(GM) Steel Stock Review & Outlook – June 2011 – Industry Outlook

The World Steel industry is rather concentrated in structure, with a few producers accounting for the lion’s share of sales.

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 comprises 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.

Historically, the automotive and construction markets have remained the largest consumers of steel, absorbing more than half of the total steel produced. Large automakers such as General Motors Company (GM), Ford Motor Company (F), Toyota Motor Corporation (TM) and Honda Motor Company (HMC) depend upon the steel industry. Other steel consuming industries include appliances, agricultural implements, converters, containers, energy, electrical equipment and industrial machinery.

Production

The global steel industry has been going through major changes since 1970. World crude steel production has continued to show a steady increase since April 2009 on the back of a moderate rise in demand and the resumption of work at idled facilities. China has emerged as a major producer and consumer.

According to the World Steel Association (WSA), world crude steel production was 127 million metric tons (mmt) in April 2011, an increase of 5.0% from April 2010. In 2010, world crude steel production reached a record 1,414 mmt, up 15% year over year. ArcelorMittal (MT) is the world’s largest steel company, with crude steel production of 90.6 million tons in 2010.

China’s crude steel production for April 2011 was 59 mmt, up 7.1% year over year. Japan produced 8.4 mmt of crude steel in April 2011, down 6.3% year over year due to the production disruption caused by the recent earthquake and tsunami. South Korea experienced an increase of 15.9% from April 2010, producing 5.9 mmt of crude steel in April 2011.

The US produced 7.1 mmt of crude steel in April 2011, an increase of 2.1% year over year.

In the EU (European Union), Germany’s crude steel production for April 2011 was 3.8 mmt, down 1.7% year over year. Italy’s crude steel production was 2.5 mmt, up 9.8% year over year. Spain produced 1.5 mmt of crude steel in April 2011, down 5.8% year over year.

Turkey’s crude steel production for April 2011 was 2.8 mmt, up 14.3% year over year. Egypt crude steel production in April 2011 was 0.5 mmt, down 0.8% year over year.

In April 2011, the world crude steel capacity utilization ratio of the 64 countries was 82.8%, up 0.9% than in March 2011. Compared to April 2010, the utilization ratio remained unchanged.

Growth Trends

With the global economy picking up in late 2009, the steel industry started seeing signs of improvement. However, given its economic sensitivity, we expect global steel demand to improve gradually, in line with the recovery in the user industries, especially automotive and residential construction.

According to World Steel Association, steel demand in the U.S. was down 41.6% in 2009 to 57.4 million tons. However, with the economy in recovery mode, production increased by 7.7% to 7.1 million metric tons in March 2011 from 6.6 million metric tons in February 2011. This marks a 0.2% decrease from the March 2010 production level.

The steel industry has recorded high growth rates in both production and consumption over the past few years, benefiting from soaring steel demand in the automobile and construction sectors before the recession. Moreover, cost effective and highly efficient steel-making technologies have lifted the demand for US steel in the Middle Eastern and Asian countries.

As per the WSA, India was the fourth largest producer of crude steel during January to September 2010. India produced 50.1 million tons crude steel during the period. However, according to the industry estimates, India is likely to be the second-largest producer of crude steel in the next four years from its current fourth place.

In the short term, local steel demand in Japan will be lower as the country’s carmakers have suspended production following the earthquake. However, the need for reconstruction of earthquake-devastated areas offers the steel industry significant hope. In the medium term though, steel demand will likely surge.

However, WSA expects the Chinese steel consumption to decelerate in 2011 as China tries to ease back on its own economic boom.

Here, we will discuss recently quarterly results of a few companies, whose results were aided by higher selling prices and increased shipments, and their growth expectations.

Steel giant ArcelorMittal reported diluted net earnings of 69 cents per share in the first quarter of 2011, above the Zacks Consensus Estimate of 47 cents as well as last year’s 42 cents per share. Total steel shipments in the first quarter of 2011 were 22.0 million metric tons compared with 21.0 million metric tons in the year-ago quarter.

Quarterly revenues increased 27.3% year over year to $22.2 billion from $17.4 billion in the year-ago quarter and increased 7.2% sequentially. Sales were higher over the previous quarter primarily due to higher shipment volumes (+4%). However, the results were slightly below the Zacks Consensus Estimate of $22.8 billion.

For the second quarter of 2011, management expects EBITDA to be approximately $3.0 – $3.5 billion. Steel shipment volumes, average steel selling prices and EBITDA/ton are expected to increase sequentially, while capacity utilization levels are expected to improve to approximately 80%.

Additionally, operating costs are expected to increase sequentially due to higher raw material prices. The company also expects mining production and profitability to improve sequentially in the second quarter.

The company expects working capital requirements to increase in line with the increased activity levels and prices resulting in further increase in net debt in the second quarter. The company expects its full-year 2011 capital expenditure to reach $5 billion, of which $1.4 billion is estimated to be spent on mining.

The commercial metals company AK Steel Holding (AKS) posted its first-quarter 2011 results delivering an EPS of 8 cents compared with 2 cents during the year-ago quarter and striding ahead of the Zacks Consensus Estimate of a loss of a cent.

Net sales were $1,581.1 million on the shipments of 1,423,100 tons versus $ 1,405.7 million and 1,385,800 tons in the prior-year quarter. It however, missed the Zacks Estimate of $1,609 million. The improvement in shipments was mainly due to higher pricing, which increased 9% on a year-over-year basis to $1,109 per ton.

The company expects shipments in the second quarter of fiscal 2011 to be in the range of 1,500,000 and 1,550,000 tons, indicating a strong increase over the first-quarter shipments. The company also anticipates its average per-ton selling price to be 7% higher compared with the first quarter. The operating profit is expected to be approximately $65 per ton for the second quarter.

AK Steel is uniquely positioned to focus on products with high margins. Electrical steel continues to be the company’s strongest product line, with demand recovering in the U.S. and abroad, though at a slower rate. AK Steel is operating its plants at above 80% capacity and is well positioned to serve the end markets when the demand rebounds.

However, higher input costs, particularly iron ore, are eroding margins of the company. Iron ore pricing concerns have led to a negative outlook for steel manufacturers.

Allegheny Technologies Inc. (ATI) also earned $56.3 million, or 54 cents per share, in the first quarter of 2011, surpassing the Zacks Consensus Estimate of 49 cents and last year’s $18.2 million, or 18 cents per share. First-quarter results were impacted by $5.8 million, or $0.05 per share, for previously announced executive retirements and a discrete tax item.

Quarterly revenues soared 36.5% year over year to $1.23 billion from $899.4 million on higher shipments and rising raw material prices. Revenues were above the Zacks Consensus Estimate of $1.12 billion.

Segment wise, revenue increases were distinct in the Engineered Products segment (46%) and in the Flat-Rolled Products segment (38%), while sales in the Higher Performance Material segment increased (32%).

Allegheny continues to expect 2011 revenue growth to be in the range of 15% to 20% compared with 2010, and expects segment operating profit to be approximately 15% of sales. The company targets a minimum of $100 million in new gross cost reductions. Capital expenditures are forecasted at $300 to $350 million.

During the second quarter of 2011, management anticipates utilizing approximately $395 million of cash on hand to fund the cash portion of the merger consideration for the previously announced acquisition of Ladish and to pay related fees and expenses.

Currently, Allegheny has a short-term (1 to 3 months) Zacks #2 Rank (Buy).

Nucor Corporation (NUE) reported a stupendous increase in profit to $190.8 million or 56 cents per share (excluding special items) in the first quarter of 2011 from $55 million or 15 cents per share (excluding special items) in the same quarter of 2010. With this, the company has beaten the Zacks Consensus Estimate by 21 cents per share and its own guidance of 30 cents–35 cents per share.

Consolidated sales surged 32% to $4.83 billion due to a 22% increase in average price per ton and a 9% rise in shipments (to 6.0 million tons) to outside customers. It was higher than the Zacks Consensus Estimate of $4.43 billion.

Steel mill shipments grew 10% to 5.2 million tons during the quarter. The average scrap and scrap substitute cost per ton gained 33% to $424.

Nucor expects results in the second quarter to improve over the first quarter, despite some market weakness that may impact results at the end of the second quarter. Further, the company continues to see slow but steady improvement in real demand in certain end markets.

The most challenging markets for its products are associated with residential and non-residential construction. The company retains a Zacks #3 (Hold) Rank on its stock.

According to the World Steel Association (WSA), in 2011 world steel demand is expected to grow by 5.9% to reach a historical high of 1,359.2 mmt, up from 1,339.7 mmt predicted in October 2011. While 2012 global steel consumption is forecast to rise 6% to 1,440.6 mmt, the WSA noted that the forecast was made prior to the Japanese earthquake, which would likely lead to steel demand coming in below 63 mmt estimated by the association in 2011, while steel consumption will probably be higher than the 2012 forecast of 63 mmt.

Industry Capacity

The global steel industry is capital intensive, cyclical, highly competitive and has historically been characterized by overcapacity. Capacity utilization rates were, however, low (around 60%) at the beginning of 2009, in response to the much softer demand. With steel demand picking up in the latter half of the year, the world crude steel capacity utilization ratio in January 2011 was 75.6%, up from 73.3% in December 2010.

Steel makers continue to add capacity besides resuming operations at the idled facilities, inspired by the expected rebound in steel industry in the longer term.

Price Trends

The steel industry has long witnessed volatility in prices with a large spot market. Steel prices rose steadily for most of 2008, after which there was a downtrend. Lower prices had an adverse effect on steel producers, who recorded lower revenues and margins, and had to write down finished steel and raw material inventories.

The period witnessed major steel producers slashing production to minimize inventory accumulation. The U.S. Steel Corporation (X), the eleventh-largest steel producer worldwide, slashed production by almost 62% during the second quarter of 2009, while Korean steel maker POSCO (PKX) cut production by about 15%. This was the first time in its history that POSCO was forced to adopt such a measure, which is a proof of the adverse operating environment.

Although steel prices have been stabilizing since the latter part of 2009, they are significantly below the pre-crisis level. We believe that a sustained recovery in steel prices remains uncertain in the backdrop of sluggish economic activity.

Factors Affecting Steel Prices

Chinese Imports: The steel industry is also affected by fluctuations in steel import–export and tariffs. China is the largest steel producer globally, and balances its domestic production and consumption, which is an important factor in global steel prices.

Consumers in the U.S. are importing cheaper steel from China, which is forcing domestic steel producers to sell at lower prices, and even at a loss, sometimes. To this end, the U.S. government has been imposing anti-dumping duties on Chinese steel imports.

Economic Sustainability: Concerns about the sustainability of economic recovery and queries regarding China’s growth momentum come into play in the pricing equation. This relatively uncertain Chinese outlook, coupled with a still tentative recovery in the developed world, is expected to weigh on prices.

Threat from substitutes: Steel has many substitutes like aluminum, which replaces it in the automotive markets. Cement, composites, glass, plastic and wood are also used as steel substitutes. This significantly influences market prices and demand for steel products.

Raw Material Trends

The key input for steel production is iron ore. Apart from this, coking coal and coke, scrap, electricity and natural gas are also used as inputs in steel production. The raw materials industry is highly concentrated with only three major players — Vale (VALE), Rio Tinto (RTP) and BHP Billiton (BHP) — having significant pricing power. The risk lies in further consolidation among raw material suppliers. For instance, the announced iron ore joint venture between mining companies BHP Billiton and Rio Tinto would further increase the pricing power of both the suppliers.

Steel makers would face higher production costs if suppliers shift to sales based on spot prices from the long-term fixed price contract system, as spot prices for most of the raw materials, especially iron ore, remained high from 2006 through 2008. Iron ore prices dropped 5.7% to $168 a ton for ore with 62% iron content delivered to China.

Iron ore prices have remained volatile during most of 2010 and are expected to rise sharply in 2011. ArcelorMittal’s iron ore and coal mining projects have been a key focus in the recent years and this focus is only expected to intensify in the medium term, as the company has a goal to secure 100 million tons of iron ore supply from its own mines and under strategic long-term supply contracts on a cost-plus basis. As part of this strategy, in January 2011, the company announced the acquisition of Baffinland, which holds a substantial undeveloped iron ore deposit in the Canadian territory of Nunavut.

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

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.

Zacks Recommendation

Steel demand in the emerging markets outside China is expected to grow strongly in 2011. In China, the government’s expansionary economic policies, easy credit and construction initiatives have thus far sustained demand. But with China attempting to rein in its overheated property sector and engineer a soft landing for its economy, steel demand will most likely soften noticeably in the coming months. This relatively uncertain Chinese outlook, coupled with a still tentative recovery in the developed world, is expected to weigh on prices.

In the short term, we are neutral on steel manufacturers like AK Steel Holding Corporation (AKS), Steel Dynamics Inc. (STLD) and Allegheny Technologies Incorporated (ATI).

AK Steel’s cost structure is higher than its peer group due to a greater reliance on external supply of raw materials such as carbon scrap, purchased slabs, iron ore and purchased coke. Iron ore is the key raw material in steel manufacturing operations.

However, industry giants with integrated business models like U.S. Steel and ArcelorMittal have an edge over their peers. Both steel makers have substantial captive sources of iron ore and coal and source about 75%–80% of their coke and iron ore requirements from owned and/or operated facilities.

AK STEEL HLDG (AKS): Free Stock Analysis Report

ALLEGHENY TECH (ATI): Free Stock Analysis Report

BHP BILLITN LTD (BHP): Free Stock Analysis Report

FORD MOTOR CO (F): Free Stock Analysis Report

GENERAL MOTORS (GM): Free Stock Analysis Report

HONDA MOTOR (HMC): Free Stock Analysis Report

ARCELOR MITTAL (MT): Free Stock Analysis Report

NUCOR CORP (NUE): Free Stock Analysis Report

POSCO-ADR (PKX): Free Stock Analysis Report

STEEL DYNAMICS (STLD): Free Stock Analysis Report

TOYOTA MOTOR CP (TM): Free Stock Analysis Report

VALE RIO DO-ADR (VALE): Free Stock Analysis Report

UTD STATES STL (X): Free Stock Analysis Report

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