Cheap Imports, Overcapacity Hamper Steel Industry

4th Sept

The steel industry is poised to benefit from solid demand in the United States and emerging markets like India. However, steel stocks have to struggle 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 19.55 and 16.06, respectively, higher than the S&P 500 EV/EBITDA multiple of 10.81. Meanwhile, the steel producers industry has a trailing 12-month EV/EBITDA multiple of 7.24, which compares favourably with the S&P 500 EV/EBITDA multiple of 10.81. Overall, valuation looks expensive for the steel industry.

The continued surge of steel imports in to the United States has hollowed out much of the domestic steel industry. Per the latest figures released by The American Iron and Steel Institute (AISI), total steel imports in the first seven months of 2017 surged 22% year over year. Imports have captured almost 28% of the U.S. market, year to date. The largest offshore suppliers were South Korea, Turkey, Japan, Taiwan and Germany. Steel imports had dipped briefly last year due to Commerce Department anti-dumping and anti-subsidy duties imposed on steel products from China and some other countries.

These cheap imports hurt the margins of American steel players like Steel Dynamics Inc. (STLD), United States Steel Corp. (X), ArcelorMittal (MT), AK Steel Holding Corp. (AKS) and Nucor Corporation (NUE).

Performances at some key emerging and developing economies have 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, Africa continues to have a negative effect. Political uncertainty in the Brazilian economy has resulted in a sharp decline in steel demand.

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 to 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.

The crude steel capacity utilization ratio remained stubbornly below 80% in both 2014 and 2015. The average capacity utilization in the 2016 was around 69%. 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 their steel plants.

Currently, steel is the major raw material for the auto industry, the second largest steel consumer. However, major automakers like Ford Motor Co. (F), General Motors Company (GM) and others are becoming increasingly aluminium-intensive, given the metal’s recyclability and light-weight properties. The global push to improve fuel efficiency in vehicles is expected to more than double the demand for aluminium 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.

How to Play the Industry

Source-Nasdaq