Despite decent demand from key sectors, steelmaker stocks look cheap as they confront imports, a strengthening dollar, and the specter of Chinese overcapacity.
There is a statistic that encapsulates the complexities of the global steel industry. The portion of China’s steel capacity that is sitting idle is four to five times the size of the entire U.S. steel industry. That’s the result of production getting out in front of the country’s boom in the 2000s. As that boom has cooled off, the country now has plants that are running nowhere near full capacity.
That’s just one of the concerns looming over U.S. steelmakers. Indeed, imports have been a key threat to U.S. steel companies lately. While a flood of cheap steel from China has largely been kept in check by sanctions, imports from countries such as Turkey and Brazil compete directly with U.S. production. Complaints lodged by U.S. steelmakers that some nations are illegally dumping product have been met with mixed findings from U.S. regulators. And China could always decide to dump steel exports in other countries, forcing those nations to then shift their excess production to places like the United States. Add in a strengthening U.S. dollar that makes imported goods cheaper, and it is easy to see why some steel stocks are trading at low valuations.
But Andrew Lane, an equity analyst at Morningstar, and Daniel Rohr, who heads up Morningstar’s basic materials team, argue that U.S. steel companies deserve a closer look. For one, these companies are enjoying decent demand from key end markets such as construction and automakers, and the U.S. economy looks to be on solid footing. In addition, their valuations indicate pessimistic outlooks for these companies that belie Morningstar’s fair value estimates.
Rob Wherry: To begin with, can you give us a sense for the backdrop that steel companies are operating against.
Lane: From a very broad perspective in the United States, the largest sector that consumes steel is construction. About 40% of total steel consumption is directed to the construction end market, followed by automotive, which accounts for about 25%, and then energy and industrial applications are each about 10% of the total pie. So, what we’re seeing for U.S. steelmakers is a pretty solid outlook for demand from its two key end markets, and that’s offset, to some degree, by a weak demand outlook from the energy end market, which is being driven by the mechanism of low oil prices discouraging drilling activity and thereby causing demand for steel to wither.
So, in that situation, energy companies aren’t spending money on new rigs, right?
Lane: Right, and in fact, the rig count has declined precipitously in light of lower oil prices. Very few companies are looking to establish new rigs. Additionally, a lot of exploration and production companies are destocking their inventory to protect cash flow. That combination is a clear negative for steelmakers that serve that end market.
Steel stocks actually moved up through the recent earnings season. Are investors betting they’ve seen the worst?
Lane: There are a few different factors at play. We suspect that with so much focus on withering demand from the energy end market investors lost sight of the fact that energy is not one of the two most important end markets for steel demand, and in fact, as I mentioned, construction and automotive steel demand looked very strong, even relative to recent years. Another factor is that investor sentiment had soured on the U.S. steelmaking space. That had to do with the role of import volumes. In recent quarters, the spread between domestic steel spot prices and international steel spot prices was much wider than it had been. Historically, we’ve seen a spread of $100 per ton. That had ballooned to $250 per ton or briefly even higher. That spread was making it much more attractive on a relative basis to purchase steel abroad and ship it here to our shores.
That factor was only compounded by a stronger U.S. dollar. As the relative value of the U.S. dollar increased, it made foreign-produced steel much more attractive on a relative basis. Imports rose roughly 40% in 2014 relative to 2013 levels. That’s an enormous jump, and it’s really a function of those two factors.