Strengthen Your Portfolio: Invest in Steel

Worldwide output of global steel production reached a record 1,414 million metric tons (mmt) last year. That is up 15% from 2009, when steel demand levels were down …

Worldwide output of global steel production reached a record 1,414 million metric tons (mmt) last year. That is up 15% from 2009, when steel demand levels were down considerable levels. Forecasts indicate production and demand are expected to continue to rise. To learn more about this, read the full article from Money Morning.

Global steel producers were prolific in 2010, with worldwide output reaching a record 1,414 million metric tons (mmt). According to the World Steel Association (WSA), that represented an average production increase of more than 15% from 2009, when the poor global economy had pushed steel demand down to levels not seen since before the turn of the century.

And, based on recent economic and industry forecasts, both production and demand are expected to continue rising for all of 2011 – which bodes well for investors looking to turn hard metals into solid profits.

The WSA forecasts finished steel consumption in 2011 will rise 5.3% to nearly 1,340 mmt – in spite of the fact that steel prices have reached near-record levels in recent months, climbing in January to more than $800 per ton of hot-rolled coil steel, the industry’s base product unit.

Unfortunately, the margins and gross profits for major steelmakers – weighed down by soaring costs for raw materials – didn’t follow prices substantially higher.

As a result, stock prices for many leading steelmakers, though well above their 52-week lows, remain in bargain territory, with some now trading at less than a third of where they were in April 2008, the last time steel prices approached current levels.

For instance, domestic industry leader United States Steel Corp. (NYSE: X), which topped $160 a share in early May 2008, closed early this week at just $53.96. Even more dramatic, AK Steel Holding Corp. (NYSE: AKS), a leading producer of stainless and electrical steels, stands at just $15.35 after topping $70 a share in May 2008.

Admittedly, the financial numbers support the lower prices to some extent. As an example, U.S. Steel’s 2010 revenue climbed 57.2% to $17.37 billion, but the company still posted a net loss of $3.36 a share. That was down from a profit of $17.85 a share in 2008, although still well above the $10.60 a share loss posted in 2009.

Despite that – and the high cost of iron ore and coking coal, the key ingredients in steel making – analysts are projecting a consensus profit of $3.67 for U.S. Steel in 2011 (with some estimates running as high as $4.87 a share) and $5.80 in 2012. In mid-February, Goldman Sachs Group Inc. (NYSE: GS) upgraded US Steel to a "buy," issuing a price target of $75 for the coming year – a 36% increase over recent prices.

Asia Demand

Of course, not every steelmaker is in such good standing. There are some headwinds facing the steel industry – not the least of which is the catastrophe in Japan.

In the near term, Japan’s troubles will be a negative for steel prices. Major Japanese automakers – Toyota Motor Corp. (NYSE ADR: TM), Honda Motor Co. Ltd. (NYSE ADR: HMC) and Nissan Motor Co. Ltd. (PINK ADR: NSANY) – have shuttered some or all of their plants. Meanwhile, rolling blackouts, radiation and shortages of everything from gasoline to personnel have hamstrung many other Japanese manufacturers. The short-term demand for rolled sheet steel and other non-construction steels will undoubtedly suffer as a result.

In a very short while, however, Japan’s crisis will become bullish for steel manufacturers elsewhere in the world. That’s because many of the industrial companies dealing with disaster-related problems are steelmakers. In fact, Japan is the world’s second-largest steel producer after China, with a 2010 output of 109.6 million metric tons. (The steel industry in Japan employs nearly 200,000 people, so the economic impact of production disruptions will be substantial.)

Relative to global competition, two of Japan’s industry giants – Nippon Steel Corp. (PINK: NISTY) and Sumitomo Metal Industries Ltd. (PINK: SMMLY) – just last month announced plans to merge into the world’s second-largest steel company, a move designed to help counter challenges from emerging producers in China, Korea, and India, as well as leverage raw-materials costs.

However, the U.S.-traded shares of the two companies lost more than 18% of their value in the first two sessions after the Sendai earthquake, mirroring losses in the Tokyo market sell-off and raising doubts about whether the merger will be able to go forth as scheduled.

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More importantly, Japan is the world’s second-largest exporter of steel (trailing only China), sending a record 43.4 million tons overseas in 2010. By contrast, while U.S. steel exports climbed 29.3% last year, the total was just over 12 million tons – not even enough to rank in the Top 10 among exporters.

The current crisis will reduce Japanese exports substantially, both because of lost production by steelmakers there, and also because demand for materials for rebuilding quake- and tsunami-ravaged areas will soar, keeping much of Japan’s steel at home.

That could generate price-boosting shortfalls throughout the rest of the world, giving non-Japanese steelmakers the excuse needed to continue raising prices – and profit margins. That should boost stock values.

Natural disasters and turmoil, both economic and political, have also played a key role in the escalation of steel-related expenses.

Recent unprecedented flooding closed mines in Queensland, Australia, which produces roughly 70% of the planet’s coking coal. That event sent futures prices for summer delivery as high as $400 a ton, up 77% from just $225 in February.

The floods also cut production in some iron ore mines in Australia, but the biggest factor in rising prices for ore was increased demand from China – demand that’s likely to grow even stronger in the months (and years) ahead. China’s production rose 9.3% in 2010 to 626.7 million tons, but the WSA expects China’s output to climb by more than 15% in 2011, based on January/February figures.

Phil Newman, chief operating officer of the metals consulting group CRU, told Reuters that 95.1% of global steel production growth from 2007 to 2021 will occur in Asia, with China the dominant force.

Based on similar forecasts and projects, analysts at Credit Suisse Group AG (ADR, NYSE: CS) projected in January that iron ore prices would climb by 21% this year – a forecast given validity when the spot price of ore delivered to China neared $200 a ton in mid-February. The average price so far for 2011 stands at $178 a ton – up from an average of $147 in 2010.

Potential Setbacks

Raw materials prices also have more flexibility to rise than in the past, thanks to changes in the pricing structure adopted last year by Rio Tinto PLC (NYSE ADR: RIO), BHP Billiton Ltd. (NYSE ADR: BHP) and other top international mining companies. Previously, the big miners set ore prices on a yearly basis, but now the contracts are negotiated to allow for quarterly adjustment.

Conflict in the Middle East has raised the price of oil back into the $100 per barrel range, which represents another major cost factor in the steel market. Smelting iron ore requires high heat and is thus energy intensive, plus higher oil prices drive up steel delivery costs. Because of its weight and high density, finished steel is one of the most expensive products to transport, especially when it comes to overseas shipping.

One restraining factor for further price increases is that the recovery in construction markets has been slow since the financial crisis. At the end of 2010, plants that manufacture so-called "long steel" used in construction – I-beams, girders, concrete-reinforcing rods and the like – were running at just 70% of capacity and had shown little increase for more than a year. Historically, capacity utilization of 80% or more has been needed to support price hikes.

However, that level could be reached fairly quickly. In projecting higher profits for U.S. Steel in 2011, analysts cited a forecast that capacity utilization would rise to 85% by the end of this year from 76% in 2010.

Many steel market observers also believe the weak construction sector is overshadowing strength in other markets, such as the production of flat-rolled steel for autos and appliances.

"The nation’s flat-rolled mills are running full out," Rick de los Reyes, metals and mining analyst for T. Rowe Price Group Inc. (Nasdaq: TROW), recently told The Street newsletter. "There’s really not a lot of excess capacity."

Also dampening the long-term potential for higher steel prices is the fact that, while iron ore and coking coal prices are near record levels, they remain in ample supply around the world, which could keep them from moving higher. The steel-making process is also getting more efficient, with smelting of ore into steel now possible in a single day.

Another supply-side factor is the availability of scrap steel for re-smelting into new product, steel currently being the most recycled material in the world.

Given all these conflicting factors, the outlook for steel stocks will, in the end, depend on steelmakers’ ability to keep prices for finished product ahead of costs for raw materials, thereby increasing margins.

"While demand for steel is quite strong, one of the problems for steelmakers around the world is rising costs," Gavin Wendt, a senior resources analyst at Mine Life Pty in Sydney, recently told Businessweek. "It’s all about lowering costs and enhancing margins."

Investing in Steel

As for possible ways to play for steel stock profits, we’ve already mentioned U.S. Steel, which is now trading well below its level when Goldman Sachs recommended it thanks to the recent oil-price and disaster-related market pullbacks.

We also mentioned AK Steel – a company that showed a loss of $1.18 a share in 2010. However, analysts now project a rebound to a 79-cent-per-share profit for 2011, with a further rise to $1.39 in 2012. That makes this company a bargain at its recent price of $15.35.

Although scrap metal prices have also risen sharply in recent months, stocks of companies that focus on steel recycling may provide a way around soaring raw materials costs. Two choices in this sector are:

  • Steel Dynamics Inc. (Nasdaq: STLD), recent price $18.28 – STLD gets the bulk of its revenue from the processing and sale of recycled ferrous and nonferrous metals, and the manufacture of steel products from those metals. The company earned 67 cents a share in 2010, with a rise to $1.75 forecast for this year. The stock pays a 40-cent dividend, good for a yield of 2.18%.
  • Nucor Corp. (NYSE: NUE), recent price $46.01 – NUE operates in all major steelmaking sectors, and also operates several mines. However, it’s a leader in recycling, having recovered and reprocessed roughly 13.4 million tons of scrap steel in 2009, with even higher numbers expected when 2010 totals are released. The company earned 42 cents a share in 2009, with a rise to $2.75 projected for this year. NUE pays a healthy $1.44 dividend, representing a current yield of 3.15%.

Since North America now accounts for just 14.3% of global steel production – down from the 37% the United States produced in 1900 – you may want to take a look at foreign manufacturers, many of which have stocks or ADRs trading on U.S. markets. Two top players are:

  • Gerdau S.A. (NYSE ADR: GGB), recent price $12.44 – Based in Brazil, but with operations in the United States as well, Gerdau is the largest producer of long steel in the Western Hemisphere. It stands to be a major beneficiary of recently announced plans for a major infrastructure improvement campaign in Brazil, as well as construction of new venues for hosting the 2016 Summer Olympics and the World Cup. The company is a major recycler of steel scrap, but also owns a large South American iron ore mine and has rights to an additional 1.1 billion tons of reserves. GGB earned $1.06 per share in 2010, giving it a very reasonable Price/Earnings (P/E) ratio of 11.66, but estimates project only limited growth to $1.08 per share this year. The company pays a modest 12-cent dividend.
  • Posco (NYSE ADR: PKX), recent price $112.24 – POSCO is South Korea’s largest steel producer and is in the middle of a campaign to expand elsewhere in Asia, having won approval in January to construct a $12 billion steel plant in India, the biggest single foreign private investment ever made in that country. Earnings per share came in at $11.06 in 2010, with $12.07 forecast for this year. The dividend of $2.12 represents a yield of 1.97%.

For those interested in taking an offbeat approach to steel investment, here’s another idea. Steel is essential to any major construction project and construction spending is expected to rise in the years ahead, due both to the global economic recovery and rebuilding in Japan. That means there will be a rising demand for cranes.

Manitowoc Company Inc. (NYSE: MTW), recent price $20.89, is one of the world’s largest manufacturers of engineered lifting equipment for the global construction industry, including lattice-boom cranes, tower cranes, mobile telescopic cranes and boom trucks. Hurt by the recession, the company lost $1.21 a share in 2009, but cut that loss to just 26 cents in 2010 and is expected to return a profit of 66 cents a share in 2010. The stock is near its 52-week high of $21.25 but well off its pre-recession peak near $50 a share.

For those who prefer the fund approach, there are two major exchange-traded funds that focus on the global steel industry:

  • Market Vectors Steel ETF (NYSE: SLX), recent price $72.20 – Attempts to mirror the price and yield performance of the NYSE Steel Index, which is composed of companies primarily involved in steel production, including the operation of manufacturing mills and fabrication of finished steel products.
  • PowerShares Global Steel Portfolio ETF (Nasdaq: PSTL), recent price $23.29 – This fund tracks the price and yield performance of the NASDAQ OMX Global Steel Index, investing at least 90% of assets in the stocks, ADRs and GDRs of companies that comprise the underlying index.

This article was republished with permission from Money Morning.


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