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Steel yourself: the global slump for makers and miners

Steel is dominating the news. With the industry suffering from enormous oversupply, we survey the prospects for those most exposed to the metal
April 15, 2016

News headlines, like world markets, are currently flooded with steel. It's not merely a domestic issue. Last month's decision by Tata Steel (In:TATASTEEL) to sell all or part of its lossmaking UK operations may be the industry's defining moment in this country, but similar convulsions are being felt across the globe.

Australia's industry is in meltdown. Earlier this month Arrium, the country's second-biggest steelmaker, filed for voluntary administration, rocking Malcolm Turnbull's government ahead of a federal election. Luxembourg-headquartered steel giant ArcelorMittal (Nl:MT) is cutting chunks out of its global operations. UK steelworkers have also taken a battering in the past year - be it the 2,200 jobs culled in SSI's closure of its Redcar operations, the 1,700 positions at risk from Caparo Industries' administration, or the thousands of Tata employees facing an uncertain future - but spare a thought for the Chinese. In February, China's minister for human resources and social security announced 500,000 steel jobs would be cut and "relocated" in an effort to halt overcapacity. Despite that restructuring, China's domestic consumption is still likely to be oversupplied to the tune of 400m tonnes of steel by 2020. Chinese steel exports - or 'dumping' practices, depending on your point of view - aren't going away.

So, although Tata has a plan - to sell its Scunthorpe plant to private equity firm Greybull Capital - the India-headquartered industrial's exit from its lossmaking UK operations is likely to be protracted. The laundry list of political and workforce guarantees - which prospective buyer Sanjeev Gupta has asked for before committing Liberty House to a takeover of Port Talbot - is telling. Put simply, much of the global steel industry is in crisis. For many operators, making money in the sector is not going to be possible for some time.

Given this ongoing shake-out, and the inelasticity of global steel markets, investors tempted to follow in Greybull's path should approach with caution. As we'll explain later, the safest way to play steel is probably through the largest iron ore miners.

 

Lurch of the makers

As many in the industry have noted, high energy prices, EU laws preventing state aid and domestic attitudes and policies weighted towards protectionism have put the UK industry at a competitive disadvantage. In fact, with the exception of Tata - whose shareholders warmly greeted the decision to can the UK operations - there are scant options for stockpickers looking to play our domestic steel industry. That's unless the government decides to part-nationalise Port Talbot, thereby making every taxpayer a de facto owner.

Russian steelmaker Evraz (EVR) stands alone as a significant London-listed operator. The £1.4bn market capitalised company, which operates a large number of iron mines and steel mills across North America, Russia, Europe and South Africa, sold 12.8m tonnes of steel last year, booking $1.1bn (£769m) in cash profit on revenue of $8.3bn. However, Evraz is being hammered by its end markets. In 2015, net losses narrowed to $719m from $1.3bn the prior year, as cuts to the group's cost base helped cushion the blow of difficult end markets, but this couldn't stop a full-year pre-tax loss of $0.7bn.

The company is also mired in something of a debt spiral. Although net borrowings declined to $5.35bn by the end of 2015, a thinner equity pool means the company's leverage stands at more than 350 per cent. March's issue of a five-year rouble-denominated bond worth $219m is unlikely to help matters, given that it comes with a 12.6 per cent coupon. Debt management has also been a feature of ArcelorMittal's recent newsflow. Following a $3bn rights issue, the largest steelmaker in the world just announced plans to buy back a series of bonds maturing between November 2017 and June 2018. The move comes after a disastrous 2015, in which the Netherlands-listed company posted a $7.9bn net loss, scrapped its dividend and pared back expansion plans as part of efforts to reduce its borrowings.

Such manoeuvres will feel familiar to investors in natural resources companies. And just as we have seen with many oil and gas companies and miners, related services sectors have felt the pain. Vesuvius (VSVS), which principally provides engineering and consultancy services to the steel and foundry industries, is a prime example. Last year, it saw a 15 per cent sales reduction in its key steel flow control and advanced refractory businesses across the Americas, Europe and Africa. Hopes are currently pinned on the technical services division, which could help struggling steelmakers desperate to manage costs, but sentiment is damaged and the shares have fallen 41 per cent in the past 12 months.

 

Overinvestment and oversupply give us little reason for hope in the steel industry's short- or medium-term prospects. Greybull's decision to rebrand Tata's European long products division as British Steel carries heritage, but it comes with enormous challenges. Talk of nationalisation, whatever the political and social merit, also means capital markets are shut.

 

Last men standing

As 98 per cent of all iron ore ends up in a steel mill, the slump in demand for steel has inevitably had a sharp knock-on effect for the metal's miners.

Rio Tinto (RIO) and BHP Billiton (BLT) have enormous exposure to the base metal, but also have the monopoly when it comes to world-class iron ore mines, in both cost profile and size. Rio's Hamersley complex in Western Australia is the biggest in the world, and produced 189m tonnes in 2015. Even after accounting for the suspension of operations at the disaster-hit Samarco mine in Brazil, BHP expects total iron ore production to hit 237m tonnes in the year to June 2016.

Yet despite their weight to iron ore, the price of which dropped 80 per cent below its 2011 high last year, neither miner has seen the sort of share price slump (and 2016 rebound) witnessed by the likes of Glencore (GLEN) and Anglo American (AAL). The reason for this, according to finnCap analyst Martin Potts, could be down to short sellers covering their positions after the miners announced a spate of self-help measures. Of equal importance is the comparative health of the balance sheets of Rio and BHP. "The two companies have been relatively prudent during the cycle, owning high-quality assets with capital investment mostly well spent and a manageable level of debt," says Mr Potts.

Both have also faced accusations - from Andrew Forrest, the billionaire chairman and founder of rival Fortescue Metals (Au:FMG) no less - that they are content to oversupply the market in the pursuit of a "last man standing" strategy. According to this logic, BHP and Rio's low costs and enormous mines effectively mean they can increase volumes, shut out junior miners and ride out the slump. Of course, the size of the miners' operations means they do affect iron ore prices, although such criticisms could equally extend to China's state planning. Whether or not Mr Forrest's argument is fair, his observation is surely correct: BHP and Rio easily have the strength to ride out the glut in steel and iron ore, to well after the top quarter of the production chain has been forced to shut. However, as demand for iron ore moves back in line with global GDP growth, the days of outsize returns are probably in the past.

Ferrexpo (FXPO) is another London-listed iron ore producer at the foot of the global cost curve, but one with a mountain of operational and funding issues. In 2015, the company was the lowest-cost producer of iron pellets anywhere, according to mining consultancy CRU, and since the turn of the year it has reduced cash costs a further 8 per cent. But operating in Ukraine comes with its downsides. The liquidation of its transactional bank last December meant that $175m of the group's cash has had to be recorded as a charge in the income statement. What's more, the iron ore miner cannot be certain of recovering the funds, which could result in a $146m loss after expected tax relief, and caused its auditors to raise "material uncertainties" over its ability to repay its debts, which, excluding Ferrexpo's remaining cash, stood at $868m at the end of 2015. But at least the larger iron ore companies have big assets and cash flows. As for junior iron ore miners, in the words of one commodities analyst, "they have simply got their hands over their eyes".

For an infographic on the iron ore majors, click here.