Investing in steel over the past decade has been a minefield. Faced with stagnant pricing and exorbitant labor costs, the U.S. players suffered a near-death experience in 2001, when Bethlehem Steel, the No. 2 steel maker, went bankrupt. But that was then. A wave of bankruptcies, supply constraints, improving global demand, a weak U.S. dollar and, not least, a country called China has investors rushing into steel shares. Over the past 12 months, industry bellwether U.S. Steel is outpacing the S&P by 170 percentage points.
The industry's return to health emerged somewhat unexpectedly, even after President Bush ended steel tariffs in late 2003, thereby exposing American companies to the rigors of free trade. Since a weaker U.S. dollar made American exports more competitive, the surprise result was that repealing the tariff didn't hurt a bit. Over the past year, steel exports rose 38 percent and imports fell 30 percent. According to Morgan Stanley, that makes the steel-trade balance “the best in 12 years” and is helping the U.S. steel industry without any increase in consumption.
The main cause is simple enough: Surging global demand for steel, particularly from China (where production is expected to increase 19 percent this year), is creating tight conditions throughout the industry. As a result, prices for iron ore, scrap and finished steel products are improving. Also improving the sector is consolidation activity, in which inefficient steel mills are gobbled up and shut down by stronger ones. Take International Steel Group, the second largest integrated steel producer in North America. ISG's bid to take over the assets of Weirton Steel was recently approved, continuing the process of rolling up bankrupt steel companies that it began two years ago. ISG now owns four once-busted steel makers.
The consolidation typified by ISG's strategy limits steel supply and concentrates the market into fewer hands. In the important area of flat-rolled steel, the top three mills owned a 32 percent share in 2001, but extended their reach to 55 percent of the market by 2003. As The Wall Street Journal deftly points out, “Consolidation is one factor behind a recent upswing in steel prices.”
Then there's China, the steel producing/consuming beast in the East. According to Fortune, the top year for steel production in the United States was 1973, with 151 million tons. By contrast, in 2003, China's demand for steel was well over 200 million tons. Now the world's single largest producer and consumer of steel, China's rapid growth increases demand for such input materials as iron ore and ferrous scrap. Taken together, the effects of an improving global economy, greater consolidation and China are creating beneficiaries throughout the industry supply chain: scrap merchants, such as Schnitzer Steel; ore suppliers, like Brazil's Companhia Vale do Rio Doce (CVRD); and integrated steel firms, such as U.S. Steel and new roll-up International Steel Group.
Taking these in turn: Schnitzer CEO Robert Philip, explaining his firm's impressive 100 percent quarterly income jump, pointed to rising demand for ferrous scrap metals from both China and the domestic market, and claimed average selling prices for the coming quarter would likely be “significantly higher.” Schnitzer is an environmentally focused company that salvages and recycles metal from old cars, ships and appliances. The company dates to the days of Andrew Carnegie.
In addition to its highly profitable scrap-metal business, Schnitzer also manufactures finished steel products in a mini-mill using company-collected scrap. It recently completed its acquisition of Pick-N-Pull Auto Dismantlers, one of the U.S.'s leading self-service auto parts businesses, where customers can buy used and wrecked auto parts. UBS Securities, in a recent survey, concluded that the shrinking U.S. manufacturing base is now providing a smaller quantity of scrap, making it likely that scrap prices will remain above historical levels through at least mid-2005.
Iron ore, another steel input, is also in short supply. The world's largest producer and exporter of iron ore is Brazil's CVRD. American depository receipts of CVRD trade on the Big Board under the appealing ticker, RIO. The global supplier recently contracted to provide 20 million tons of iron ore to European steel giant Arcelor from 2004 through 2009. CVRD also signed contracts with eight new steel producers in 2003, all in China, each promising to purchase two to four tons of iron ore annually over the next three to 10 years. In addition, China's largest steel maker, Baosteel, and CVRD are planning a $2.5 billion Brazilian joint venture that would mark China's largest overseas investment ever.
A Game of Concentration
Consolidation among steel makers is a global trend that should continue. The world's largest steel maker, Arcelor SA, is a supply-constraining merger of steel makers from France, Luxembourg and Spain. Many steel companies are in bankruptcy, including Stelco, Canada's largest steelmaker. In the past three years alone, 14 blast furnaces have closed and 40 steel makers have filed for bankruptcy.
Such industry distress spells opportunity for a company like International Steel Group. Run by bankruptcy specialist Wilbur Ross, ISG has been acquiring mills from busted companies and lowering costs through new-style labor agreements that scale back on benefits. Relatively speaking, ISG's balance sheet is strong, remarkably free of “legacy liabilities,” such as pension obligations and post-employment health benefits that weighed heavily on the old mills.
With International Steel Group's purchase of Weirton Steel, the nation's fifth-largest integrated U.S. steel maker, ISG's total haul comes to four companies since ISG's own founding in 2002 out of the bankrupt carcasses of LTV, Bethlehem and Acme Metals. Today, ISG produces hot rolled steel for about half the cost at the former LTV and Bethlehem — and industry consolidation is allowing the company more control over pricing. For the fourth fiscal quarter of 2003, ISG earned 28 cents per share, well over the 14 cents analysts were expecting.
Then there is U.S. Steel, the largest integrated U.S. mill. It too has strong numbers: Fourth-quarter revenue surged 41 percent, and the company forecasts strong demand. The company's first-quarter domestic order book for sheet products is sold out and production levels are near capacity. In the first quarter, U.S. Steel announced it would increase prices for orders shipped in April on both hot-rolled and cold-rolled products, reserving the right to raise prices still further.
“We intend to let the market determine prices, and we don't intend to be disadvantaged,” said U.S. Steel's John Armstrong.
Steel: A Growth Industry?
|Name||Ticker||Forward P/E||Debt/Equity Ratio|
|Recent price: $31.83|
|• Major ferrous scrap producer|
|• Vertically integrated, owns fleet and scrap yards|
|Intl. Steel Group||ISG||10.8||0.7|
|Recent price: $36.23|
|• Second-largest integrated U.S. steel producer|
|• Run by bankruptcy specialist Wilbur Ross|
|Recent price: $36.44|
|• Largest U.S. integrated steel maker|
|• “Last man standing” titan of industry|
|Recent price: $52.73|
|• Largest global supplier of iron ore|
|• Major beneficiary of China's industrial growth|