Is the Steel Industry Regaining Its Shine?

Is the Steel Industry Regaining Its Shine?

The steel market has been in the dumps since the financial crisis, and many large steel conglomerates have found it hard to turn a profit. ArcelorMittal, for example, has been slashing costs and closing steel mills constantly throughout the last five years as it struggles to return to profitability. It would appear that the steel market is starting to return to growth, however, with the World Steel Association predicting that global steel consumption will expand 2.9% this year.

The Association expects South America to lead the world in consumption growth. According to forecasts, steel use within South America is expected to expand 6.2% during 2013. More specifically, it expects 4.3% growth in steel use within Brazil alone, although much of this growth is a result of preparations for the 2014 World Cup and 2016 Olympics.

After the recent emerging market sell-off, investors have an opportunity to take advantage of rock-bottom share prices and a rising demand for steel by buying into emerging-market steel producers.

Investors need to be carefulThere are some barriers in the industry that investors need to be aware of, of course, such as unfair trade practices and competition from cheap Chinese producers. These are trends that the Latin American steel producer Ternium SA is working hard to break down.

In particular, the Mexican government enacted a preliminary resolution last month to determine a suitable import tariff, which could be up to 60% on cold-rolled steel from South Korea. Investigations were also opened into a tariff on imports of Russian cold-rolled steel and plate. Elsewhere, the Colombian government is looking to impose a minimum price on Chinese steel imports.

Ternium produces steel in mills across South America. The amount of steel shipped by the company was flat during the second quarter when compared to the first. The company shipped 2.2 million tons of steel during the second quarter, which translated into EBITDA of $370, unchanged from the previous quarter.

As Ternium has plants all over South America, the company is able to take advantage of the different country-specific growth rates across the continent. For example, during the second quarter Ternium shipped less steel to Mexico but sold more steel to both the Brazilian and Chilean construction markets.

Ternium's management is expecting a decline in operating income for the second half despite sales remaining relatively static. Lower income is forecast as a result of lower prices in Argentina due to currency devaluation. Nonetheless, Ternium should be able to ride out this temporary weakness as the company has $500 million in cash and a current ratio of 1.5.

Record revenues
Elsewhere, Brazilian steel producer Companhia Siderurgica Nacional recently reported second quarter results that blew past estimates. Net income came in at R$502 million, up 80% from the first quarter result of R$186 million. Moreover, volume of steel shipped by the company grew by 15% and the firm's mining and cement operations notched sales growth of 45% and 12% respectively. This was all as a result of the construction boom currently under way in Brazil.

There is one thing I want to point out about Companhia, however. The company looks relatively expensive. Companhia trades at a price-to-book ratio of approxmatly 1.6, compared to the sector average of less than 1. At first glance this does not look that overpriced, but when compared to other companies such as Buffett's favorite steel producer Posco, which trades at aprice-to-book ratio of 0.6, Companhia looks costly.

Still, Companhia is a vertically integrated producer and mines iron ore as well as producing steel. While some investors are right to express concern about the company's exposure to the mining side of the industry considering the softness of iron ore prices throughout the first half of this year, things could be about to turnaround.

In particular, restocking in the Chinese steel market is pushing up the demand for iron ore. The reason for this restocking? Inventories of iron ore at Chinese steel mills have been running as low as 20 days worth of production during the past few months, almost half of the historic 40-day level considered appropriate.

Unfortunately, steel mills across China believed that the price of iron ore was going lower. It would appear they got their forecasts wrong, however, and buying has caused a sudden spike.

The U.S. is falling behind
Sadly, the rising price of iron ore is going to cause problems for US Steel , which is struggling in the current market environment. With very little international exposure (the company has one production facility in Brazil, three in Mexico and one in Europe), US Steel is highly dependent on the domestic steel market, which is stagnating. Rising iron ore prices are only going to make thing harder for US Steel, compressing margins and squeezing income. For a company that has high fixed costs, this is not ideal.

Moreover, according to the company's management, steel consumption in the US is not expected to start expanding until 2015!

Still, US Steel has the ability to survive until then. With cash and short-term investments of $770 million and a current ratio of 1.6, debt is only 26% of assets. For the first half of this year, the company generated $360 million in cash, and only $70 of this was through debt issuance; the rest was generated from operations.

Foolish summary
Steel production is starting to pick up worldwide, but investors need to be careful where they place their bets. For a play on the South American market, I believe that Ternium SA offers the best choice. Ternium is well capitalized and well placed to take advantage of growth within the market. US Steel and Companhia Siderurgica Nacional are both plays that should be avoided, however, due to their high valuations and exposure to low-growth markets.

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Fool contributor Rupert Hargreaves owns shares of Ternium S.A. (ADR). The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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