Light at the End of the Tunnel?
What Service Centers See Ahead
MCN editors polled service center executives for their views on demand, inventory levels, pricing and their expectations for the second half.
By the Staff of Metal Center News
With the first half of a difficult year in the books, service center executives across the country agree that the inventory correction has finally run its course. Unfortunately, they report, there is little sign yet of improved demand for metals.
|McNeeley: Recovery’s Coming,
But Steel May Be Slow to See It
“Steel was six months late getting into the recession, so it will likely be six months late coming out. Although we’ve bottomed out, we may not begin to experience the recovery until the end of the second quarter next year. I think that’s the reality we all have to brace for,” says Dr. Don McNeeley, president of Chicago Tube & Iron Company, who is also an economist and professor at Northwestern University.
McNeeley does not see the hoped-for V-shaped recovery in our future, with a rebound as rapid as the downturn. Rather, we are in a U-shaped recovery and have finally turned the corner on a slow climb upward. “We have been in this recession for 14 to 16 months, and should begin coming out of it late in the third quarter or the fourth quarter, for sure,” he says.
2007 was a great year for the economy and the metals industry, he recalls, with U.S. GDP growth of 2.3 percent. 2008 saw similar growth for the first three quarters, followed by three disastrous months. The 6.3 percent contraction in the fourth quarter offset all the growth earlier in the year, and stunned the market.
GDP declined 0.8 percent in 2008, and is projected to decline another 1.4 percent this year, which suggests 2009 will be worse than 2008. But that is not the case, McNeeley says. “If you look at it by quarter, things have been steadily improving. Even if it’s a negative number, it gets progressively better.”
First-quarter 2009 saw a 5.7 percent decline in the economy—certainly awful, but better than the 6.3 percent plunge the previous quarter. Second-quarter 2009 registered a 1.8 percent drop, substantially better than the previous quarter’s negative 5.7 percent. If predictions by McNeeley and other economists are true, GDP will turn positive in the third quarter and continue its slow but steady improvement, with a 1.8 percent gain forecast for the fourth quarter.
Why then does unemployment continued to worsen? Joblessness has grown from 8.1 percent in the first quarter, to 9.3 percent in the second, to a predicted 9.8 percent by year’s end. One reason is the growing number of workers postponing retirement, McNeeley explains.
“Chicago Tube and Iron had 24 people last year who said they would retire this year. In October, everyone lost about a third of the value in their 401ks, and about 18 of them rescinded their retirements. We aren’t going to force out 30-year veterans who now can’t afford to retire. So the rising unemployment rate does not only reflect more people losing their jobs, it’s the kids coming out of school joining the unemployment ranks because the jobs they would normally fill are not being vacated.”
Steel, aluminum and copper distributors have been in a stock-slashing mode since last October when the economy took its historic nosedive. Most have right-sized their inventory levels to match today’s weak order volume and are holding their breath to see what happens next.
“Not everything got to the right level at the same time, and there may be a few products still with excess, but in general the overhang has been worked off,” says Gary Stein, president of Triple-S Steel in Houston.
“There’s no question the general destocking has hit a critical mass stage,” says Greg Gross, president of Northshore Metals, Deerfield, Ill.
The Metals Service Center Institute, Rolling Meadows, Ill., backs up this assessment. According to its June Metals Activity Report, U.S. steel inventories were down to 5.98 million tons, 44.4 percent below last year’s level or about a 2.4-month supply. U.S. aluminum inventories, at 269,800 tons or a 3.0-month supply, were 44.1 percent below year-earlier levels. Similarly, in Canada, steel inventories were 33 percent, and aluminum inventories 15.7 percent, below levels of a year ago.
In fact, mills report they are beginning to see a slight resurgence in order activity. But any excitement about a true turnaround would be premature, most experts say.
Don McNeeley, president of Romeoville, Ill.-based Chicago Tube & Iron Company, is among those who see renewed enthusiasm in the steel market because the excess, high-priced inventory has finally worked its way through the channel, but warns there are still tough months ahead. “There is still no demand. I don’t see demand picking up anywhere. If you consider that 25 to 30 percent of all steel is consumed by automotive, how can we have a recovery without automotive coming back?”
“Most people are buying only what they need. There’s a slight uptick in orders, but it’s more inventory correction than demand,” says Ted Riddle, chief operating officer of Pacesetter Steel Service in Atlanta.
“People are hopeful, but I believe what they are seeing is service centers and manufacturers ordering what they need now, as opposed to ordering what they need minus a few percent, now that the destocking is basically over,” says Roy Berlin, president of Berlin Metals, Hammond, Ind.
Like service centers, their OEM and fabricator customers have been running as lean as possible, and much of their purchasing is simply to fill holes in their depleted inventories. “I’m hoping the mills don’t think service centers are shipping more, because we’re not,” Berlin adds.
The end to destocking is good news for the service center sector, but it’s even better news for North America’s steelmakers, which anticipate renewed orders from distributors. Most mills reduced production below 50 percent capacity early this year as orders dried up and prices weakened. More recently, some have begun to bring capacity back on line, and prices have moved upward.
A year ago, basic commodity steel was selling for over $1,000 per ton. It sank as low as $360 earlier this year, but has since recovered to nearly $500, according to various sources. Higher prices were not just inevitable, but necessary, executives say.
“With the pressure on the mills to get out from under losses, to pay for higher cost raw materials and to get their numbers above variable cost, [raising prices is] something they have to do,” says Dave Lerman, president of Steel Warehouse, South Bend, Ind. “I think they will summon up the courage to keep working in that direction.”
U.S. Steel has announced three price increases for July and August totaling $120 per ton. Others have followed suit. How can steelmakers raise prices in the absence of demand?
“The mills have recognized that at less than 50 percent capacity utilization, with prices so low, it’s simply not a sustainable model. The mills cannot cut costs any further without damaging the steel industry and, quite frankly, the infrastructure of this nation,” McNeeley says.
To service center operators, even more important than the increase in prices is the question of how long the trend will last. “Pricing is running up fairly rapidly. I’m concerned it’s driven by inventory correction. Once inventories are replenished, I’m not sure true demand will support the run-up and we’ll be left with high-priced inventory again,” says Riddle.
“Pricing in carbon flat-roll has moved up considerably in the past six weeks. We believe those increases definitely will hold, at least in the short term. Whether they hold in the long term will depend on if the mills have the discipline to keep production in line with demand in the marketplace,” says Wayne Bassett, president and CEO of Samuel, Son & Co. Ltd., Mississauga, Ont.
Higher prices are supported by the low level of imports, which are not currently competitive, and high levels of exports, which help to tighten up the market, Bassett notes. But there is widespread concern the mills will bring back production too quickly and produce an oversupply that will put downward pressure on prices once again. “If they get over 60 percent capacity, these increases are done because the market can’t support them,” he says.
Disciplined buying behavior from distributors to prevent another disastrous oversupply situation can help alleviate some of the pricing concerns, experts say. “My perception is that what we are currently seeing is probably a pretty realistic picture of real consumption as opposed to apparent demand. We are buying what we are selling. No one is speculating. No one is buying inventory now because they think the price is going up,” Stein says.
Mike Sawyer, vice president of Universal Metals, Toledo, Ohio, says that’s the approach his company is taking. “We are treading very lightly [in purchasing], because no one wants to make the same mistakes as before.”
“I’m not a big prognosticator, but I see a steady, solid increase in prices through October,” says Lisa Goldenberg, chief operating officer of Delaware Steel Company of Pennsylvania in Fort Washington, Pa. “And the price should remain low enough to keep significant amounts of imports out.”
Northshore’s Gross says it’s imperative that mills take care in pushing increases through the supply chain, and don’t get too greedy. “We’ve got a little flicker, a tiny flame. If mills try to shove the price up too fast, we’re going to put that flame right out.”
Auto gets a boost
Not all dismal demand is created equal. Some sectors are showing small signs of life, while others are expected to get healthier quicker. The most likely to enjoy an uptick in the second half is the downtrodden automotive sector as it emerges from first-half shutdowns and begins to see some benefits from domestic automakers’ reorganization efforts and government stimulus programs.
“We think beginning in August automotive will come back at a pretty good level, comparable to January or February, and we expect that to hold for the balance of the year. We are relatively positive there,” says Bassett.
Samuel forecasts a 10 to 15 percent increase in business in the second half, largely due to automotive steel orders. “In the first half of the year, automakers produced far fewer cars than they sold. Now we believe they will build roughly the same number of cars they will sell. So even if they stay at a 9.6 million unit build rate, they will have to produce more cars and order more steel,” Bassett says.
In the United States, the “cash for clunkers’ stimulus program enticed thousands of car buyers to trade in their old vehicles for new, more fuel-efficient ones, exhausting the $1 billion in government funding in just a week, rather than several months. At press time, the Obama administration and lawmakers were considering whether to extend funding for the program to sustain the surge in car sales and aid the struggling auto industry.
“Automotive has completed its shutdown, so we’re optimistic people will start buying cars again,” says Goldenberg. “I don’t know if it will be in large volumes, but the smoke stacks churning and the wheels rolling will be good for everybody.”
Gross acknowledges that the automotive sector is due for a shot in the arm, but doubts it will gain sustainable momentum due to weak consumer confidence. “We will have a short-term bubble of a 16-week committed build schedule in automotive, but when that build schedule is complete, who’s coming in to buy these things? We’ll start the same cycle again.”
No quick fix for construction
Government stimulus has not yet provided the hoped-for boost in construction spending. The outlook remains gloomy for both residential and nonresidential construction, service center executives agree. According to Census Bureau data, U.S. total construction spending amounted to $368.8 billion in the first five months of this year, 11.7 percent below the same period in 2008.
“We don’t see much in infrastructure spending. We are not counting on government spending to make a big difference,” says Bassett.
“For us, the beam business is dependent on nonresidential construction, and it may still be falling. Projects getting built this year got financed last year. What gets built next year must get financed this year—and that’s about nothing. So other than governmental or institutional spending, you are not seeing any developer spending. Architects are not busy at all, which is an indication of what next year looks like,” says Stein at Triple-S.
The situation in the housing market is common knowledge as the economy struggles to recover from the glut of homes built during the days before the credit crisis. Weak home construction also affects related markets such as heavy equipment.
“The U.S. construction market was building at a rate of two million homes a year, and somebody bought enough equipment to do that. They are down now to 500,000 homes a year, so who is going to buy heavy equipment anytime soon?” asks Bassett.
Canada did not suffer from the same housing bubble as the United States, he notes. In fact, housing starts and sales actually rose in the second quarter vs. last year. “The consumer in Canada is in better shape because our house prices have only come off 3 to 5 percent,” says Bassett. “In Canada, you can only borrow 85 percent of the value of your home. We don’t have people here under water on their mortgages.”
Largely due to its healthier housing sector, the Canadian economy overall is doing better than that in the United States. Bassett estimates metals industry sales are down 45 percent in the U.S. but just 35 percent in Canada. “Canada has fared a little better in terms of the significance of the downturn. If you roll steel, aluminum and stainless together, Canada has come off about 10 percent better than the U.S.”
Energy ups and downs
But not everything in Canada is rosy. The Canadian oil and gas business has ground to a halt because it is too costly to extract oil from the tar sands, Bassett says. “When the price of oil collapsed, most of those tar sand projects were stopped. Unfortunately, with the way the industry works in western Canada, it will be early next year before they can really get back on track. Oil that comes out of the tar sands is high-cost oil. It costs them about $60 a barrel to ship it. So they have to see a market price well north of $60 before they will be gung-ho to move ahead on those projects.”
Chicago Tube & Iron’s energy tubulars business remains relatively strong, as has its sales to the defense market, says McNeeley. “We’d be very concerned if we did not have a diversified customer base, and energy and military doing pretty well.”
Construction of wind towers, a promising market for steel plate, has lost momentum. Wind power competes with other forms of electrical generation, and energy prices are relatively low right now. “We are big in the wind tower business, which also consumes a lot of aluminum, but most of the business we have been doing is on hold or has been scaled back,” says Bassett. “I don’t think it’s very economical right now.”
Riddle says Pacesetter’s primary market, HVAC, has also held its ground better than others.
Where’s the shakeout?
Surprisingly absent from the recent recession is a major shakeout of service center businesses. Many have closed facilities and downsized, but there has not been a major spike in mergers and acquisitions, observe service center executives.
“Lots of people regret not selling out a year ago,” McNeeley says, “but it does not appear a shakeout is under way.”
Berlin notes that many owners have to decide whether to inject more personal capital into their companies, “but if they’ve lasted this long, with the big decrease in demand and prices since last fall, my feeling is they are probably going to survive.”
One exception may be Michigan, where metals distributors are suffering intensely right along with their customers. “We probably have more factories shut down than any other place in the country,” says Don Simon, owner of Contractors Steel in Livonia, Mich. “Michigan is probably in a depression, whereas everybody else is in a recession.”
Larger players are looking for acquisition opportunities, but they are surprisingly hard to find. “We have been looking, particularly in the U.S., to find good service centers that would improve our network. Up to now, we really haven’t found anything of significance that we could pick up,” Bassett says.
In some cases, potential targets may be hanging on until conditions are more favorable and they can get a better price. “You can only lose money for so long, though,” Bassett adds. “That is when you will start to see the [M&A] activity.”
“I do think you will see some consolidation activity, though it’s just a little bit early,” Stein agrees. “We’ve all had our confidence decimated. It will be awhile before anyone feels like placing a bet. Considering the future environment for both steel and all of industrial America, who wants to invest in this kind of uncertainty?”
Riddle says Pacesetter has also been on the lookout for attractive deals, and has found some companies interested in partnering or being acquired. He believes more buyout opportunities will arise as the price of steel increases and raises the bar on the working capital necessary to sustain a service center’s operations.
Ironically, though sales are down, cash reserves are up at many service centers. With the price of steel half what it was at this time last year, and overhead costs pared to the bone, many distributors have the cash flow necessary to do business without as much borrowing as in the past.
“Many service centers are flush with cash,” McNeeley says. “The inventory they sold has not been replenished yet. And when your sales aren’t growing, your receivables look awfully good. I don’t remember my business ever being this soft, yet I have more cash than I’ve ever had. But I’d rather have that cash in inventory and receivables. You can only have a receivable if you’ve had a sale.”
Samuel is in a similar position. “When the market deteriorates and activity slows, it frees up inventory and receivable dollars. We’ve generated huge amounts of cash in this downturn,” Bassett says.
For companies in a weak financial position, however, the rising metals prices could be troublesome, especially during the seasonally slow summer months. With July shutdowns complete, August is traditionally the tightest cash month of the year, and will likely be an even greater concern this year, notes Goldenberg.
Persistent tightness in the credit markets, despite the federal government’s efforts to stimulate the economy, may not affect service centers directly, but it could affect their customers, she adds. “Low demand is manageable. You cut your overhead and manage your inventories down. But you can’t control people not being able to pay their bills. If people can’t get credit from the banks, they can’t pay me.”
McNeeley and Gross both expect the banks’ stinginess to continue for a while. “The government forced the banks to take stimulus money, which makes their books look better,” McNeeley explains. “The moment they lend it out, the bank will have to discount it 20 percent for credit risk. So one million dollars becomes $800,000 on the books. If a bank is worried about the value of its stock, why would it loan out the money and take a 20 percent hit on the asset side? It floors me that the government expected the banks to do something that is not in their own best interest.”
“What [the banks are] doing is protecting their own rear ends. They’re there to loan—if you don’t need the money,” Gross adds.
Lerman believes the banks will “come out of their bomb shelters soon. They can’t really sit on the money. They have to find some reasonable places to loan it. I think they’ll find companies that are good credit risks, and those of us [in the metals industry] who have survived are good credit risks.”
Perhaps the biggest concern expressed by service center executives is that, when the economy finally stabilizes, the “new normal” will be a much smaller steel market. “If the future calls for a 75-million-ton consumption market instead of 130 million tons, we certainly don’t need the service center industry we had,” Stein says.
“I don’t think the marketplace is going to come back to what it was. A number of the industries will be operating at lower levels even when we get back to what is considered a normal economy. That is our main concern going forward, that the service center industry will have to consolidate or downsize because volumes may never return to previous levels,” Bassett says.
Despite the slow, painful recovery that remains, Berlin sees a solid future for good companies that keep inventories lean, costs low, and are conservative and efficient in their operations. His forecast is “not cheery, but not overly gloomy either,” he adds. “Look at it this way—there are no worse times ahead.”
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