Like all steel makers, United States Steel Corporation (X -3.53%) worked hard to survive the steel downturn. A key focus was cutting costs, but that appears to have happened at the expense of reinvesting in the business. Now that the steel industry is starting to see better days, U.S. Steel is going to have to make up for that decision by spending money and time on upgrading its assets. That could be a notable drag on results.
A painful stretch
The steel industry downturn really started after the 2007 to 2009 recession. It was so bad that industry leader Nucor Corp (NUE -1.08%) lost money in 2009, the first (and only) time it had lost money in its history as a steel company. The downturn lingered for years, too, exacerbated by a global oversupply and imports that many industry participants argue were being unfairly priced. The downturn has only begun to let up recently.
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United States Steel, which has a heavy reliance on blast furnaces, was at something of a disadvantage during the downturn compared to peers like Nucor and Steel Dynamics. The electric arc furnaces that Nucor and Steel Dynamics rely on are smaller and more flexible. U.S. Steel needs to run its mills at high capacity levels in order to make money. That just wasn't happening during the downturn, leading to a string of earnings losses. To put a number on that, U.S. Steel has lost money in eight of the last 10 years, including 2016.
To deal with the downturn, U.S. Steel focused on cutting costs. That's clearly not a bad plan. However, one thing it didn't do enough of while it was cutting costs was reinvesting in the rest of its business.
Playing catch up
When the company reported first quarter 2017 earnings then CEO Mario Longhi noted that, "This remains a cyclical industry and we will not let favorable near-term business conditions distract us from taking the outages we need to revitalize our assets in order to achieve more reliable and consistent operations, improve quality and cost performance, and generate more consistent financial results." The company reported a loss larger than investors had expected, too.
The stock fell over 20% in a single day following the news, and the CEO stepped down less than a month later. There's a new CEO at the helm today, but as you can see below, the damage has been done.
U.S. Steel is going to have to spend the money and time now to prepare for the future, something new CEO Dave Burritt hinted at in the second quarter earnings release when he explained that, "We are focused on our strategic priorities: driving operational excellence across our business -- from our plants to our support teams; investing in our facilities through our asset revitalization program; and providing our employees with the resources they need to implement positive, substantive changes." (Emphasis mine.)
Why you need to care
There's no question that reinvesting in the business is a good thing for U.S. Steel over the long term. And I believe it has the financial strength to handle the effort. But that doesn't mean it will be a smooth ride for investors.
The problem is laid bare in the annual report's risk factors section. The second operational risk factor: "U.S. Steel continues to incur certain costs when production capacity is idled, increased costs to resume production at idled facilities, or costs to idle facilities." To update a plant, U.S. Steel generally has to idle capacity, which costs money. It then has to spend on the upgrades themselves. And then it has to spend even more money to get the plant up and running again. During all of that time, the company isn't earning money from the facilities it has idled.
X Capital Expenditures (TTM) data by YCharts
If it's doing all of that work now, as the industry recovers, it will miss out on at least some portion of the industry upturn in a cyclical industry. A worst case scenario is that it gets done with all of this work just in time for the next industry downturn. It probably should have been doing this work all along, like industry leader Nucor. Look at the graph above, Nucor's spending stayed fairly constant over the last decade with a couple of notable bumps for big investments -- despite an industry downturn. U.S. Steel's spending just kept trending lower.
A potentially heavy weight
At this point, it's not clear just how large a headwind making up for the lack of capital spending will cause. But investors need to keep a close eye on this issue because it will be a drag on results during an industry upturn. Yes, upgrading its facilities will make U.S. Steel a better company over the long term, but that doesn't mean that it won't bite today. This is one issue U.S. Steel investors need to be wary of.
