By Bridget Freas, CFA
While we think United States Steel Corporation (U.S. Steel: X) has some promising developments in the pipeline, there is little to look forward to in the near term. Domestic steel prices have been tepid in 2012, and while demand continues to improve, the U.S. economy is not yet strong enough to handle the pressure of weak steel market conditions in Europe and potentially China, as well as added domestic supply. The stock price looks attractive, but 2012 will be a challenging year and we see hurdles for U.S. Steel even once demand fully recovers. We believe the company has no economic moat, with a competitive position that is weaker than many steel companies we cover, and we see the potential for further moat deterioration over time.
Operating Rates Strong, but Near-Term Upside Limited
U.S. Steel's annual capacity utilization rate at the North American flat-rolled business exceeded that of the sector as a whole for 2010 and 2011, given the relative strength of the automotive, appliance, and general manufacturing sectors and less exposure to the anemic construction markets. The medium-term outlook for auto and machinery remains positive but slower, and we think there is more upside potential ahead for steel producers with more leverage to growth in infrastructure spending. Further, the flat-rolled markets have seen the greatest volatility in pricing and order rates in the past few years, and that is likely to continue. This is partly due to added domestic capacity by RG Steel, ThyssenKrupp (TYEKF.PK), and Severstal in the past year, as well as added imports. We estimate this segment will represent more than 50% of operating income, but is likely to experience the greatest earnings volatility. While import pressure may ease with the slide in steel pricing and shorter domestic lead times, we believe the overall share of imports is consistent with historical levels and, given the relative health of the domestic sector compared with other regions, we see little room for import relief.
U.S. Steel's Cost Position Improving, but Structural Disadvantages Remain
The sale of the Serbian operation in January is a major catalyst for earnings improvement, given the mill's significant earnings drag, which was unlikely to abate due to its cost structure and the economic conditions in Europe. Another cost challenge the company has faced is the high price of merchant coke needed to operate its blast furnaces. U.S. Steel is finishing installation of a new coke battery at the Clairton plant and coke substitute modules at the Gary plant, which should avert the need for any purchased coke going forward. This should save about $100 per ton of coke, or about $40 per ton of steel produced. The push for greater natural gas usage to replace coke in the blast furnace could shave off another $7 per ton of steel produced, assuming natural gas prices of $4 per million Btu.
However, we think this margin improvement could be partially offset by weaker steel prices, which may come under pressure in the next few years as China's steel consumption growth slows. Not only would this create import pressure in the United States, but Chinese steel production will probably fail to keep pace with global mining expansion, which should drag iron ore prices even lower. Since iron ore is the largest steel production cost, this should help support margins in the face of weaker steel prices for much of the industry, but this is less true for U.S. Steel's North American flat-rolled business. One of U.S. Steel's greatest assets is its 25 million tons of annual iron ore output in Minnesota. At iron ore pellet production costs of $65 per ton, it is unlikely that iron ore could become a losing enterprise for U.S. Steel. However, given the lack of margin support the mining operation provided during times of record-high iron ore pellet spot prices - which were above $160 per ton for most of 2010 and 2011 - due to other cost challenges, we are cautious about the direction of margins for U.S. Steel when steel prices adjust to an iron ore market that is back in balance.
Recent weakness in iron ore and scrap pricing, in addition to general economic malaise, brought domestic hot-rolled coil prices back down to $600 per ton as recently as June after peaking at nearly $800 per ton early in the year. There is little margin to be made at that price level for an integrated flat-rolled producer. U.S. Steel's business model demands stronger pricing power, which will be difficult to achieve in the face of declining input costs, shortened lead times, healthy imports, and higher domestic capacity. Much of the margin squeeze for flat-rolled steel producers in recent times was caused by soaring iron ore and coking coal prices. In the face of lackluster steel pricing, many producers can still hope for lower input costs. There is less upside for U.S. Steel as the steelmaking earnings contribution reverts to the 60%-80% range, in our view. Considering the substantial legacy costs of the company's underfunded pension, with $530 million of pension expense expected for 2012, U.S. Steel bears a larger share of cost challenges ahead.
Opportunities Exist In Auto, but Difficult to Quantify Value
The company's total exposure to the automotive market is about 30% if we include shipments to service centers and other customers that eventually end up in the hands of automakers. Fuel economy standards will require automakers to produce lighter vehicles, driving a push toward higher-strength steel. U.S. Steel's PRO-TEC joint venture with Kobe Steel is planned to reach full production in 2013 with capacity of 500 thousand tons of cold-rolled advanced HSS. The company has been working closely with automakers to develop products that will meet stringent fuel efficiency and safety standards, while also creating relationships to solidify U.S. Steel's position in this key sector. The company is essentially developing a steel product that costs more to make, and thus sells at a higher price point, but requires less tonnage per vehicle, so the cost to the automaker is roughly unchanged.
We believe substituting aluminum for steel will also be part of the solution to meet fuel economy standards, and therefore there will be some market share loss to the lighter metal. But as the incumbent and much cheaper material, steel is likely to continue as the dominant choice, and the continued growth of the automotive market worldwide should more than offset metal substitution effects. We think these investments in HSS are critical for U.S. Steel to maintain its share in this important end market, but the value is uncertain. Whether selling fewer tons at a higher price point will yield additional margin is hard to predict. It's also unclear whether these investments will achieve any market share gains, as other steelmakers such as ArcelorMittal (MT) and ThyssenKrupp have HSS initiatives of their own.
Asset Base Improved in Europe, but Kosice Plant Not Out of the Woods
The 5 million-ton Kosice plant is now U.S. Steel's only presence in Europe following the sale of the Serbia plant in January. Kosice is somewhat protected from the turmoil in Europe as the majority of its shipments are to the relatively stable economic markets in Hungary, Poland, Slovakia, and the Czech Republic. The capacity utilization of the plant in the second quarter was 94%, compared with the middle 70s for the EU 27. This plant has stayed out of the red for most of the past two years, but it is still operating in an economically challenged region. A push for greater contract business and higher concentration of premium products can only add value if steel market fundamentals hold up. We expect to see little earnings contribution from the Kosice operation over the next two years.
Energy markets should sustain tubular, but it is not immune to oversupply and weaker pricing. We estimate the tubular segment will generate 35% of U.S. Steel's earnings power over the long term. It has been the most stable and consistently profitable segment of the company's portfolio, and this is likely to continue, given the relative strength in the energy markets. Low natural gas prices have weighed on the rig count, but rising oil rigs more than offset this effect, pushing spending on oil and gas exploration--and the demand for oil country tubular goods - higher. However, there are some risks on the horizon. Demand will need to keep up with new capacity in the NAFTA region from Tianjin Pipe, Vallourec (VLOWY.PK, VK), and Tenaris (TS). Management appeared confident that added supply would mainly displace imports, but we view that as a best-case scenario. In addition, many of the positive trends in the oil and gas sector - particularly the unconventional drilling demanding more premium tubes - will provide a greater benefit to tubular producers that operate at the higher end of the value-added product range than U.S. Steel. Despite the positive consumption trends, OCTG pricing is influenced by the price of flat-rolled coil as it is used as substrate for welded tubes. OCTG prices slipped in July to their lowest level since October 2011 following the downtrend in the flat-rolled markets.
Capital Projects in Hopper, but Not a Go Until Fundamentals Justify Need and Cost
The company has more flexibility in its capital spending with the winding down of several projects, including the Clairton C Battery, Gary Carbonyx, and Lorain finishing facilities. Management is encouraged by the opportunity to expand its Keetac iron ore mines by 3.6 million tons. The current capacity of 25 million tons from Minntac and Keetac supplies the majority of the company's 28 million tons needed annually, but at an estimated production cost of $50 per ton (relative to a pellet cost that is unlikely to fall below $100 per ton long term), it would be easy to justify the expansion to achieve full self-sufficiency in North America even though the capital cost is probably higher now than the original $300 million estimate given in 2009. Two key questions remain: How will U.S. Steel pay for it, and will demand be strong enough to sustain steel output to make use of the full iron ore production capacity?
The same is true for the company's potential direct reduced iron project to leverage natural gas rather than coking coal as a steelmaking input, which could substitute scrap in the basic oxygen furnace or be used in a new electric arc furnace. The capital cost for a DRI facility is estimated at $250 per ton and would be further facilitated by the Keetac expansion, which would provide more raw material. This has the potential to yield operational flexibility and cost savings, particularly if the low natural gas prices and high coking coal prices persist. Ultimately there is little to look forward to until the company has the operating cash flow to pay for these initiatives and the confidence in the medium-term outlook to justify the projects.
U.S. Steel Undervalued, but Better Opportunities Exist
U.S. Steel's valuation is compelling based on our view of long-term earnings power, but better long-term opportunities are out there. Steel stocks have been whipsawed by economic conditions in Europe and China, and we don't believe strategic initiatives or domestic market conditions will move the needle until more clarity develops around global economic stability and growth. We think U.S. Steel will face a larger share of challenges ahead and believe there are companies with more sustainable competitive advantages whose stock prices have been equally punished, such as POSCO (PKX) and ArcelorMittal.
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