% in 2010. The aluminum giant predicts Chinese aluminum consumption to jump 21% and about 6.5% globally (excluding China) in 2010. Currently, Alcoa, Paramount Gold and Silver and Aluminum Corporation of China hold a Zacks #3 Rank (Hold) supported by a long-term Neutral recommendation.

Copper

Copper prices started on a downtrend in early July 2010 and are expected to remain volatile in the near term, which could be a major headwind for copper companies. Revenues and margins for copper producers like Freeport-McMoRan Copper & Gold Inc. ( FCX - Analyst Report ) and Southern Copper Corporation ( SCCO - Snapshot Report ) were affected by the recent fall in copper prices and volumes, primarily driven by the slowing economic activities in China.

However, the long-term view is favorable. Market conditions are expected to be positive for copper in the next couple of years due to higher consumption of the metal in the developing nations. Copper companies that have a high leverage to copper prices will benefit immensely from the potential demand in copper in the developing markets.

The near-term headwinds led to the short-term Zacks #4 Rank (Sell) and Zacks #3 Rank (Hold) on Freeport and Southern Copper, respectively. However, both companies have a Neutral recommendation on a positive long-term outlook.