Is Vertical Integration Good for Steelmakers?

At a time when steel prices remain under pressure, low iron ore and met coal prices could have provided support for steel makers. However, increased vertical integration by U.S. Steel (NYSE: X  ) , ArcelorMittal (NYSE: MT  ) , and AK Steel (NYSE: AKS  ) has made it harder to take advantage of this low-price environment. Was it a wise move by these companies?

U.S. Steel preferred to integrate iron ore operations
U.S. Steel is self-sufficient on iron ore for its U.S. operations. In fact, the company even sold a portion of its iron ore pellets in 2013 and 2012. Only U.S. Steel's Slovakian facility has to purchase iron ore from external sources. The situation is totally different on the coal side. U.S. Steel purchases all coal required for its coke making facilities from outside sources.

Thus, while U.S. Steel cannot take advantage from low iron prices, it fully benefits from the downturn in met coal. So far, this was not enough to overcome all headwinds. U.S. Steel had a decent first quarter despite harsh winter weather, but the company is expected to return to a loss in the second quarter.

ArcelorMittal's mining segment is important for the company
For ArcelorMittal, mining is a separate and important business. This segment brought $1.25 billion of revenue in the first quarter. This number might seem small in comparison with total first-quarter revenue that was close to $20 billion, but there are several important facts to consider. First, the segment was a source of $274 million of operating income. Compare this to the efficiency of ArcelorMittal's European sales, which brought just $80 million of operating income on revenue of $10.3 billion.

Second, the company sells part of its iron ore and coal internally. In this case, iron ore and met coal pricing depends on company's cost rather than on prevailing market prices. Thus, the profitability of the segment also depends on the share of market-priced sales. The higher the share of these sales, the more profit will be obtained, all else equal. All in all, ArcelorMittal is a vivid example of successful vertical integration.

AK Steel's Magnetation plant yet to prove its worth
AK Steel expects that its investment in the Magnetation plant will allow it to cover 50% of its iron ore needs in the next year. The company also has met coal assets, which were purchased in 2011, when met coal prices were at their highs. The timing of these investments proved poor, but the premise was viable. It's generally good to have part of raw materials' demand covered by internal production.

Magnetation's credit rating outlook has been recently changed to negative by Moody's. The rating powerhouse stated that weak credit metrics, short operating history, small scale and low level of revenue put pressure on Magnetation's creditworthiness. This highlights the difficulties of the plant's start-up, as it will have to operate in a low-price environment right from the start.

Bottom line
In the long term, vertical integration is a good thing to do for steelmakers. The mining segment can even play its role in the company's earnings, like in ArcelorMittal's case. However, current price environment significantly reduces the advantages of operating own resource base. In the case of AK Steel, it even adds uncertainty.

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  • Report this Comment On July 14, 2014, at 12:04 PM, musicbrain wrote:

    Your article is highly flawed. If US Steel is "self-sufficient" in its iron ore supply, and if only its Slovakian plant needs to purchase any, then this iis not a net negative, and your statement seems meaningless.

    Yet, you state X benefits from the downturn in met coal, which would increase its profits.

    Your claim the company "is expected to return to a loss in the second quarter," is old news. The company and its followers no longer have this view. But you fail to mention that.

    Motley's belief in "a diverse range of insights" to me does not apply to an article of this low caliber.

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Vladimir Zernov

Vladimir Zernov believes that fundamental analysis works best with energy and materials stocks and covers them on Motley Fool.

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