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How Steel Margins Get Flat Rolled

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Steelmakers are accustomed to working under very high-pressure loads. Flat products are produced by rolling steel slab between cylinders ... exerting enormous pressure to squeeze out a thinner sheet of steel plate.

It follows logically, then, that the industry would take it in stride when its profit margins undergo a high-pressure squeeze.

Thanks to the company's vertically integrated, low-cost procurement of scrap iron, the nature of Steel Dynamics' (Nasdaq: STLD  ) margin squeeze is rather distinct from that of traditional blast-furnace steelmakers. While heavyweights like ArcelorMittal (NYSE: MT  ) and POSCO (NYSE: PKX  ) are struggling with rising costs for iron ore and met coal, Steel Dynamics is able to keep some of those cost pressures in check by sourcing nearly one-half of scrap-metal consumption by its arc-furnace mills from its in-house metals recycling segment.

Impressively, even in a rising price environment for ferrous scrap metal, Steel Dynamics delivered a 4% sequential increase in its steel segment's operating income for the fourth quarter ... even alongside flat shipment volumes.

Zooming out to the company's consolidated outcome, however, we find the root causes of Steel Dynamics' lower sequential operating margin and anemic net profit of only $8 million ($0.04 per share) for the fourth quarter of 2010. Although the metals recycling and ferrous resources segment continued to bolster the profitability of Steel Dynamics' mills, that segment reversed to an operating loss from a modest third-quarter profit.

Continued challenges associated with the start-up of the company's 81%-owned iron nugget production facility in Minnesota led to a $13 million hit during the quarter, and affected full-year 2010 earnings by $42 million. However, with several modifications now in place, the company is turning increasingly upbeat about the facility's ramp-up process during 2011.

Longtime observers will have grown accustomed to persistent weakness in domestic demand for fabricated steel products. Severely impaired demand for construction-related items like joists and decking led competitor Commercial Metals (NYSE: CMC  ) to sever that limb from its corporate corpus last year. Despite a 68% increase in shipments over its prior-year quarter, the segment yielded a $500,000 operating loss before a $13 million impairment charge from a recalibration of the unit's fair value.

Joining a chorus of executives touting improving business outlooks for 2011, CEO Keith Busse welcomed a "favorable" outlook for his company's business in 2011. He expects demand growth from multiple industries and something resembling a bottom in that all-important construction-related demand.

Noting a recent contract to supply more than 28 tons of continuous welded rail for a RailAmerica (NYSE: RA  ) project to upgrade tracks between coastal Connecticut and the Canadian border near Quebec, Steel Dynamics seems to possess a number of unique aces up its sleeve to aid the company's ongoing adaptation to a margin-stressed environment for steel. I continue to prefer scrappy arc-furnace producers like Nucor (NYSE: NUE  ) and Steel Dynamics over their blast-furnace counterparts, although I approach the entire sector with caution given the array of cost pressures observed.

Fool contributor Christopher Barker can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets. He owns no shares in the companies mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy is entirely unmalleable.

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