Wednesday, November 24, 2010

Steel Industry

After 186 posts about value investment philosophy, I think it’s about time to write about something else. Well, after all, value philosophy can actually be surmised into just 3 words. So, I am actually quite amazed why I could write so much. So going forward, hopefully I can write about industries and individual stocks. As and when new ideas hit, I will still talk about value philosophy and the big picture. Ultimately, that is what’s most important and what will drive long term return for investors.

In this post, I would like to talk about the steel industry. Steel is a basic commodity used by humans and has been pretty integral throughout the development of our civilization. Sadly as a business, it sucks. The industry as a whole doesn’t really create much value for shareholders although there are periods where it churns out enough cash to whet some appetite.

Today, about 1 billion ton of steel is consumed every year. China accounts for half of the usage. Outside of China, Asia including Japan, accounts for bulk of the rest. Well, this is unsurprising as steel is mostly used in construction and infrastructure which Asia needs, a lot.

The business model is simple enough. Buy raw materials like iron ore and coking coal, throw it into a blast furnace, out comes molten steel, add some other metal to make it better (like nickel for stainless, or zinc coat it for shine) and process it into sheets or beams etc. This in itself is not bad. What is bad is:

1. Both the input and output prices are uncontrollable.
2. Competition is very, very tough
3. It is very capital intensive

Raw material prices are controlled by the ore majors: BHP, Rio Tinto and Vale. Specifically, they dominate the spot market and use the spot prices to determine contract pricing. So the steel makers have no say in pricing. The final product prices are also determined by the spot market. There are international market prices for a variety of steel products including the most famous hot rolled coil (or HRC), for H-beams used in construction, for pipes etc.

The reason why such spot markets developed is probably bcos there are simply so many players in the market that is just have to be done for the benefit of both the steelmakers and their buyers. With such markets, products could be standardized, distributors can handle them easily and lengthy negotiations could be avoided. But that’s bad for profits.

But why are there so many steelmakers globally? Well, in the past, it was a country’s ambition to have its own steel mill. It’s a symbol of strength for the nation. The western countries had it. Japan still has it. Korean has it and now China and India are building theirs. What’s worse is when the various provinces or prefectures also decided that they should have, hence you have all these few hundred steelmakers all over the world, each having less than 1% of the global market.

In the middle of this decade, someone decided to restructure the whole industry. His name was Lakshmi Mittal. So he started buying small steel mills all over the world. But he realized that wasn’t enough. There were just too many. In a move that shocked the industry, he decided to buy over one of the biggest steel players globally. Today, his company is called ArcelorMittal and it has capacity of 100mn tonnes or 10% of the market.

But still, 10% is nothing in a world where the suppliers and customers are much stronger and you still have over a few hundred competitors. ArcelorMittal, amazingly, has been able to generate good cashflow by squeezing cost and investment. Unfortunately, the money has to be used to pay down debt and it will take another 5-6 years to bring debt down to a comfortable level. Not to forget, by that time, it probably needs to resume its capex plans as well.

Which brings us to the 3rd point. Steel is insanely capital intensive. It takes USD 1,000 to bring 1 ton of new capacity on. For ArcelorMittal to increase capacity by 10%, it will cost USD 10bn! That’s one sixth of its equity base today. Most other steelmakers are not even that half its size and a new blast furnace project almost always means new financing.

So in short, the steel business, though integral to the development of our civilization, is bad business. There is usually nothing left for shareholders, after everything is said and done.

Well, that is the big picture. Value investors are also stock pickers and hence the dynamics can change for individual companies.

Buffett had a stake in the Korean steelmaker POSCO for the longest time. The story for POSCO is that the company is the No.1 leader in a country that is perpetually in short of steel despite being one of the biggest exporters of steel intensive products like ships, cars, and consumer electronics. What is more amazing is that POSCO is also one of the world’s lowest cost producers of steel. It can achieve this bcos it has the most integrated high capacity steel mill in the world and it also attracts the best talent in Korea to work for the firm. To that end, it even has its own university!

Hence the firm consistently generated free cashflow and paid dividends while having a clean balance sheet with no debt. Having said that, the wheels of fortune might be turning as Hyundai tries to break its monopoly in the Korean steel market while the company had also tried unsuccessfully to expand into the Indian market. In recent times, the dividend has fallen to 2% while free cashflow yield is also below 5%.

So that’s a short summary of one of the oldest industry on earth. In short, it’s best to avoid, as the industry had not been very profitable for shareholders except for the 5 years starting 2003 when the whole world got into a once in 30 year situation whereby there was a shortage of steel. This happens when a big country industrializes after a long drought and no new investment was made in steelmaking. The last country before China was Japan, which started the steel boom in 1970s.

Next on the list is India, but that might be 2030, if we use the once in 30 year rule.
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