Once upon a time, the saying went: "Birds of a feather flock together." Apparently, that truism had its feathers plucked. Within the steel industry, at least, companies aren't doing a very good job of flying in formation, in the wake of bullish pronouncements from twin mini-mill operators Nucor (NYSE:NUE) and Steel Dynamics (NASDAQ:STLD) over the last several days.
Oh, Nucor and SDI themselves are doing just fine, up 5% and 6% since the turn of the month, respectively. And the companies you'd expect to suffer from any pricing strength among the steel sellers -- service centers like Novamerican (NASDAQ:TONS) and Reliance Steel (NYSE:RS), for example -- are exhibiting predictable weakness (down 4% and 2%, respectively).
But steelmaking rivals down at the bottom of the food chain with Nucor and SDI are failing to reap much benefit from their peers' bullishness. Grand dame of the industry U.S. Steel (NYSE:X) is up 3% since March 1, but AK Steel (NYSE:AKS) is down 1%, and global titan Arcelor Mittal (NYSE:MT) has lost a good 3% over the last two weeks. What gives?
Beginning at the beginning
Let's begin with what we know, before trying to interpret it. Aside from Nucor and SDI, no one seems to be talking in this industry -- at least, by releasing earnings warnings and similar guidance. So with the caveat that the following is a bit one-sided, here's what the mini-mill operators are saying.
First up is Nucor, which last week guided investors to expect $1.15 to $1.25 per share in profits in Q1 2007, roughly flat versus Q1 2006. Nucor had not previously issued numerical guidance, saying only that Q1 profits would be "solid." Some of the more instructive verbiage included in its terse update included:
- "improving market conditions"
- "decreasing import levels"
- "continued decline of excess inventory levels at service centers and OEM's"
- and a prediction of "healthy demand for our products in 2007."
That all sounds well and good -- what about Steel Dynamics? In contrast to Nucor, SDI had previously issued guidance, predicting back in January that it would earn between $0.85 and $0.90 per share this first quarter of fiscal 2007. On Monday, SDI raised that estimate about 10%, bursting the ceiling on previous expectations and saying that Q1 results will likely come in somewhere between $0.94 and $0.98 per share.
If you've got a calculator handy as you read this, you'll notice that one firm "issuing" guidance and the other "upping" its guidance isn't the only difference between Nucor and SDI. In contrast to Nucor's expectation of flat profits, SDI is predicting profits 26% higher than in last year's Q1. (Clearly, there are qualitative differences between companies, even within subsectors of this industry.)
The "color" with which SDI painted its numbers, however, mirrored Nucor's own pronouncements. According to CEO Keith Busse, "market conditions for flat-rolled steels have improved since mid-January." Busse also echoed Nucor's statements in citing "decreased import activity," "lower inventories at steel service centers," and a "recovery in both demand and pricing."
Scrap! More margin compression
The bad news: Steel Dynamics says that "Steel scrap prices are trending much higher in the first quarter than previously forecast." Regular Fool readers will recall that just three months ago, both Nucor and SDI were both talking about a downturn in scrap prices. SDI's observation this week just goes to show how very volatile pricing is in this sphere.
Even so, Busse thinks the firm can maintain its margins (how, he didn't say). The fact that both firms are noting strong demand, but only SDI claims it can maintain margins to capitalize on that demand, seems to explain why SDI is predicting double-digit profits growth, while Nucor is only hoping for flat profits.
Houston, we have a disconnect
To summarize, here's how the picture seems to be forming up in the steel industry, as painted by the mini-mill operators: Imports and inventories are down, while prices and demand are up. Where margin pressure exists, it comes from supply constraints on steel scrap, which mini-mill operators use to manufacture "new" steel.
It seems to me that this situation should benefit old-guard steelmakers like U.S. Steel, AK Steel, and especially Arcelor Mittal. On one hand, they've got the capacity to satisfy rising demand for steel and reap the benefits of stronger pricing. On the other, because they make their steel "from scratch," as opposed to from scrap, they shouldn't feel the margin pressure from higher scrap prices that might pinch profits at Nucor and SDI.
At the other end of the food chain, regardless of who makes the steel, service centers that process it, such as Novamerican and Reliance, should be hurt somewhat by a rise in the cost of new steel, unless and until they can pass on the price increases to their customers. (They'll be hurt less to the extent that they process steel for a fee, but hurt more to the extent that they take ownership of the steel before working it over.) That part of the equation squares with what we're seeing in share prices, with the steel processors showing some recent weakness. What doesn't make sense -- to me, at least -- is why the mini-mill operators, not the legacy steel companies, are seeing their shares rise at the steelmaking end of the food chain.
I seem to be missing something here. If you know what it is, drop me a note. And if you know enough about the industry to do that, don't forget to drop by Motley Fool CAPS and place your bets on who's most likely to benefit from the trends Nucor and SDI describe. Show the world how much you know, and watch your CAPS rating soar in the process.
My, how three months change things. Read what these same companies were saying back in December.
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Fool contributor Rich Smith does not own shares of any company named above. As Mittal Steel, Arcelor Mittal was a former Motley Fool Inside Value pick. The Fool has a disclosure policy.
