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Building a Moat in a Commodity Industry

Elizabeth Collins, CFA

Elizabeth Collins: Hi. My name is Elizabeth Collins and I'm the Associate Director of the Basic Materials team here at Morningstar. Joining me today is Dick Teets, the COO of Steel Dynamics. Dick, thanks for joining me today.

Dick Teets: My pleasure. Thank you.

Collins: So, for steel companies, it seems to me like having low costs is important. How do you compare your operating costs with other companies in the U.S. steel industry, and even on a global basis?

Teets: Well, Steel Dynamics is, we would tell you, the lowest-cost producer, or right in that echelon of companies from an operating perspective year in and year out. We have a very real and decisive advantage from a capital structure. We are low-cost from an installation perspective and from an ongoing operations, from a lean management and a lean employee head-count perspective. We are very aggressive in our purchasing of not only the capital goods, but consumables. And that translates, then, on a quarter-in and quarter-out basis of low-cost production.

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Collins: Thinking about one of your key inputs, scrap, scrap prices have been volatile over the last few years. What is your strategy on obtaining raw materials and how will that change your company going forward?

Teets: Steel Dynamics has decided to invest heavily in the upstream requirements of steel operations. We have, under Mark Millett, his directive, he's in charge of our scrap and scrap substitute ferrous goods. And we have invested in Iron Dynamics, which is located at our Butler facility. And it produced liquid pig iron for direct consumption in the arc furnaces at our flat roll facility.

We are currently in the startup phases of our Mesabi Nugget project up in Minnesota, which is about a $275 million capital expansion to take iron range iron units and combine it with coal and create a high-concentrated, high-purity iron product for consumption within our arc furnaces, mostly at the Butler location, but wherever those units would be beneficial. In Columbia City when we are making railroad rail and Pittsboro at our SBQ operations for many products there also.

And so, we look at having a resource control, not necessarily underwriting it in a manner, because we want to make a reasonable return and a profit on the scrap side, but just having control over it and then being smart about the buying as well as the selling of those scraps into the marketplace.

We consume about 45% of the scrap that is processed by our Omni-Source division, and they supply about 50% of the scrap that we consume in the steel side of things. So there is a pretty good market balance that occurs month-in and month-out.

Collins: So, on a macro level, a lot of people have been talking about the U.S. dollar. How does the U.S. dollar's strength or weakness play into your business? For example, would a weak dollar be good for you or bad for you?

Teets: [laughs] That's always subject to the moment and many other factors that are playing out in the world scene. When the dollar is weak, needless to say, exports are an improved opportunity. Regretfully, scrap is a large export component. And that being our major raw material, it puts pressure on the supply side of things and has a tendency, then, to drive prices up.

But likewise, when the dollar is weak, we have an opportunity, even when Steel Dynamics is not positioned to be a major exporter of our finished products. And we are a part of a play amongst all of the like-minded individuals or companies that are making products. And so therefore, if anyone is exporting, that helps the overall supply side of things being in balance.

So it is good for all of us. We do export probably in a single-digit manner at our Pittsboro operation of special bar quality. We send quite a bit to Europe and to Scandinavia. We have a big customer in Brazil that buys about four and a half inch diameter high alloy bar and makes them into chain links for holding down moorings, mooring chains for offshore oil wells, drilling rigs, and so forth. And we also ship some smaller sections out of some of the other long products mills.

We do, on the non-ferrous scrap side, do quite a bit of exporting of that scrap, mostly to Asia, when it is an appropriate exchange rate. Needless to say, we also then have to watch from an import protection standpoint as the dollar strengthens. So it is a balancing act.

Collins: Last question. Thinking about barriers to entry in this space, the electric arc furnace has a lower capital intensity than a blast furnace. Is this lowering barriers to entry in the U.S. steel industry? And how do you think about the threat of new competitors going forward?

Teets: Well, competition is good for everybody. Nobody invited us to create Steel Dynamics and come into the marketplace, so we don't expect anyone else to ask for permission.

But lower cost capital goods doesn't necessarily win the war. And that is even in a perspective today of to build a steel mill, and let's just say it is a flat roll mill, it could be a billion dollars. That is not any small amount of change anymore. Whereas, 20 years ago a mini mill could be built for $85 million or $125 million. Those days are come and gone.

So there is still a barrier that people just don't throw that money around. But again, because of technology, we have some of the most modern technology in our mills, even though they are eight years old or 10 years old, and we are constantly updating it, as our existing competitors are. And so, there is as much threat without new facilities coming on, but it is there. And so it's real and we have to manage around it in light of it.