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United States Steel Corp. (NYSE:X)

Q3 2008 Earnings Call

October 28, 2008 2:00 pm ET

Executives

Dan Lesnak - Manager of IR

John Surma - US Steel Chairman and CEO

Gretchen Haggerty - Executive VP and CFO

Analysts

Evan Kurtz - Morgan Stanley

David Lipschitz - Merrill Lynch

Kuni Chen - Banc of America Securities

Michael Gambardella - JPMorgan

Michelle Appelbaum - Michelle Applebaum Research

Timna Tanners - UBS

Sal Tharani - Goldman Sachs

Tony Rizzuto - Dahlman Rose

Mark Parr - KeyBanc Capital Market

Michael Willemse - CIBC World Markets

John Tumazos - Very Independent Research

Marty Pollack - NWQ Investment Management

Bob Richard - Longbow Research

Operator

Welcome to the United States Steel Corporation third quarter 2008 Earnings Call and webcast. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder this conference is being recorded.

I would now like to turn the conference over to your host, Mr. Dan Lesnak, Manager of Investor Relations. Please go ahead.

Dan Lesnak

Thank you, Dimitri. Good afternoon and thank you for participating in United States Steel Corporation's third quarter 2008 earnings conference call and webcast. We'll start the call with some brief introductory remarks from US Steel Chairman and CEO John Surma. Next, I will provide some additional details for the third quarter, and then Gretchen Haggerty, US Steel's Executive Vice President and CFO will comment on the outlook for the fourth quarter. Following our prepared remarks we'll be happy to take any questions.

Before we begin however, I must caution you today's conference call contains forward-looking statements and that future results may differ materially from statements or projections made on today's call. For your convenience the forward-looking statements and risk factors that could affect those statements are referenced at the end of the release and are included in our most recent annual report on Form 10-K and updated on quarterly reports on Form 10-Q in accordance with Safe Harbor Provisions.

Now, let's begin the call here is US Steel Chairman and CEO John Surma.

John Surma

Earlier today for the third quarter, we reported record quarterly earnings of $7.79 per share. As you might have noted in our release, that figure included the $0.67 per share effect of $105 million pre-tax charge for employee signing bonuses paid as provided for in our new labor agreements with the steel workers and a $23 million charge related to environmental remediation at a former production site.

In addition, net interest and other financial costs in the third quarter included a foreign currency loss that decreased net income by $39 million, or $0.33 per diluted share. That's related to the re-measurement of $840 million US dollar denominated inter-company loan to European affiliate, which is partially offset by euro/US dollar derivative activity.

Excluding the effect of those three items, our earnings were $8.79 per share, which exceeded, both the high range of analyst expectations and the consensus, which I understand was around $7.05 per share. Turning now to our segment results, third quarter operating income of over $1.3 billion was nearly 40% higher than the then record results we reported last quarter, and almost four times our results from last year's third quarter.

Although capability utilization was lower than second quarter levels in both North America and Europe, as production was reduced later in the quarter to levels corresponding with declining customer order rates. We had significant improvement in operating margins for both the North American Flat-rolled business and the Tubular segment as a result of a strong pricing environment.

As in the second quarter, our safety performance remained very strong in the third quarter with all of our performance metrics continuing to show significant improvement over year ago periods. We thank our employees for their personal commitment to this most important of our metrics.

Our North American Flat-rolled segment earned record operating income of $835 million in the quarter, significantly higher than our second quarter results and nearly five times our earnings from the third quarter of 2007. Compared to the second quarter, third quarter average flat-rolled pricing increased by $130 per ton to $907 per ton as the increase in spot market prices was more fully reflected in our average realized flat-rolled prices in the third quarter.

Third quarter North American flat-rolled shipments were down due to some seasonality and weakness in the automotive segment and some softening in the service center and converter markets while energy-related markets remained the most resilient. Stable global steel demand for most of the quarter and the relatively weak US dollar helped us supplement third quarter North American flat-rolled shipments through slab sales and export opportunities.

Lower imports and manageable inventory levels across most industry market segments helped shipments and prices during the quarter. We're currently negotiating customer contracts that expire at the end of the year and we anticipate contract proceeds improving in 2009 as the new contracts more closely reflect market conditions. We'll have a better view of this matter next quarter.

Our third quarter European segment operating income was $173 million, down substantially from last quarter's record performance primarily due to lower shipments due to market conditions, higher raw materials costs and increased operating costs as we proceeded with the scheduled reline of one of our three blast furnaces at US Steel Kosice.

For our Tubular segment, operating income was $420 million in the third quarter, more than double our second quarter results. Operating income reached $809 per ton of shipments, 519,000 tons. Our average realized price climbed to $2,390 per ton. These record quarterly results were driven by the strong tubular market environment and full realization of July 1st, and prior price increases.

Now I'll turn the call over to Dan for some additional information about the quarter's results. Dan?

Dan Lesnak

Thank you, John. Our current capital spending plan for 2008 is approximately $860 million with $650 million from North American operations and $210 million from European operations. This excludes spending by a variable interest entities, which totaled $95 million in the first three quarters of the year.

Depreciation, depletion and amortization costs totaled $149 million in the third quarter and are expected to be about $600 million for the year. Defined benefit and multi-employer pension and OPEC costs for the quarter totaled $60 million. We made cash payments of $160 million for benefits during the third quarter. $41 million in required pension contribution and $119 million for retiree insurance plans including $52 million of profit-based contributions to a trust based on an agreement with the United Steel workers.

Also during third quarter, we made $70 million voluntary contribution to our main defined benefit pension plan bringing our year-to-date voluntary contributions to this plan to $140 million additional details we included in our third quarter Form 10-Q.

Third quarter net interest and other financial costs totaled $46 million, which included $6 million of unfavorable foreign currency effects. Excluding foreign currency effects, we expect fourth quarter net interest expense to be about $42 million.

Our annual effective tax rate for the balance of 2008 is projected to be approximately 27% and lastly for the quarter, we averaged $117.8 million fully diluted outstanding shares.

Now Gretchen will review some additional information and the outlook for the fourth quarter.

Gretchen Haggerty

Thanks, Dan. Through the third quarter, cash flow provided by operating activities was very strong at over $1.3 billion. Our free cash flow after capital spending and dividends, but before external financing was $572 million.

We ended the third quarter with $793 million in cash and total liquidity of just over $2.1 billion. As noted in the earnings release, we repurchased 1.13 million shares of common stock in the third quarter for a total cost of approximately $130 million. This brings our total repurchases to 16 million shares or approximately $1 billion and represents almost 12% of the balance of fully diluted shares outstanding when we authorized the original repurchase program in July of 2005. As of September 30th, 4.7 million shares remain available for repurchase under the current authorization.

Turning to our outlook, the volatile global economic climate is having significant negative effects on our overall business and our forward view is limited because of low order backlogs and short lead times. We expect a decline in fourth quarter results, mainly due to softening demand in prices for our flat-rolled products in North America and Europe and we expect to continue to operate at reduced production levels corresponding with customer order rates.

For flat-rolled, fourth quarter results are expected to decrease from the third quarter due primarily to substantially lower shipments and lower average realized prices, partially offset by lower raw material costs.

Based on very weak market conditions, we expect results to decline substantially for US Steel Europe in the fourth quarter. Fourth quarter results for Tubular are currently expected to be comparable to the third quarter. We believe over the longer term, our company is well positioned from an operating and commercial standpoint.

We've been through many downturns in the past and we're confident that our facilities and our people are in a much better competitive position to address the challenges ahead of us. We will continue to focus on making steel for our customers as safely and as cost effectively as possible. Thank you.

Dan Lesnak

Thank you, Gretchen. Dimitri, can you please queue the line for questions.

Question-and-Answer Session

Operator

Next question is from Kuni Chen with Banc of America Securities. Please go ahead.

Kuni Chen - Banc of America Securities

Hi, good afternoon.

John Surma

Hi.

Kuni Chen - Banc of America Securities

Just on the contracts, John, you mentioned you'll have a better view on that in the upcoming quarter. I think I remember last time you said you had about 5 million tons to 6 million tons coming up for year end. How much of that is out of the way at this point?

John Surma

Some, but not by any means all. That's probably a decent number. That would be a decent number assuming somewhat normal volumes as of today and it might be a bit less now, but a pretty good number. But some has been concluded, but more yet to come, and as I said, we'll give you a little more on that next quarter. We should know quite a bit more then.

Kuni Chen - Banc of America Securities

Okay. And then just as a follow up, I just want to get your thoughts on the potential impact of auto industry bankruptcies or mergers and what the impact there is on the supply chain and what type of things are you doing internally to sort of analyze the situation and better position yourself for continued volatility there?

John Surma

Sure. I will let Gretchen maybe talk about the sort of credit aspects of that. But just from an overall market standpoint. First and foremost, they are all really good and important customers and they have been for a long time and our assets and their assets and our people and their people and our systems and their systems match up well.

We want to see them do really well. In the case of merger or some other kind of instability, I guess what really matters at the end is how many cars or vehicles are manufactured in North America because we think we are in a position to get a pretty good share of that regardless of who owns it and how they own it. We would prefer that all of our good customers continue to do business as they are, I suppose and if they build more than they build this year, but for us, we're going to be here to be a good supplier to whoever is on the other side. We just want to see them making as many automobiles as we can, and we're hopeful that all the customers find a way through this mess and morass and come out the other side, better stronger companies but Gretchen on the credit side I'll let you talk about that.

Gretchen Haggerty

Just from a receivables standpoint, I think we've worked very closely with all our major customers and we're pretty comfortable with where we are. We monitor our relationships closely and obviously its commercial relationship, too. So, we look at it in the context of that whole relationship, but I think we're pretty comfortable with where we are.

Kuni Chen - Banc of America Securities

Okay. Fair enough. Thanks a lot.

John Surma

Thank you.

Operator

Next question is from Michael Gambardella with JPMorgan. Please go ahead.

Michael Gambardella - JPMorgan

Hi, John, how are you?

John Surma

Fine, Michael?

Michael Gambardella - JPMorgan

Good, good. Could you give us a sense on how you have seen the markets, for Flat-rolled, say in the US, transpire over the last two months?

John Surma

Two months is a long time.

Michael Gambardella - JPMorgan

I know.

John Surma

Well, there has been, at least in my experience, a bit of fairly abrupt change in the market. We were perhaps expecting there to be some normal softness for either seasonality or otherwise later in the latter part of the year, but nothing that was as abrupt as, in fact, has transpired. How much of that is because of worries about credit, I think probably some of it is. How much of it is because a broader slowdown in the economy, undoubtedly some of it is. So it was a very abrupt slowdown.

But what seems to be happening now is the credit crisis, if I could use that common term is not so much that we don't have access to capital or liquidity and cash as strong as Gretchen mentioned, or that the customers we deal with that they don't have the ability to run their business. I think they do. But everybody, including us, is trying to take their investment in working capital down and there by preserve liquidity.

And I think particularly where we can observe it in the service centers in particular because of the monthly statistics, inventory has been driven down and it feels like in total they are heading towards another drive down by the end of the year.

It may be that's another million tons below what the restated number is right now. If that's the case, it may be that by the time that additional reduction is achieved, it just maybe that the relative consumption that underlies the economy and what's in the pipeline begins to calibrate a bit and we maybe return to some normalcy in the order book, but those are all just suppositions, but to answer your original question, it was a very abrupt slowdown unlike any we've seen.

Michael Gambardella - JPMorgan

And what are you seeing on tubulars going forward?

John Surma

Well, I think our outlook as Gretchen indicated is that our order book for the fourth quarter on the tube side is pretty good, and we expect to have a very good fourth quarter in tubular. We don't for a minute think of course, that that particular sector of the economy is immune from all the other difficulties that the economy is bearing right now. To the extent that translates into lower liquids and gas prices, it could perhaps translate into less drilling or at least less [petrol], right now the level of activity is near historic highs and very robust, but I think that remains to be seen how well that sector survives in this particular economic turmoil.

Michael Gambardella - JPMorgan

And final question. I know you still have nearly 5 million shares left on the buyback program. Are you still actively around this closeout period, around the earnings release, blackout period, rather, are you still going forward with a buyback program?

John Surma

I'll let Gretchen comment on that. It's not that she really wants to, but I'll let Gretchen.

Gretchen Haggerty

I think you can obviously see that we bought more shares back in the third quarter than we did in the second quarter, so we were active there. We really don't like to comment about what our plans are for repurchasing shares or what we might we have underway, but we've got that authority available to us and I think we've been pretty good about using it overtime.

We'll continue to look at that as an aspect of how we balance the capital that we have available and just take that into consideration, but I guess I would just note that there are many other companies who have done that, too, who are husbanding their liquidity, as I guess I would put it, and that would seem to be more of a predominant trend among some industrial players, but we've been pretty measured in how we've done this. So, we'll continue to try to be measured even in light of this difficult environment.

Michael Gambardella - JPMorgan

Thanks Gretchen.

Operator

The next question is from Michelle Appelbaum with Michelle Applebaum Research. Please go ahead.

Michelle Appelbaum - Michelle Applebaum Research

Hi. First, an amazing performance in the flat-rolled business in the third quarter and it's obviously disappointing that it comes in time when obviously we're not going to be able to repeat that, but congratulations to your team for that profitability.

John Surma

Thanks, Michelle.

Michelle Appelbaum - Michelle Applebaum Research

When I look at my screen, I see three tickers that are the same from the list of 20 names I had when I started off 30 years ago. Yours is one of them. And I think that looking back over that 30-year period, there were some amazing forks in the road where US Steel made choices, they kept US Steel alive and prospering, relatively rich in cash flow, pension fund, not building [connate] things like that.

This is a philosophical question, where US Steel has consistently made choices that would be kind of more conservative, kind of what I've started to think about as building your three little piggies, you built your house out of bricks instead of straw like other situations. Can you talk a little bit, going into '09 with some of the things that you've probably still have in place, some of these conservative choices and how they'll benefit you and cushion as you go into this contraction?

John Surma

Sure, Michelle. I'll just give you a couple of general comments and then turn it to Gretchen, but one was already raised. Our predecessors were very much intent on funding our pension plans, investing it wisely, conservatively, and keeping us away from problems. Gretchen has thoughtfully continued that tradition. That's just an example I think where we've tried to deal with a matter that we didn't make, but necessarily need to be dealt with and I think Gretchen has done it in a very appropriate way.

We have taken risks, but they have been risks with a very thoughtful view of what the benefits are and what the downside was. The acquisitions we've made have all been transactions that fit within our existing systems. We have added on some elements that we didn't otherwise have where we had a feeling that the synergies would be good for us through a range of market conditions, which you've heard me say before.

And I'd just say in general, the words we use a lot around here are balanced, and responsible. And that's the way our predecessors have always thought and that's the way we still continue to try to think, but Gretchen you may want to be more specific?

Gretchen Haggerty

No, I appreciate that John. Obviously the pension funding is something that we've been very measured about, and the voluntary funding that we've done there, we did really just for the reason that were seeing now. And so, I feel pretty comfortable about where we are there. I think from a capital structure standpoint, we do try to make sure that our maturity schedules manageable and over the next two years we only average maturities of about $130 million I want to say.

So, we don't really have a near-term need to be accessing the capital markets now to refinance any debt or anything like that. So, that's been pretty conservative. I think you know this as well as anybody, Michelle, but managing in difficult times is kind of a core competency of a lot of the management that's still at US Steel, and we know the things and the levels that we have to pull when things are difficult.

And, as John mentioned, this came on a little bit more precipitously than perhaps we had or anybody had foreseen, but we're moving pretty quickly to make sure that we're maintaining our liquidity and doing the right things, pulling down inventories where we need to and matching our production to our customer order rates quickly. So, I just think we've got a good history of conservative behavior that should help us during this kind of a time.

Michelle Appelbaum - Michelle Applebaum Research

Okay, that's great broad overview. I want to ask another question. You've given out your production and your operating rate for the quarter, but I'm wondering can you comment on what your operating rate is as you exit the quarter right now?

John Surma

We prefer not to do that, Michelle, for a number of reasons. We will tell you that we're operating well below the rates that we operated at on, average during the last quarter and probably today a bit below where we exited the quarter, quite frankly. That's dictated by the order rate and as customers as tell us what they want, which is they do at the last minute in a market like this, we ensure that we're positioned to produce that.

The only thing I would comment on that maybe is a little bit off the beaten path is that, we have one of our two operating furnaces at Great Lakes, near Detroit. We intended one of those furnaces before to run into next year sometime, when we were beginning the work to do sort of moderately sized job on that furnace as part of a larger reconfiguration at Great Lakes.

But that furnace exhibited some instability in, I'm losing track of time, August, probably some time like that and rather than try to push it, we thought it better to take it down for performance reasons. Initially as it turns out it probably wouldn't have been necessary anyway.

And so, we're about doing that job now. We weren't really prepared for it so it's going to take a bit longer to get the materials in, and we need to do refractory states etcetera, that's all underway. I was just in the furnace last week actually. And so that furnace will be out probably through the end of the year or close to it. We're not quite sure how much work we’re going to do because we’re still in the process right now. But that's the only slight operational difference the rest is, we're going to run as much as we need to. That’s very dynamic and I could give you a number today and a configuration today, but it could be different next week.

Operator

Our next question is from the line of Timna Tanners with UBS. Please go ahead.

Timna Tanners - UBS

Yeah. Hi, thanks. I wanted to ask a little bit about the context structure that you might see going into next year. How much of that might be more variable versus fixed price and how you’re seeing those talks go?

John Surma

Sure, we're having as I said, during the discussions right now and it's sort of impolite to get into too much of that, while we're conversing with our customers, I wouldn’t want them to, I think we’re talking about their business in this form. But your interest is understandable and appropriate.

We are pointing towards a somewhat more variable contract structure to provide both us and our customers some better feeling that we can deal with the intra year volatility that just in the last six months has been extraordinary. Some of that might be around published indices. Some of it might be around more input based kind of adjustments. We're not quite sure how that's all going to shake out yet. Those discussions are underway, but the direction probably would be less fixed for a term, more some with some kind of market related adjustment factors in it.

Timna Tanners - UBS

Okay, great. And then along those same lines can you remind us how much of your cost in general are variable. I know in the flat-rolled division in North America maybe a little less so, but if you look at your cost per ton, it was 722 in the third quarter. I mean, how do we think about that going forward, when there is outages, does that number go up? What's variable within that and then if you could give us a little bit of information on the other segments similarly?

John Surma

Sure.

Timna Tanners - UBS

Thanks.

John Surma

Well, it all depends on how you want to measure it. But let me start [differ this] away in Europe, most of our inputs are market based in these days raw materials are two-thirds or more of our cost structure, you [through] in energy in your three quarters probably somewhere in that range. And those are all market based over sometime, whether its quarterly or annually it is maybe monthly the way [extract] this.

So, I think in Europe the majority are variable and we look for them to vary down either during this quarter or the next quarter. In tubular, sort of that the inputs, which would be either steel rounds or hot band, those would be variable when measured at the segment level we're transferring mostly from other segments and we're finding some of that outside, [but not a lot].

The other major components would be energy, which would be variable over sometime period and the labor would be fixed in that area. So I think in two better segments, the vast performer would be variable, if that's your definition of variable. And then back into flat-rolled side, probably two-third at least would be variable, and you might think even though we have our own iron ore that’s just a fixed cost, it rally isn’t, the majority of the cost, when you are all said and done, is energy and transportation in other elements that have a variable component to them.

And I point out in our labor contract because of our profit sharing. There is a not insignificant piece of variability in that cost as well. It could be $15, $20 a ton potentially, somewhere in that range. And then we can pull a bit of a labor level, where we have some contract services and other things that we could exit from quickly and easily and already have in many cases. And begin to cut down over time and schedule vacations, etcetera. So, we can do all those things, so there is a good, there is a significant amount that’s variable, but it is a monthly reset in every case that there are two different definitions there

Timna Tanners - UBS

Thanks.

Operator

Next question is from Sal Tharani with Goldman Sachs. Please go ahead.

Sal Tharani - Goldman Sachs

Hi, John. How are you?

John Surma

Hey, Sal.

Sal Tharani - Goldman Sachs

John, on USSE again on your cost for our [non-cooking coal]. Are these quarterly priced or monthly or how do you a buy these?

John Surma

It's not monthly. It has been periodically, whether it is quarterly, or six months depending on the material and the vendor. In Europe, we are largely a spot priced steel seller. We have some contracts, but probably 70% would be spot, one kind another. And if you look back to the second quarter, it was a record quarter for Europe. The spot prices were firm and moving up, and the new raw materials costs that we had entered into, new contracts as of April 1, really had to work there way through the system. So, we had widening margins and right now we have sort of a triple whammy of volumes down, furnaces off for part of third quarter, part of the fourth quarter, which gives us higher costs and raw material costs high and spot prices going down, so it has put some pressure on us.

The spot price reduction has been more rapid than we ordinarily seen in Europe and we're going to be about getting our raw materials costs inline with that, but that may take a little time. Probably, we're hoping to get some relief on that this quarter or next quarter, but certainly into the second quarter we would expect to begin to see that kind of relief.

Sal Tharani - Goldman Sachs

And also your new galv line a little bit, galvanizing line. Have you been able to get contracts with he auto companies on those, although you're selling that product mostly?

Dan Lesnak

Well, it's staying fairly close to home, but there's a good deal of auto consumption there, so we have some contracts with automotive suppliers. Again, it only started up this year, sort of formally. So we're in the process of getting qualified. But we have a good bit of auto, some appliance and whatever is left over because of the construction market, we've been able to glow that line pretty full, actually very full since we started it. And I think its viewed, the product is excellent. We have done metallurgy in front it. And I think all the European auto companies see is it as a good alternative and we look forward to continuing to make inroads in that market, but we're doing pretty well on that right now.

Sal Tharani - Goldman Sachs

Is the demand any different in Europe than here?

John Surma

Demand, probably no. I think I read one of the trade papers this morning that said the markets are absolutely dead. That's a bit extreme but it's not much better than. I think the European stocks inventories are a little bit on the high side and perhaps the European market is maybe a little ways behind some of the de-stocking that's gone on here but European market we look at stop market, Central Europe, Southern Europe is a little bit on slow side right now.

Operator

Next question is from tone Tony Rizzuto with Dahlman Rose. Please go ahead.

Tony Rizzuto - Dahlman Rose

Thank you very much. Good afternoon.

John Surma

Hi, Tony.

Tony Rizzuto - Dahlman Rose

Hi, John. With respect to fourth quarter volume, I know you don't want to comment on that specifically, but would it be the best thing just to watch the AISA data very closely and perhaps to be a assumption that your volumes are going to be fairly close to that at least in Flat-rolled?

John Surma

I mean that's a piece of are direction, I mean I think that’s a fairly good direction in the other odd all that many times going in there piece of it so I think that's a reasonable, that certainly would give a good indication, good direction in our, we could change ours more as quickly and then that data might suggest I think that's a pretty good indication.

Tony Rizzuto - Dahlman Rose

Alright, I wanted to ask a question to John. I mean I can't recall any economic downturns where any industry has acted as quickly to counter acquisitions in a, I am interested to hear your thoughts on the discipline we are seeing around the world but and also do you think this is sustainable?

John Surma

Well, I can only as I've said through say concern when good times and bad we can only speak for our own actions and we've had a pretty fund policy of making what our customers order. We prefer them to order less than we can make, but see no alternative to that. We think that that's the proper business approach and we've been pretty studious and pretty clear that’s the approach we take. I can't really comment on what goes around, as you can read about that is the trade press as well as I can't tell you but our view is that we see no value in putting costs into the product and putting the product on the ground and we are not going to do that.

Tony Rizzuto - Dahlman Rose

As a very important person in the world steel association, I was wondering if could you comment on China. It seems like we're beginning to see a bit of reversal from earlier policy where the government and (inaudible) seem to be talking about, that you are looking to restore the VAT rebates, can you comment on that?

John Surma

Well only that I read those kinds of rumors. I did not hear anything like that, the last time that the group convention was in session. Not that we would talk about it necessarily, but I had heard sort of thing, just what I have read in the trade press recently, that would be I think a very unpleasant result and would be certain to cause additional trade tensions and it would be the poster child example of what state involvement and state ownership causing market distortions.

It would be a perfect example that causing additional exports with a state favored rebate because of internal market disruptions. That would be an absolute textbook case for trade distortions and we are not at all ashamed of saying that we expect our nation's trade loss to be respected and if necessary enforced.

Tony Rizzuto - Dahlman Rose

Thank you very much, John.

Operator

Next question is from Mark Parr with KeyBanc Capital Markets. Please go ahead.

Mark Parr - KeyBanc Capital Market

Hey, thanks very much. Good afternoon.

John Surma

Hi, Mark.

Gretchen Haggerty

Hi, Mark.

Mark Parr - KeyBanc Capital Market

I don't know if you want to comment on this directly, but I want to ask the question anyway. John, could you talk about how you feel regarding the profit outlook for the domestic business in the fourth quarter compared to how the fourth quarter of '06 turned out?

John Surma

That's a long time ago let me think. Fourth quarter of '06 if I recall, Gretchen is going to flip to our segment analysis. We operated at quite low levels, if I recall, that was a 65% in capability I think and…

Mark Parr - KeyBanc Capital Market

It wasn't that long ago. Now, come on.

John Surma

It seems like a long time ago. No, I think we were marginally profitable then. I think a couple of things, Mark. One, I think our company is much better now than we were then. We have the additional operations in Canada, we have the addition of Lone Star, which has taken away roughly a million tons a year, which provides a lot more stability in our operating configuration now than it would have then.

So big positive which as we said was one of the synergies we saw and even though as spot prices have not been responding to the direction we like, relatively speaking they are still quite fulsome at this point compared to where they were last year or certainly in that period. So, I like to think that compared to '06, we are a much better company and maybe we can do a little bit better.

Mark Parr - KeyBanc Capital Markets

Okay and along those lines, just to follow the thought process, I think you had made some comments about better flexibility with over time and scheduling and things like that, were there any changes in the recent labor contract that give you more or less flexibility as far as the scheduling and the use of labor?

John Surma

No, not really. No changes. Although, we always had a good deal of that flexibility and then the '03 contract. I think with the improvements in productivity orientation on job classes and otherwise I think we improve that position and I don't mean that in a us-versus-them way, just a better way to operate the company and that works for everybody as a result of profit sharing.

I think we have had that. We maintained it in this most recent contract and I think as I've said, we intend to use it judiciously to make sure that we can keep our cost structure in line with what we are actually producing.

Mark Parr - KeyBanc Capital Markets

If I could just ask one last question, could you give us a sense of natural gas costs in the fourth quarter, domestically and how much you have been able to take advantage of the lower prices that have emerged on the spot market?

John Surma

Well, we do a little buying ahead on natural gas for our operating units are gone mostly to match up to some of the contract tons, where we've sort of already sold the BTUs forward on a fixed price. We do some buying ahead, but that still leaves an awful lot that we buy on the spot market. You could take a look at the strip like we do, if the gas price comes in, we are doing do a bit better. Of course we also keep an eye on our Tubular business and certain level of gas price there we find very healthy. So, we have to try to get the sweet spot, I am not sure exactly what it is, but the sweet spot is what we are looking for?

Mark Parr - KeyBanc Capital Markets

Okay, terrific. Thanks very much.

John Surma

Thanks, Mark.

Operator

Next question is from Michael Willemse from CIBC World Markets. Please go ahead.

Michael Willemse - CIBC World Markets

Great. Thank you. Thanks for taking my call.

John Surma

Hi, Mike.

Michael Willemse - CIBC World Markets

Just first question actually on scrap. Do you look at how much scrap prices are falling off? Is there any ability to increase your mix of scrap in steel making or are you pretty much maxed out right now?

John Surma

No, maybe we can flex it around 5% or so, with the charge and where that make sense, because you have to look coke positioning and transportation and what coal (inaudible) we have et cetera, but overall I think we would probably be leaning toward to somewhat heavier scrap blend given where the scrap price has gone. We have got some flexibility, yet 5% is a rough number.

Michael Willemse - CIBC World Markets

Do you have any thoughts on where you think the scrap prices could be going near term and maybe 6 to 12 months out?

John Surma

No, no. No, it’s not really. I mean we are amateurish compared to others that are using that for their major materials. So we buy a lot of scrap in total, but comparatively less than many others. We run our prices against the indexes that are available in the marketplace. We think we do pretty good at that. But we have never done well with predicting the scrap price and I am not sure anybody has.

Michael Willemse - CIBC World Markets

Okay. And then just actually focus on costs again. If you look at your cost per ton in Europe at $963. You look at your cost per ton in North America, at $722, you would think North America was much more cost competitive, but obviously mix has a big factor there. So, I just wondered if in your internal analysis which mills have you generally seen as more cost competitive, especially particularly given where the US dollar has gone over the last couple of months?

John Surma

Well, if there is really three elements I'd call out, one would be the dollar/euro relationship because that certainly has an influence. And that moved in one direction and now it's moving the other direction. We can all see what those curves are. So you can fill for that if you want to, but that certainly has an influence.

The other element is that just a pure conversion costs, our European operations are quite competitive. Not exactly the same levels of productivity, still more competitive wages. But on a conversion cost basis, they're quite competitive. We measure them mostly against other European competitors and we think they stand up very, very well and have a bit of an advantage.

But then on materials, if they are converting in Europe those materials cost have gone up much more than the corresponding materials cost we would have had in the US and North American plants, mostly Eastern European, Russian, Ukrainian ore and coal from the Northern regions.

So the overall cost increases in Europe have been more materials driven. We still have a very competitive conversion structure, but that's been somewhat diverse by the increase in the materials cost.

Michael Willemse - CIBC World Markets

Okay. Great. Thank you.

John Surma

Thanks.

Operator

Next question is from John Tumazos with Very Independent Research. Please go ahead.

John Tumazos - Very Independent Research

Congratulations on all the earnings and liquidity.

John Surma

Thanks, John.

John Tumazos - Very Independent Research

When you decide potential capital investments, business expansions, outlays and the very uncertain world of the moment, what are the planning metrics you are using two, three, four, five years out? Some of us worry of the great depression. Other people think this is just a panic that will pass and please tell us how the captain of the ship is steering the big boat?

John Surma

Well, thank you, John. It's a very artful question, I guess and one that I am afraid it's a better question than I probably have answer for. I'd say carefully, thoughtfully and responsibly and without resorting to extremes. That's the way we like to do things. We deal through a lengthy strategic planning process every year, and we do using outside sources, inside information, we look at price curves and cost curves and where we think the sector and the adjacent sectors are going. I must confess. Last time we did that. We didn't build in a huge global recession occurring one day in August or September, but we do have up and down cases and high case low case sort of thing.

So we are not completely inexperienced to [pre-siding] over this, but when we're looking at investing in a coke plants or blast furnace, that's a 30-year operating life and I think it's likely to say that when you make those investments, you are going to go through two or three or four cycles before it's all said and done.

So, we have to take a somewhat longer-term view of that. We try to focus our capital on the things that are most pressing for environmental safety, continuing operations and highest ROI, not in any particular order. And then we take a look at what our available capital is while maintaining a good capital structure and we try to make those two come together in some way, but I have no real magic elixir or weegee board to tell you how we do it, John. We just think about it, talk about it, and try to come up to an answer that balances all those things.

On the margin, we are going to tend to be a conservative responsible group that thinks more about what difficulties we may encounter rather than running a big risk and trying to hit the big home run.

John Tumazos - Very Independent Research

Do you have specific metrics you use such as a dollar/euro exchange rate or long-term growth rate of world steel output and consumption that you can share with us?

John Surma

On the long-term steel forecast, we tend to look at the world steel numbers. They are coming in from all the different regions, so it's a kind of a grassroots effort and they go through a lot of filters and analysis. And so I tend to think that's as good directionally as anything, and I think the long-term case for pretty good global steel demand is still there. 70% of the world's steel is consumed in the developing world and I see no reason why the 4.5 billion people who live in the developing world that their improved life has to stop today. And I think the long-term case for more steel consumption is very, very good. When that gets back on track, or whether it's a lower track or higher track, your guess is as good as mine.

On the exchange rate which is extremely important these days, we get all the econometric forecasters we can. Gretchen talks to her colleagues at the various financial institutions and we try to come up with a composite view, but again, we model everything we do across the range of possibilities, not trying to just guess one or the other. Those would be two metrics we used, but I'm not sure we use them to any absolute, precise manner.

John Tumazos - Very Independent Research

Thank you.

John Surma

Thanks, John.

Operator

The next question is from Marty Pollack of NWQ Investment Management. Please go ahead.

Marty Pollack - NWQ Investment Management

Yeah. Just back to Europe, clearly one of the things that we've seen in Europe in the past through thick and thin, you guys have done very well even when the price of your hot-rolled was $600 a ton, you made as much money as you are making now, at least looking at this quarter.

What are the things it will take to normalize those operations next year? Is it going to be utilization and other benefits maybe lower raw material costs, beyond the simple one quarter or two? Should '09 be reflecting more historical trends?

John Surma

Very fair question, Marty. And I think it should reflect more historical trends. Again, the very sharp turndown in spot pricing, against a rising raw materials environment is something we have encountered before, but over a much longer period of time. It's really the speed that one has moved and the other one hasn't, that's quite different this time, which by the way implies that we should be thinking about how price of those materials in the future try to be more responsive to what happens in the market, but over a some period of time, the materials cost coming into better alignment with what the conversion market has to offer, and then us getting the plant done, the blast furnace finished and getting those costs out of the way I think that's just an item that's going to happen once in a while. I don't see that as an indicative of the future.

It's really that conversion margin that has been, as you point out, quite good historically. I think we have every reason to think we are going to be able to maintain something like that. This latest downturn happen so quickly, they just took away the margin much more rapidly then they did before.

Marty Pollack - NWQ Investment Management

Do you think when you are looking at where the marginal cost curve is, if historically been a low-cost producer? Western European steel producers at this point are likely facing the same current cost that essentially makes you wonder how low can the price go when we've got the kind of environment that we're facing, at least out of Europe? I am just wondering whether there's some indication that prices there have to start dropping.

John Surma

Well, it's a very good question, Marty. If you are getting the point that at some point when you start to hit the marginal cost of a large volume of production that something has to change, that's probably a fairly good observation. I don't know what the right number is, but I think that the other European mills again just based on public information, world cost curve that kind of stuff. Their costs are probably not much different than ours, maybe a little bit lower, again based on public information only. And we're probably getting fairly close to that with the spot prices right now.

So I think that's a fair observation. A good bit of the piece of the world steel dynamics, world cost curve is probably at least the European piece close to being underwater at this spot price.

Marty Pollack - NWQ Investment Management

And just one question on the Flat-rolled of North America. You have a spot buyer of scrap, part of your requirements of the couple million tons a year. Is scrap an offset benefit to the, assuming that things continue as they are and scrap prices stay low, is that a net positive for you going into next year?

John Surma

Yes, compared to our costs this year, scrap coming off gives us a cost benefit. Again, its only 15% to 20% of our total charge, but lower scrap means lower cost for us, although [positionally] from a overall market standpoint, probably high scrap is better for us, but a low scrap price does help us from a cost standpoint.

Operator

Our next question Charles Bradford with Bradford research. Please go ahead. Mr. Bradford your line is open. We go to the next line. We will take the question from Bob Richard with Longbow Research. Please go ahead.

Bob Richard - Longbow Research

Good afternoon. Thanks for taking our call. Any lower cost or market tissues on your steel product inventories, would that be material? I don't know what your inventory levels are exactly, would it be an issue?

Gretchen Haggerty

We're largely…

John Surma

In North America.

Gretchen Haggerty

We're a LIFO.

John Surma

Were LIFO player, so they've got low base inventories.

Gretchen Haggerty

In Europe and Canada, we're FIFO. We don't really have an issue there I think.

Bob Richard - Longbow Research

Okay, thanks. And capital expenditures year-to-date, 66% of the $630 million spent in North America. Where is, on the flat-rolled business, pardon me, where is the bulk of that going? Can you refresh me on that?

John Surma

Well, there's been a couple of blast furnace projects. We have a variety of mobile equipment up in Minnesota. We have a fairly heavy diet of that at the iron mines this year. We also have an ERP project underway, some of the software cost and other things get capitalized as part of that. The rest would be spread throughout a variety of other project at different locations.

And a good bit of it right now is heading towards the [coal] side of operations we are doing, through walls and other refurbishment project, some of which are capital. But no individual big hit project to include that in list. Just a variety of things.

Bob Richard - Longbow Research

And do you have the flexibility to halt that for a quarter or so, if you had to?

John Surma

We have the ability to throttle back and reprioritize and move some things out within reason. There are some things that we must do under a variety of environmental requirements or must do for production reasons, but we do have the ability to moderate slowdown, reprioritize. We've done that in the past many, many times and we're in the process of doing it right now.

Bob Richard - Longbow Research

Thanks, and again, great quarter.

John Surma

Thank you.

Dan Lesnak

All right, like to thank everybody for participating, and we will talk to you next quarter. Thank you.

John Surma

Thank you all.

Operator

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Source: United States Steel Corp. Q3 2008 Earnings Call Transcript
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