The steel industry is poised to benefit from solid demand in the United States and emerging markets like India. However, steel stocks are plagued with equity market volatility and a host of other broader factors. Below, we discuss some of the key reasons and what investors in the steel sector should be wary of in the coming months and years.
Going by the EV/EBITDA multiple (a preferred valuation metric for cyclical industries like steel) the steel-pipe and tube and steel specialty have a trailing 12-month EV/EBITDA multiple of 20.2 and 14.3, respectively, higher than the S&P 500 EV/EBITDA multiple of 11.7. Meanwhile, the steel producers industry has a trailing 12-month EV/EBITDA multiple of 9.2, which compares favorably with the S&P 500 EV/EBITDA multiple of 11.7. Overall, valuation looks expensive for the steel industry.
Expected Deceleration in China
In 2017, China’s government stimulus measures helped lift the construction activity. However, investment continued to decelerate and steel demand showed only a moderate increase despite the boost. In 2018 and 2019, China’s GDP growth is expected to decelerate mildly and as the government continues to focus on shifting the growth driver toward consumption, investment is likely to further decelerate.
In 2018, steel demand is likely to remain flat and contract 2.0% in 2019 due to a further slowdown in construction activity. The machinery sector is anticipated to deliver positive growth aided by a strong global economy while automotive and home appliances will decelerate.
Trump’s Softening Stance Not a Good Sign
Following the tariff announcement, President Trump softened his stance by excluding Canada and Mexico — two major sources of steel imports to the United States — from the tariff orders. Moreover, the orders have provisions for other countries to apply for exemptions provided their imports do not hurt the U.S. economy, leaving some wiggle room for U.S. allies to seek concessions.
The President noted that Canada and Mexico represent “a special case,” and will continue talks with them to address concerns. The exclusions of these countries are dependent on the outcome of the North American Free Trade Agreement (“NAFTA”) renegotiation talks that are underway.
Canada is the largest steel exporter to the United States, accounting for roughly 16% of total U.S. steel imports in 2017, per the U.S. Census Bureau data. Mexico is the fourth-largest exporter of the metal with around 9% market share. Together these countries represent roughly a quarter of U.S. steel imports.
To make the matters more complicated, the Trump administration later added that it would temporarily exempt more countries from steel and aluminum tariffs, according to a proclamation released by the White House. The list includes the European Union, Argentina, Australia, Brazil, Canada, Mexico and South Korea, many of which have been in talks with the United States to win an exemption. However, the administration may impose import quotas on these countries to protect the domestic industries.
The Trump administration’s gradually softening tariff stance is bad news for the domestic steel makers. More countries may seek exemptions for steel imports in the future that cannot be made in the United States. This may thwart the administration’s efforts to curb the influx of cheaper imports and eventually hurt steel prices.
Risks of Trade Retaliation
Concerns over a full-blown international trade war gripped the markets since the declaration of the metal tariffs. The U.S. trade actions are likely to trigger a potential backlash from the affected countries and major foreign trade partners. The tariffs risk tit-for-tat retaliation measures on American exports, consequently hurting the U.S. economy.
China imposed new tariffs on 128 US imports worth $3 billion in retaliation to the steel and aluminum tariffs recently, fueling fears of a trade war. While China only accounts for 2% of U.S. steel imports, it is the world’s biggest producer of steel accounting for around half of the global production. Beijing has been repeatedly accused of dumping excess steel capacity into global markets. Trump has a record of attacking China for unfair trade practices. In fact, the President has plans to implement new tariffs on some $60 billion of Chinese imports.
Japan, the sixth largest exporter of steel to the United States, is also currently not on Trump’s temporary exemption list. Japan's Minister of Economy, Trade and Industry, Hiroshige Seko earlier said that the United States’ move to levy trade tariffs is “extremely regrettable” and could significantly unsettle global trade.
The EU had also threatened to impose tariffs on Harley-Davidson motorcycles and other iconic U.S. brands in retaliation to the Trump administration’s tariff move. The 28-nation bloc recently published a list of U.S. products worth around $3.4 billion on which it plans to impose trade penalties. Brazil, the second-largest exporter of steel to the United States, with roughly 13% share of total imports last year, has also pledged to take “all necessary actions” to protect its interests.
Performance of some key emerging and developing economies has deteriorated due to internal structural issues, lower commodity prices associated with China’s economic slowdown, and escalating political instability. Geopolitical tensions and political instability in the Middle East and Africa continues to have a negative effect. Political uncertainty in the Brazilian economy has resulted in a sharp decline in steel demand.
Sluggish Momentum of the Auto Sector
In China, the automotive sector is expected to decelerate in 2019. Also, the automotive sector in both the EU and the US is expected to moderate due to saturation effect and rising interest rates.
Other Dampening Factors
An expected monetary tightening in the United States and the EU will lead to deceleration of steel demand growth in 2019. Improving investment sentiment and government stimulus has been beneficial to steel demand in Japan. However, the scope of growth will continue to be limited by structural factors such as an aging population. Further, despite improved consumer sentiment, steel demand growth in South Korea will be constrained by high consumer debts, weakening construction and a depressed shipbuilding sector.
Excess Capacity: Perennial Problem
The biggest obstacle to persistent growth and profitability in the steel industry is excess capacity. The industry is under relentless pressure caused by years of excess steel-making capacity, further aggravated by weak demand and uneven economic growth. To solve this problem, steelmaking capacity needs to be reduced for the industry’s profit margin to reach a sustainable level, and raise the capacity utilization rate from below 80% levels.
The industry remains highly fragmented compared with other global businesses. However, the restructuring and consolidation needed to eliminate overcapacity is progressing at a slow pace.
Low Crude Steel Capacity Utilization
The crude steel capacity utilization ratio remained stubbornly below 80% in the last three years. The average capacity utilization in the 2016 and 2017 was around 69% and 66%, respectively. The average capacity utilization till March 2018 was around 73.6%, an improvement from the 71% in the comparable period last year. Excess steel capacity has been a perennial problem for the steel industry as steel prices generally move in tandem with capacity utilization rates. To remain competitive and rationalize operations, some major steel companies have resorted to idling steel plants.
Increasing Use of Aluminum in Auto Industry
Currently, steel is the major raw material for the auto industry, the second largest steel consumer. However, major automakers like Ford Motor Co. (F - Free Report) , General Motors Company (GM - Free Report) and others are becoming increasingly aluminum-intensive, given the metal's recyclability and light-weight properties. The global push to improve fuel efficiency in vehicles is anticipated to more than double the demand for aluminum in the auto industry by 2025. Hence, in order to remain competitive, the steel companies will have to come up with better and lighter varieties of steel.
Stocks to Steer Clear
The short-term prospects are a bit clouded considering the headwinds plaguing the steel industry globally as discussed above. So, it would be prudent to stay away from steel stocks that carry an unfavorable Zacks Rank now. Particularly, we suggest staying away from Aperam S.A. (APEMY - Free Report) which carries a Zacks Rank #5 (Strong Sell) and Shiloh Industries, Inc. (SHLO - Free Report) which carries a Zacks Rank #4 (Sell).
The estimates for Aperam have declined 8% for fiscal 2018 and 9% for fiscal 2018. Shiloh Industries has witnessed a 13% drop in earnings estimates for fiscal 2018. The company also has a negative average earnings surprise of 43.48% in the trailing four quarters.
However, investors, who can look beyond the near-term clouds to the industry’s bright long-term prospects, may consider buying some steel stocks based on a favorable Zacks Rank.
We also recommend stocks such as Steel Dynamics, Inc. (STLD - Free Report) , Ternium S.A. (TX - Free Report) which sport a Zacks Rank #1 (Strong Buy) and Nucor Corporation (NUE - Free Report) which carries a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.
Check out our latest Steel Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is shaping up for the future.
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