Winners and Losers With Tariffs

Keith Schoonmaker: U.S. President Donald Trump recently shook up global financial markets by announcing plans to enact import tariffs of 25% on steel and 10% on aluminum. The exact form these tariffs will take remains unclear, but we expect some additional information later today. We've updated our forecasts based on the expectation that certain key trade partners such as Canada and Mexico will be exempted. A blanket tariff covering imports from all countries would be far more severe. The consequences for U.S. metal users, while significant in aggregate, are far more diffuse, touching industries from aerospace to aluminum cans. Accordingly, our long-term forecasts and fair value estimates for these companies aren't materially affected. However, harmful second-order effects, including retaliation by U.S. trade partners, are possible, but we have not assumed major moves in our base-case forecasts.

We've raised our fair value estimates for U.S. steelmakers, as the proposed tariffs increase our forecasted spread between U.S. steel prices and world steel prices. Combined with operating leverage from greater production volumes, U.S. steelmakers are likely to generate higher margins than we previously anticipated. Regardless, we continue to forecast materially lower global steel prices (including the U.S.) over the long run as Chinese gross capital formation growth decelerates, global overcapacity remains, and cost support falters as steelmaking raw material prices decline.

Aerospace investors shouldn't panic over cost increases. Not yet, at least. Aluminum, represents less than 10% of the cost of newer aircraft, and when average aluminum prices rose 23% last year, the aerospace industry managed to absorb the increase. Investors should be concerned about a trade war, though, because Boeing delivers around 70% of its aircraft to non-U.S. customers. In particular, retaliation from China is a concern. China accounted for more than 25% of 2017 total deliveries and represents an estimated 20% of Boeing's backlog in unit terms. China could potentially shift aircraft purchases from the U.S. manufacturer toward Airbus. While the existing backlog most likely isn't at risk, new orders most certainly would be. We estimate the Chinese market alone will drive about $1.3 billion of operating profits for Boeing in 2018. That's 10% or 11% of operating profit and our fair value estimate. We're more concerned about Spirit Aerosystems because, as the largest independent aerostructures manufacturer, aluminum is a significant production input. But we're not planning to change our fair value because we believe the tariff can be absorbed and that Spirit's contracts include abnormal-price-increase clauses.

An increase in automotive input costs might have a temporary impact on margins but if the impact were large enough to cause a downturn in auto demand, given the industry's capital intensity, the impact could be much more devastating. The key issue for the auto industry is how long the tariffs last. Automakers use staggered contracts, collars, and long duration contracts to attempt to smooth out changes in steel and aluminum pricing. GM and Ford source about 90%-95% of their U.S. steel needs domestically. We estimate that in a worst-case scenario, the proposed steel and aluminum tariffs would result in approximately a 1% increase in the average price of a light vehicle in the U.S. However, the average transaction price of a U.S. light vehicle has grown at an annualized rate of roughly 2% since 2012, so we believe the impact of tariffs on U.S. light vehicle demand will be minimal absent a trade war.

We estimate that heavy equipment firms like Caterpillar and John Deere will be exposed to rising steel prices, which account for around 10% of their total operating expenses. Moreover, companies on our coverage list operate without hedges and are thus exposed to steel price fluctuations. We view it as unlikely these firms can materially pass along their increased raw material costs to customers because foreign competitors stand ready to take advantage. If we assume two years of tariff impacts and an inability for manufacturers to pass the increased steel prices along to customers, we expect operating margins to decline over 200 basis points, resulting in fair value declines of less than 5%.

In sum, we view U.S. steelmakers as beneficiaries of the tariffs, and Boeing as perhaps the firm with the greatest risk resulting from this action.