United States Steel Corporation (X +0.00%) is getting hit hard by falling steel prices and foreign imports. It's doing the best it can to hunker down so it can survive this cyclical industry's deep down cycle. That includes jettisoning assets. Only the news that it's extracting itself from its Canadian business is actually better news than it may at first seem. Here's why.
Everyone's hurting
The U.S. steel industry is indirectly feeling the effect of the economic slow-down in China. Chinese steel makers ramped up to meet their country's once-ravenous demand for the construction material only to create an oversupply situation now that demand has started to fall off. That excess steel is being exported around the world and, ultimately, has pushed foreign steel makers from many different countries to sell their steel at low prices just to get rid of it. And the United States has been a prime end market.
A U.S. Steel mill at work. Image source: U.S. Steel.
For example, according to U.S. Steel competitor Nucor Corporation (NYSE: NUE), "Steel prices and margins remain under pressure from exceptionally high levels of imports that continue to flood the domestic market." Imports accounted for roughly 30% of the U.S. finished steel market in the first nine months of the year -- that was up from around 27% in the same span in 2014. To give you an idea of the scale of the China export problem, according to Nucor CEO John Ferriola, that country is on pace to export more steel than the United States produced all of last year.
So, that's the backdrop that has seen U.S. Steel's earnings fall into the red in seven of the last 10 quarters. For this famous mill, this is clearly an environment in which cutting costs is key, which is why it's severing ties with a struggling Canadian affiliate. This is actually pretty good news for the company's U.S. mills, though.
Oh Canada!
U.S. Steel and U.S. Steel Canada have basically agreed to go their separate ways after the Canadian company was forced to seek relief from its creditors. There was an attempt to sell the Canadian operations, but it didn't work out. After industry watchers suggested it was because U.S. Steel was involved in the process, U.S. Steel recently agreed to stay out of it.
This is good for two reasons. First, assuming a successful sale, U.S. Steel can stop propping up the operations of a failing business. That will preserve much-needed cash. The company burned through nearly $150 million of cash in the first six months of the year, pulling its cash hoard down to around $1.2 billion. That may sound like a lot of money, but it really isn't when you consider the troubling industry backdrop in which U.S. Steel is operating. Nucor, for reference, has nearly $1.9 billion of cash on hand as of the end of the third quarter but, unlike U.S. Steel, it's making money.
Sparks fly at another U.S. Steel operation. Image source: U.S. Steel.
Getting out from under the weight of U.S. Steel Canada's money losing operations is a good thing. But so, too, is the impact this move will have on the company's U.S. mills. Basically, all of the work U.S. Steel was pushing across our northern border will be brought back home, going to U.S. Steel's domestic mills. Not only is the company getting rid of a drag, it's also going to increase the capacity utilization at its other mills.
This is important because steel mills are very expensive to operate, and many of the costs aren't variable, so they don't change based on the amount of steel being made. Because of this, the more steel a mill produces, the cheaper it is to run the plant. Thus, U.S. Steel is not just adding business to current mills, which should boost the top line, it's also making them more profitable to run, which will help support the bottom line.
The best outcome, given the circumstances
In an ideal world, U.S. Steel and its Canadian affiliate would have seen so much demand that they would have had to run flat out and even expand. But that isn't the world steel makers live in today. And while U.S. Steel having to get out from under U.S. Steel Canada isn't really good news in that regard, the current agreement appears to be a pretty good outcome given the difficult situation.
Does this transaction make U.S. Steel a screaming buy? No way. But it does show that the company is working hard to be an industry survivor, making hard choices that improve the company's outlook. And it should probably be seen as a positive sign for contrarian investors looking to bet on an out-of-favor company in a struggling industry.
