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Manufacturing Recession Results in Record Low for U.S. Steel
Manufacturing Recession Results in Record Low for U.S. Steel

Manufacturing Recession Results in Record Low for U.S. Steel

  • 05-Jun-2023 6:26 PM
  • Journalist: Shiba Teramoto

US: The global Steel sector has had some difficulties recently as metal demand has decreased due in large part to a downturn in Chinese construction demand. Due to their energy constraint, Europe's production levels decreased last year, offsetting the reduction in demand. Recent figures, however, imply that increased global production levels have brought Steel back into oversupply. Most of the demand for modern Steel comes from Asia, notably China.

Due to China's massive production and consumption of Steel, US Steelmakers may sell largely to US manufacturers and construction companies, but their prices are greatly affected by China's level of demand. since a result, when it comes to Steel prices, rising energy costs are a major supply factor (since energy shortages lower worldwide output). Contrarily, China's fluctuating construction activity is a big demand-driver.

The cost of Steel in China recently returned to the level of support that it has maintained steadily since 2017. The cost of U.S. hot-rolled coils has likewise decreased to within typical bounds.

Except for the 2014 downturn caused by falling energy costs, the present price of Steel rebar is traditionally bullish, with the commodity often turning higher after falling to the 3500 CNY/T level. Although it is far less than in the 2021 shortage, the price of HRC Steel in the United States is still slightly higher than its ten-year range. Overall, Steel prices have returned to normal ranges, which somewhat suggest a worldwide oversupply and no longer represent dynamics of a shortage.

Many traders have gambled on more erratic domestic Steelmakers like U.S. Steel amid the dramatic decrease in Steel prices. That stock currently has a greater short interest level of 9%, which is much higher than most other stocks but not high enough to put it at serious risk of a short squeeze. Like the underlying commodity, U.S. Steel is currently trading close to its historical support level, suggesting it could experience a large bounce should Steel prices do the same. Similar statements can be made about its competitors, but their five-year record has been significantly better than U.S. Steel's.

The steep drop in Steel prices has put a hardship on all Steel producers. Since energy prices are still high, many producers will probably see declining profitability in 2023 and 2024. The least strong company in this group is U.S. Steel, which has a higher debt load, less surplus liquidity, and generally worse profit margins. It is a great moment to examine the company more closely because its recovery upside potential is probably far more than that of its peer group.

As prices declined while costs grew, most U.S. Steel's operating sectors were either not profitable or barely profitable during Q1. Since Steel costs were frequently at cost, the company's rising capital expenditures resulted in negative free cash flow. The company's operating cash flow also fell significantly from its peak in 2022.

Since Q2 Steel prices have remained below those of Q1 for the most part, U.S. Steel is projected to report negative profitability and cash flows for the current quarter. Consensus earnings per share as of now is $4.33 for 2023 and $1.90 for 2022. If the business maintains its current quarterly EPS level from Q1, its 2023 total EPS would be close to $3.12. However, unless prices improve, believe its quarterly EPS may be negative or flat for Q2 and beyond due to the more recent decrease in Steel prices since March.

Even with lower utilisation of the Steel manufacturing capacity, increased energy prices are likely to continue to have an impact on production costs and capital expenditure levels.

Costs per tonne have climbed by 10–30% or more across most U.S. Steel's segments in recent years because of rising labour and energy prices. Energy prices have decreased since their high in 2022, but they still generally stand above levels from before 2020. Due to the global geopolitical environment driving OPEC+ output limitations, they ought to keep doing so. In addition, despite the slowdown, there is a severe labour shortage in the Steel industry due to the industry's considerable demographic skew (many workers who are approaching retirement age and few new trainees). I predict that both long-term and short-term variables will continue to put pressure on prices for global manufacturers, posing difficulties for companies with lower productivity, like U.S. Steel.

The fact that U.S. Steel typically has lower operating costs to sales and lower gross margins than its peer group is significant. Cleveland-Cliffs' strategic growth and vertical integration initiatives have resulted in substantially lower gross margins today.

For many years, U.S. Steel has struggled to compete with its more recent competitors. U.S. Steel struggled along with typically less efficient plants and a weaker focus on efficiency and expansion despite technical advancements while its competitors strategically expanded. Recently, the business has made significant investments in its "mini-mill" plan, which calls for smaller, theoretically more efficient factories to be equipped with "state of the art" equipment. These new plants are positioned to benefit from the expansion of the EV auto market and are predicted to be less expensive than its current plants.

Due to the high CapEx expenses associated with building these operations in the current competitive labour and products markets, the company's yearly CapEx has increased to almost 45% of its market capitalization. As a result, because it is investing a lot of money in this initiative, its investments are extremely risky. These initiatives are a "hail mary" that, depending heavily on an increase in the demand for Steel in the United States and around the world, will either make or break the company.

It seems unlikely that the demand for Steel will rise in the upcoming year, and it is more likely that it will decline overall. Both the U.S. and China's manufacturing PMIs are currently below 50, indicating a decline in manufacturing activity. Over the last two years, China has averaged the lowest level, and the current U.S. level shows a recessionary decrease in manufacturing production.

China's building business serves as a significant demand generator for Steel on a global scale. With record vacancy rates (more than 20%) and the highest prices among larger countries, China has long struggled with an overdeveloped building sector and a massive housing price bubble. Although the CCP has worked very hard over the years to give stimulus to prevent this bubble from blowing, its present efforts are failing, suggesting that its construction activity may decline sharply from previous levels.

Even though there is a lot of talk and interest in electric cars in the US, total vehicle sales are still low because of rising production costs and significantly rising financing expenses. In the United States, construction activity is also decelerating rapidly and will continue to do so despite a more pronounced drop in permit levels. Almost all uses of Steel (vehicles, construction, etc.) are costly and necessitate a significant amount of blue-collar labour, energy, and funding. As a result, it is almost a given that the demand for Steel will decline amid rising producer and consumer costs when energy prices are high, skilled labour is in short supply, and finance costs are high.

Meanwhile, increased energy supplies in Europe and China as well as larger US producer investments may soon lead to an increase in Steel production levels. Think that the short-term outlook for Steel demand is largely unfavourable due to the manufacturing downturn in the US, China, and Europe. Furthermore, all Steel manufacturers may be burdened by a long-term reduction in global Steel demand brought on by China's senseless construction industry's secular decline.

In addition, it appears that production levels and costs are increasing over most of the world, which might bring Steelmaker profitability back to historic lows. I believe that the stability of the company is in jeopardy due to the macroeconomic environment, U.S. Steel's historically low efficiency, and its high capex levels.

Due to its significant capital expenditures (CapEx), anticipate U.S. Steel to experience negative earnings for the remainder of 2023 and extremely negative free cash flow. The company had previously anticipated a substantial increase in profits in Q2, but Steel prices have fallen once more since April. I think it is somewhat plausible that Steel prices will continue to fall, maybe breaching crucial support levels, given the state of the world economy. Furthermore, since iron ore prices are still marginally elevated and energy and labour costs are rising dramatically, I do not anticipate cost decreases to reverse that trend.

The fact that U.S. Steel trades at a sizable value discount to its peer group works in the company's favour. Due to significant cash flows in 2021–2022, it has positive working capital of about $3.5 billion. As a result, the business could probably live with $1 billion or more in negative free cash flows for several years before its efforts in efficiency start to pay off and demand starts to pick up.

Considering this, the stock may present a long-term value opportunity; nevertheless, I believe its price may decline soon as analysts and investors reassess its 1-3-year profit outlook to take into consideration the rising likelihood of a recession. As a result, even though I have a small pessimistic outlook for X now, I would not bet against it because of the potential upside from its low valuation should a big manufacturing recession be avoided.

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