How to do Business Analysis of Steel Companies

The current article aims to highlight the key aspects of steel companies. After reading this article, an investor would understand the factors that impact the business of steel manufacturers and the characteristics that differentiate a fundamentally strong steel company from a weak one.

Key factors influencing the business of steel companies

1) Cyclical nature of steel business:

The business of steel production goes through alternate phases of boom and bust. The key reason for such cyclicity in the steel business is the nature of its customers. Steel production is consumed primarily by housing, infrastructure, automobile, shipbuilding, capital goods etc. Demand from all these industries is highly dependent on the state of the general economy.

Rating Methodology – Steel Industry by CARE, September 2022, page 2:

Steel is a cyclical industry, strongly correlated to economic cycles since its key users, viz., construction, infrastructure, automobiles, and capital goods are heavily dependent on the state of the economy.

During the time of economic upcycle, demand for housing, automobiles as well as infrastructure investments increases, which leads to a higher demand for steel. The opposite situation prevails in downturns.

Frequent phases of demand and supply mismatch in the steel industry also contribute to cyclicity. A long construction & gestation period of a steel plant leads to frequent demand-supply mismatch. This is because during economic upcycles when demand is high, many steel producers launch capacity expansion, which takes about 3-5 years to get operational. By that time, the economic cycle has already turned and demand declines. However, at this time, all the newly operational plants add to the supply leading to pricing pressures and low utilizations in the industry, which results in many steel producers making losses and even going bankrupt.

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Apart from the cyclicality of the end-user industries, heavy capital investment and a gestation period of 3-5 years for a new plant also contribute to the cyclicality in the steel industry. This results in several steel projects coming on stream simultaneously leading to demand-supply mismatch.

As a result, for a steel manufacturer, the timing of capacity expansion is very crucial.

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CARE Ratings believes that timing and size of the expanded capacity coming on-stream is critical to the success of a steel manufacturer…The companies who face a downturn immediately post expansion or during an expansion are likely to be more at risk.

As the steel industry witnesses alternate boom and bust phases; therefore, it becomes crucial for a steel manufacturer to manage its cash flows by taking a view though out the business cycle. During upcycle, steel manufacturers make a lot of surplus cash, which they must use appropriately to safeguard themselves during downturns. Most of the successful steel plants use surplus funds during upcycle to reduce debt so that they can tide over subsequent down phases efficiently.

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companies with history of deleveraging in industry up cycles, the promoter’s financial support in down cycles and low debt appetite are seen favourably

Another factor, which leads to a sharp increase in demand for steel producers during upcycles and an equally sharp decline in demand during downturns is the high inventory present in the entire steel distribution channel.

As the channel partners e.g. wholesalers, distributors, traders etc. sense a downturn, they start liquidating their inventory and stop purchasing from steel mills leading to a sharp correction in demand for steel manufacturers. On the other hand, whenever the economy starts showing signs of revival, the channel partners and traders start stocking/accumulating inventory leading to a sharp increase in demand for steel manufacturers. These factors increase the impact and extent of cyclicity on steel plants.

Rating methodology for blast furnace steelmakers by Rating and Investment Information, Inc. (R&I), Japan, April 2022, page 4:

Besides inventory maintained by steel companies, there is inventory in the market held by distributors,…many cases where market participants at each stage have adjusted inventory when an economic slump has slowed the movement of goods and the market has begun to falter, and their actions have given added impetus to the market slowdown

As a result, steel manufacturers have to be very cautious while managing their business across different phases of cycles.

Advised reading: How to do Business Analysis of Solar Power Plants

2) Intense global competition leading to a low pricing power of steel manufacturers:

Steel is a commodity, which is standardised across manufacturers around the globe. In addition, it is easy to transport via sea. Therefore, the entire world acts as a common market for steel leading to an international benchmarking of prices.

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Steel is a globally traded commodity due to standardisation and ease of transportation of the products. As a result, domestic prices of steel products generally move in tandem with international prices adjusted for applicable duties and taxes.

Due to standardised products and ease of logistics, steel manufacturers in India have to compete with imports from various countries like Japan, China and South Korea having a surplus steel production capacity. This competition is intense in both with Indian market as well as export destinations.

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Domestic steel producers also face stiff competition in the form of low-cost imports and such imports put pressure on steel prices and profit margins of industry players. Not only in the domestic markets, but the competition also exists in the export markets to which Indian steel players export steel products.

One of the reasons for the intense competition from imports is that countries like Japan are seeing a decline in steel consumption. Due to a surplus capacity, steel manufacturers in such countries have to sell in foreign markets to maintain growth and survive.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 3:

While demand in Japan is expected to decline over the medium to long term, demand overseas is expected to increase, mainly in emerging countries. In order for each company to secure stable cash flow and sustain growth, it is important to capture overseas demand.

To control business risks, each company must continually make large investments to capture foreign demand

The intense competition from domestic as well as international steel manufacturers takes away the bargaining power from the hands of local steel producers.

Another factor, which reduces the pricing power of steel manufacturers is the ease with which customers can switch steel suppliers leading to low customer continuity. Due to the standardisation of steel grades, it is difficult for steel manufacturers to differentiate their products from each other. As a result, customers can easily replace a grade of steel from one producer with steel of the same grade from another producer without a lot of challenges.

Rating methodology for blast furnace steelmakers by Rating and Investment Information, Inc. (R&I), Japan, April 2022, page 3:

Because components of and standards and measurements for many steel products have been set, such items are versatile as basic materials and end-products. Given this situation, differentiation of products among manufacturers in the general purpose products sector is difficult, especially in steel products for construction, and in general customer continuity is low.

Due to intense competition and low customer stickiness, steel manufacturers end up being price takers.

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The producers of steel products are essentially price-takers in the market, which directly expose their cash flows and profitability to volatility in the steel prices.

To counter low customer stickiness, steel manufacturers attempt to produce specialized steel, which has custom properties as required by the customers. Parts made from special steel play a very critical role in the customer’s products. Therefore, customers are very particular about the quality of steel. It usually takes a long time for customers to assess and approve a special steel supplier, which is then given orders under long-term contracts.

As a result, customer stickiness for special steel is higher than for ordinary steel.

Rating methodology for minimills (ordinary and special steel) by Rating and Investment Information, Inc. (R&I), Japan, July 2019, page 2:

Special steel products are processed into engine parts, drivetrain parts, and suspension and brake components…All of these are critical components that affect end-product performance and safety. Consequently, many transactions take the form of “tied” transactions in which not only the price and volume but also constituents, shape and other product specifications are negotiated directly with customers, and customer continuity is relatively high

Nevertheless, despite low pricing power, steel manufacturers are usually able to pass on an increase in their raw material costs to customers because steel is essential for customers and cannot be easily replaced with any other material.

Rating Methodology – Steel Industry by CARE, August 2018, pages 2-3:

Manufacturers of steel are invariably able to pass on the increase in cost of raw material to consumers in a normal market scenario due to the importance of steel to many economic activities like construction, infrastructure sector, and manufacture of consumer durables and modes of transportation.

Further advised reading: How to analyse New Companies in Unknown Industries?

3) Capital intensive nature of steel plants:

Steel plants require a large amount of capital for setting up. It may take up to a billion US Dollars (USD) i.e. about ₹8,000 cr (at ₹80/$) to construct a one million tonne per annum (MTPA) greenfield steel plant.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 10:

Steel projects are highly capital intensive, with around US$ one billion required for setting up a greenfield capacity of one million metric tonne.

In addition to initial set-up costs, steel plants require continuous large investments for regular maintenance and upgradation.

Criteria for the steel industry by CRISIL, February 2021, page 23:

Another key issue is capital requirement, either to expand capacity or upgrade facilities. The steel industry requires regular, large capex to maintain modern and efficient facilities.

Rating methodology for blast furnace steelmakers by Rating and Investment Information, Inc. (R&I), Japan, April 2022, page 7:

Steel manufacturing facilities constantly demand a certain level of upgrade investment. Furthermore, to develop as a firm over the long term, expansion of production capacity, a shift toward higher grade products, the acquisition of resource rights and strategic investments, including the purchase of domestic and overseas firms, are indispensable as well.

The requirement of a large amount of capital is not limited to installing and upgrading steel plants. Companies need to invest a large amount of money in working capital as well because the steel business requires a large amount of inventory at different stages of raw material movement, intermediate products, and finished goods in warehouses.

Rating Methodology – Steel Industry by CARE, August 2018, page 2:

Manufacture of steel is also working capital -intensive process. The long working-capital cycle is primarily due to high inventory maintained by manufacturers both in terms of raw material and finished goods, owing to the continuous nature of the production process, the standardised nature of the finished products and the limited and geographically spread out supply of raw materials.

Advised reading: Inventory Turnover Ratio: A Complete Guide

Maintenance of a large inventory is essential for the smooth functioning of steel plants because once a steel furnace is started, it is best to keep it running continuously. Steel is produced at a very high temperature of about 1,100 degrees Celsius and it is neither easy nor economical to shut down a furnace once it has reached this temperature and started operations.

Therefore, steel production continues throughout the day and night and companies need to keep stock of sufficient inventory of raw materials to continuously feed into the furnace to keep it running, which increases working capital requirements.

Rating Methodology – Steel Industry by CARE, September 2022, page 2:

Steel is generally manufactured in a continuous process as the shutdown of blast furnaces is both costly and time consuming. Uninterrupted supply of raw materials is, thus, imperative to continuous production processes.

A large amount of capital and a long period to commence operations for the steel plants act as a key entry barrier for new players in the industry.

Rating Methodology – Steel Industry by CARE, August 2018, page 3:

The capital-intensive nature of the steel industry coupled with the long gestation period (2 -3 years) acts as an entry barrier to small entrants.

Nevertheless, even within the steel industry, many smaller players establish shops where they limit their operations to the only conversion of one form of steel to another.

Rating Methodology – Steel Industry by CARE, August 2018, page 3:

However, in India, to circumvent this problem, a number of players have set up induction furnaces which need less investment. However, these induction furnaces produce lower quality and quantity of steel.

Small steel mills are able to manage with a lower investment because they only convert one form of steel into another without indulging in a much more resource-consuming process of producing steel from iron ore and coal. It saves them from installing large segments like coking furnaces, sintering plants, a private jetty for the import of coking coal etc.

Rating methodology for minimills (ordinary and special steel) by Rating and Investment Information, Inc. (R&I), Japan, July 2019, page 6:

This is partly because minimills do not need a coking furnace or sintering plant and require the smaller scale of equipment compared with integrated mills. In addition, iron scrap used as a raw material can be obtained from nearby areas and large-scale harbor facilities for receiving raw materials are unnecessary.

Small minimills also save on working capital investments because unlike large integrated steel plants they do not have to carry an inventory of iron ore and coal. They can buy steel scrap or steel intermediates from the market as per their requirement instead of having to mandatorily buy iron ore & coal under long-term take or pay contracts with miners.

Rating methodology for minimills (ordinary and special steel) by Rating and Investment Information, Inc. (R&I), Japan, July 2019, page 7:

minimills procure iron scrap on a period-by-period basis at prevailing prices, they have a much stronger ability to cope with a production cutback phase than integrated mills, which procure iron ore and coking coal under long-term contracts. Minimills can thus be said to have relatively greater cost structure flexibility than integrated mills.

These mini-mills, though are able to establish operations at a lower cost; however, are not able to produce steel of very high quality. In addition, these small players also face product and client concentration, which increases the risk in their business model. There is no wonder that over time, in the steel industry, big players get bigger as we discuss later in this article.

An investor may read our detailed analysis of one such small secondary steel company, Beekay Steel Industries Ltd, which converts steel billets into TMT bars, which can then be used by end users: Analysis: Beekay Steel Industries Ltd

4) Efficiency in operations is a must to survive:

Steel manufacturers produce a commoditised non-differentiable product and are exposed to intense competition from India and abroad. As a result, they are price takers where they have to sell steel at the market price determined by international parity price. Steel plants cannot charge a price higher than the market to increase their profitability. Moreover, most of the key customers of steel plants are also large housing, infrastructure, automobile, shipbuilding and railway organizations that possess strong bargaining power. So, increasing the price above the market is a challenge for steel manufacturers.

Rating methodology for minimills (ordinary and special steel) by Rating and Investment Information, Inc. (R&I), Japan, July 2019, page 9:

Boosting profitability is not easy, however, since many of those customers, such as automobile manufacturers, possess strong price bargaining power and the depreciation burden for equipment is heavy as well.

Moreover, the suppliers of the key raw material used by steel plants i.e. iron ore, coal, electricity etc. are usually govt. firms, which are very large. As a result, steel manufacturers do not have a high negotiating power over their suppliers.

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the supplies of raw materials like iron ore, coal, etc., is largely concentrated with few government-owned entities, and private players, and the supply side is oligopolistic in nature

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due to limited global availability of key raw materials like iron ore and coal/coke, the raw material industry is supplier-dominated.

Steel mills across the globe face weak negotiating power against their raw material suppliers. Even in countries like Japan, suppliers of raw materials like coal and iron ore enjoy a higher bargaining power.

Rating methodology for Iron & Steel sector by Japan Credit Rating Agency, June 2022, page 3:

the market of raw material supply has been increasingly oligopolistic, typically helping the suppliers gain more power in negotiations.

In such business situations where suppliers, as well as customers, have a higher negotiating power than the manufacturer, companies get stuck between the rock and a hard place. As a result, in order to gain good profitability, steel producers have to rely on cutting their operating costs to the maximum and running their plants as efficiently as possible.

Criteria for the steel industry by CRISIL, February 2021, page 22:

Steel companies have little control over end prices. Therefore, the key to success is keeping cost low.

Therefore, in the steel industry, operating efficiency becomes the most important method to gain a competitive advantage over competitors.

Moreover, in light of internationally benchmarked pricing and competition from imports, steel producers have to be cost-competitive at a global level to be profitable.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 4:

Steel being internationally traded, a steel player needs to be internationally cost competitive to remain profitable across cycles.

Steel plants try to gain an advantage in lowering their raw material costs by either acquiring captive mining rights or by entering into long-term supply contracts with suppliers.

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CARE Ratings considers companies which have control over supply of their raw material such as iron ore, coking coal, thermal coal, power, water, etc., as more capable of being cost efficient. The control over supply could be either in the form of captive operational mines or long-term supply contracts with miners or easy access to large miners…The ability to control raw material costs is therefore a key determinant of profitability.

Another area for steel companies to cut costs is freight. Steel manufacturing involves moving a lot of raw materials and finished goods. As per some estimates, manufacturing 1 million tonnes (MT) of steel needs moving about 1.5 MT of iron ore and about 1 MT of coking coal from mines to the plant and then moving 1 MT of steel from the plant to the market i.e. a total movement of about 3.5 to 4 MT.

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Due to the bulky nature of key raw materials, the freight cost become an important cost head, and the location of the steel plant becomes a key rating factor. Assuming that 1MT of steel requires 1.5MT of iron ore, and 1MT of Coking coal, almost 2.5MT of raw material needs to be transported to steel plant from the mines.

During this movement, all the raw materials and finished steel are owned by the steel plant as inventory. Therefore, to reduce freight costs as well as inventory costs, a steel plant needs to choose its location carefully.

Most of the integrated steel plants are built near the sources of raw material because raw material movement costs are about two-thirds of total logistics costs. These can be near the mining sources or near ports if the plant needs to import a lot of raw materials as well as export its products.

Rating Methodology – Steel Industry by CARE, September 2022, page 3:

The companies whose plants are located close to the sources of raw material are likely to have an advantage in terms of freight cost, inventory holding period and therefore, working capital cycle.

Another area where steel plants work to reduce costs is power. Steelmaking is an energy-intensive process. As a result, power & fuel costs are also significant. Steel plants try to reduce their power costs by focusing on cheaper sources of power like captive power plants, waste heat recovery (WHR), renewable power etc.

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CARE Ratings views steel manufacturers who have captive power plants as superior to their peers on account of stable supply source & relatively lower cost…Steel manufacturers who are able to utilise captive fuel sources, for example, using waste heat gas recovery from its plants for power generation are viewed favourably…ability to keep power costs down as a critical parameter of operating efficiency.

Therefore, steel plants have to look for every avenue for cutting costs and gaining efficiencies to become profitable.

One of the critical areas for cost efficiency for steel plants is the technology used for steel manufacture. The latest technology usually has a lower cost of production. This is another factor, which forces steel producers to constantly invest money in upgrading their plants and machinery because otherwise, they suffer from competitive disadvantages.

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The more sophisticated the manufacturing process, the lower will be the cost of production, and therefore, higher the profitability….Also, the ageing of the plants is a critical factor as the companies with older plants may require substantial investments for modernization and upgradation of the machineries.

Advised reading: Operating Performance Analysis: A Simple & Complete Guide

5) Diversification helps in the steel business:

Steelmaking is a risky business which involves uncertainties related to demand & supply, political, and regulatory risks. To reduce many of these risks, companies go for diversification in their business model.

Steel firms can achieve diversification over different aspects like geographical location of plants, domestic & export business, customers from different industries, manufacturing different types of products etc. Each of these aspects of diversification adds to the stability in the business and cash flows of steel mills.

5.1) Geographical diversification:

Geographical diversification of customers helps a steel plant to take advantage and mitigate impacts of demand-supply and tariff barriers and duties-related situations of a region. It can increase sales of geographies where demand is favourable. In addition, geographical diverse plant locations protect the company from natural disasters, local unrest and other political factors.

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Steel companies with a diversified market base can take advantage of regional demand- supply mismatches which will help mitigate their market risk. Geographical diversification also mitigates political and economic risks.

Further advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

5.2) Customer diversification:

Companies also go for diversification in their customers in terms of industries as well as geography (domestic and exports). Usually, demand from institutional customers like automobiles etc. is more stable at a contracted price with long-term visibility. On the other hand, demand from steel traders is very volatile as this demand vanishes whenever there are signs of a slowdown. As a result, companies attempt to have a diversification of customers profile ranging from institutional and trading clients.

Rating methodology for ferrous metal entities by ICRA, March 2019, page 3:

higher share of institutional sales having longer term contracts is preferred over sales to traders, which are more opportunistic in nature than the former category.

Criteria for the steel industry by CRISIL, February 2021, page 21:

a diversified clientele is a positive factor as a setback in a particular end-user segment will have lower impact on total sales than that for a company with high client concentration. Diversification may also be across geographies, and include export.

There are certain sections of consumers of steel like tin plates used in consumer packaging for liquids like ghee, and oil, which see a relatively consistent demand. Having a product portfolio around tin plates brings stability to the revenue and cash flows of a steel company.

Criteria for the steel industry by CRISIL, February 2021, page 21:

the recession-resistant consumer packaging industry is the primary market for tin-mill products, leading to stable demand.

5.3) Product diversification:

Steel manufacturers that are able to produce various types of products like longs and flats, ordinary & value-added and special steel and other intermediary products are able to benefit from increased demand in any of the product segments. This in turn helps them mitigate the cyclicity and brings comparative stability in their revenues.

Rating Methodology – Steel Industry by CARE, September 2022, page 4:

Steel manufacturers who have progressed up the value chain by diversifying into value-added products while continuing to manufacture crude and intermediary products are considered favourably

The smaller companies with limited product diversification and limited value addition in finished products operate at lower margins.

Most integrated steel manufacturers benefit from product diversification as they can increase the production of crude or intermediate or finished or value-added steel as per the market requirements.

Rating Methodology – Steel Industry by CARE, September 2022, page 4:

such manufacturers are in a better position to take advantage of differential demand conditions for different products by scaling up manufacturing of any part of their product portfolio according to the demand conditions

Rating methodology for blast furnace steelmakers by Rating and Investment Information, Inc. (R&I), Japan, April 2022, page 5:

Different types of products have different supply and demand trends, however, and if a firm has high value-added products that can be differentiated, particularly through technology, the effect of market fluctuations can be controlled to some extent. Having a broad lineup of such products provides an effective way to improve earnings stability.

Different steel product segments like longs and flats have different characteristics. Major production of steel is in the form of longs, which are used in housing, construction and infrastructure. These products are relatively low margins than flat products, which are used in automobiles, consumer durables, shipping etc. Flats have a higher margin than longs; however, their prices are more volatile than longs.

Criteria for the steel industry by CRISIL, February 2021, page 21:

it is a prudent strategy for steel companies to adopt a judicious mix of flat and long products because prices of long products are generally more stable than those of flat products, though the latter are typically more profitable.

The ability to switch between longs and flats is also essential for a steel plant over the long term because the consumption pattern of a developing economy changes from longs to flats as it grows. In the initial stages of infrastructure development, the country uses more long steel products in roads, bridges, buildings etc. However, once it reaches the developed stages and the growth in infrastructure slows down, then the country starts consuming more flat steel products in consumer goods, automobiles etc.

Rating methodology for blast furnace steelmakers by Rating and Investment Information, Inc. (R&I), Japan, April 2022, page 1:

During the economic take-off stage or initial growth period, steel bars and shapes for civil engineering works and construction account for the majority of steel demand…As a country’s industry structure develops and its economy matures, however, the proportion of steel sheet, plate and pipe for manufacturing increases

Therefore, over time, steel producers have to adjust their product portfolio.

Steel companies, which focus on value-added, special steel benefit from higher barriers to entry for the competition. Special steel is usually made with custom characteristics as per the customer’s requirements, which brings in customer stickiness. Customers usually take a long time to assess the quality and approve new suppliers for special, value-added steel.

Rating methodology for minimills (ordinary and special steel) by Rating and Investment Information, Inc. (R&I), Japan, July 2019, page 5:

Even if a later manufacturer enters the market, the barriers to entry are high because of the considerable amount of time required to ship samples of a product to a customer, obtain approval (certification) for the product including that for manufacturing facilities, and then actually deliver the product.

Metal Industry – Key Success Factors by Pefindo, Indonesia, November 2021, page 1:

a higher-value or specialty products could partly offset the effect of cyclical downturns and pricing inflexibility, and also create barriers to entry.

Companies producing special, value-added steel also enjoy higher profitability as they can charge a premium to their customers.

Criteria for the steel industry by CRISIL, February 2021, page 21:

Value-added products offer higher realisations and hence, boost profitability. The cost of adding value is generally lower than the incremental realisation that such products offer

Higher profitability and stable cash flow are significant benefits of selling a larger quantum of value-added products.

Advised reading: How to do Financial Analysis of a Company

5.4) Diversification in production process:

Many steel companies make their production flexible where they can manufacture different kinds of steel products based on prevailing demand. This ability helps them in achieving better utilization of their plant.

Rating methodology – steel industry by MARC (Malaysian Rating Corporation Berhad), December 2019, page 3:

any manufacturing process flexibility that would allow shifts between different products as positive.

In addition, another flexibility in the steel-making process is the ease with which manufacturers can start and stop the manufacturing process. As steel is made at very high temperatures, which takes a long time to reach the furnace; therefore, once the furnace is started, thereafter, it is very costly to interrupt it.

This ability to control costs by shutting down production when demand is low has proved to be a big competitive advantage to the steel mills over their peers.

Criteria for the steel industry by CRISIL, February 2021, page 22:

During downturns in the steel cycle, the ability of a company to cut production and yet remain cost-effective is a key factor determining long-term competitive advantage.

Only small steel players especially those using electric induction furnaces (EIF) are able to show such flexibility in their manufacturing process. Primary steel producers who make steel from iron ore and coal using a blast furnace, as well as other secondary steel producers using electric arc furnaces (EAF) do not enjoy such flexibility.

Rating Methodology – Steel Industry by CARE, August 2018, page 1:

Since the size of induction furnaces are small, power requirement is less than that of an EAF and flexibility of manufacturing process is high.

6) Size of operations; big gets bigger in steel industry:

In the steel industry, companies frequently face challenging times during downturns when profitability and cash flows decline and survival becomes a challenge. In such times, large players with financial strength are in an advantageous position because they can face downturns better.

Additionally, a large size allows steel producers to benefit from economies of scale, which increases their cost competitiveness in a commoditised market. Large steel plants also enjoy comparatively better-negotiating power over their suppliers and customers when compared to smaller steel players.

Criteria for the steel industry by CRISIL, February 2021, page 21:

Large, well-diversified companies in the highly fragmented steel industry typically have greater ability to withstand external shocks, easier access to capital markets, and better bargaining power with suppliers and customers.

Large integrated steel plants also benefit from diversification in product profiles as well as customer segments. Bulk buyers of steel tend to deal with large steel producers directly in order to get the best pricing and delivery schedules.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 4:

Primary steel producers typically have a diverse customer base, with low exposure to sales concentration and counter-party credit risks and have a higher share of institutional sales compared to secondary steel players.

A diversified product and customer profile with comparatively better-negotiating power help large integrated steel producers to mitigate the impacts of cyclicity in the steel industry.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 3:

A steel producer is better insulated from the cyclical volatility when it has a strong market position, large scale of operations, and a diversified product mix. Typically, a large and well diversified operation generates more reliable cash flows than a smaller operation with concentrated product lines of more commoditised nature.

Nevertheless, smaller secondary steel players also have certain advantages like lower capital needs and better cost and manufacturing flexibility.

Rating Methodology – Steel Industry by CARE, September 2022, page 5:

Typically, integrated players with presence across the value chain tend to have longer working capital cycle due to substantial amount of inventories maintained for each and every raw materials, products and processes. In contrast, the secondary steel producers with limited presence on steel value chain are required to maintain limited inventory and therefore have relatively shorter working cycle

Smaller secondary steel plants can start and stop their production processes as per the market demand; however, large integrated steel mills cannot switch their production on & off quickly because it is very costly and time-consuming to stop and start a blast furnace.

Rating methodology for minimills (ordinary and special steel) by Rating and Investment Information, Inc. (R&I), Japan, July 2019, page 7:

From an equipment standpoint, adjusting production to match the trends in demand and steel product stocks is easy for minimills. Blast furnaces, on the other hand, cannot be shut down easily once operations are begun.

Despite a comparatively lower capital intensity and cost flexibility, smaller steel mills are at a disadvantage over large integrated primary steel plants. Large steel players have the financial strength to survive downturns. Moreover, they also benefit further from the downturns by taking over troubled small steel plants and in turn increasing their size further.

Criteria for the steel industry by CRISIL, February 2021, page 21:

A strong financial risk profile is important to the credit strength of a steel company for two main reasons. Firstly, steel producers with a weak balance sheet are less likely to withstand business downturns and maintain their investment programmes, thereby losing out on efficiency. Secondly, players with a strong financial risk profile will be able to acquire weaker competitors during a downturn

As a result, there is no surprise that the steel industry in India is in a consolidation mode and the market share of large steel players is increasing over the years.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 1:

Top six steel producers in India had close to 63% share in total crude steel production in FY2021 compared to 52% share enjoyed in FY2016, which implies increasing consolidation in the industry.

Even in overseas markets like Japan, the steel industry has seen consolidation because, in the steel sector, large players enjoy many competitive advantages over their smaller peers.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 2:

The blast furnace industry, which accounts for about 80% of Japan’s crude steel production, has seen a consolidation of manufacturers as a result of past industry reorganization

Therefore, an investor would appreciate that in the steel industry, large players enjoy advantages, which they use to further increase their strengths.

Advised reading: Margin of Safety in Stock Investing: A Complete Guide

7) Regulatory, environment & social and forex risk for steel producers:

The steel industry is a crucial sector for the economic growth of any country. Many industries like infrastructure, housing & construction, railways, shipbuilding, automobile and even banking are dependent on the steel industry.

As a result, despite deregulation, almost all countries track the performance and developments of the steel sector. Whenever a country notices steel imports at a very low price, then it usually places a safeguard, anti-dumping duty on imports to protect domestic steel producers. Similarly, when there is excess domestic production, then countries give export incentives to the steel sector to clear excess stock of steel and bring the industry to a normal situation.

These intermittent policy measures by countries expose steel players to regulatory risk as they can significantly influence the financial performance of any steel plant.

Rating Methodology – Steel Industry by CARE, September 2022, page 4:

Consequently, any regulatory intervention in the form of export incentives for domestic steel exporters or protection measures such as import duty/safeguard duty/anti-dumping duty partially alleviates pricing pressures for domestic steelmakers….any trade barriers in export markets can have a material impact on the entity’s revenues.

Other than duties and tariffs, there are other aspects where regulations have a significant influence on the business of steel plants. One such area is mining regulations. In the past, steps by courts and govt. to cancel existing coal mining leases subsequently followed by auctions impacted the sector significantly. Similarly, any major change in the allocation of mining rights or usage/extraction of ore from the mines has the potential of impacting the steel sector due to their large requirements of iron ore and coal.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 3:

Apart from duty structure, any unfavourable change in Government policies with respect to mining of iron ore and/or coal can adversely impact the availability and prices of these key raw materials and in turn a steelmaker’s profitability,

Additionally, the steel industry depends on the acquisition of land for establishing its plants and mining operations. Any unfavourable change in the land acquisition rules has the potential to hurt the steel industry.

Rating Methodology – Steel Industry by CARE, September 2022, page 5:

The Indian steel industry is exposed to the risks of changes in regulations relating to land acquisition, renewal or grant of mining rights and environmental clearances.

The mining process involves a lot of impact on the local environment as well as on the local population including tribes. As a result, operations of steel plants involve significant social risks as well.

Rating Methodology – Steel Industry by CARE, September 2022, page 5:

Social risk too emanates from the mining and production activity when it comes to the health and safety of the miners as well as the employees involved in the production activities…the destruction caused by the mining activity and the impact caused in the nearby areas

The steel-making process is energy intensive. As a result, it leads to a significant release of greenhouse gases like carbon dioxide (CO2), which impacts the environment. Blast furnace releases a lot of CO2 as it removes oxygen from iron ore by using carbon leading to the formation of CO2. Other forms of steel production like electric arc furnaces use a lot of electricity, which indirectly leads to CO2 release at the power plant if it uses coal to produce electricity.

Rating methodology for Iron & Steel sector by Japan Credit Rating Agency, June 2022, pages 3-4:

Blast furnace is an industry with high greenhouse gas emissions…Electric furnace steelmakers emit less greenhouse gases than blast furnace steelmakers. On the other hand, they consume large amounts of electricity in the manufacturing process.

Nowadays, almost all countries are attempting to reduce carbon emissions, which require polluting industries to take measure to reduce emissions. These steps by companies involve a lot of investment, which puts an additional financial burden on the players and many times has led to the closure of plants, which are not able to meet the strict guidelines.

Rating Methodology – Steel Industry by CARE, September 2022, page 5:

Significant amount of opex as well as capex cost may be required in terms of complying to different Environmental guidelines, which also vary from location to location.

Apart from regulatory, social and environmental risks, steel plants also face foreign exchange (forex) fluctuation risk. Forex risk is obvious for primary steel plants, which import coking coal for steel production.

Rating methodology for ferrous metal entities by ICRA, July 2021, page 3:

coking coal is primarily imported by India due to domestic shortages and thus remains sensitive to foreign currency fluctuations in addition to price risks.

However, forex risk also impacts secondary steel plants, which buy their raw material locally. This is because, for these steel plants, the expenses are in local currency (INR); however, the selling price of their products (steel) depends on the import parity price of global steel after factoring in forex fluctuations.

Rating methodology for ferrous metal entities by ICRA, March 2019, page 7:

The manufacturing costs of a domestic steel producer are incurred primarily in the domestic currency (except cost of imported coal and scrap), while selling prices are, even if the company sells its produce within the country, linked to the exchange rate, being typically benchmarked against the landed cost of imports.

Therefore, an investor must be cautious of the foreign exchange risk while analysing any steel producer.

Nevertheless, those secondary steel producers who use scrap to make steel are relatively protected from forex risks because the prices of their raw material (scrap) as well as the finished product (steel), both depend upon international steel prices. It also helps in the stabilization of their profit margins.

Rating methodology for ferrous metal entities by ICRA, July 2021, pages 5 and 7:

scrap purchases by a domestic steel producer, there is an element of natural hedge as its selling prices are, linked to the exchange rate, being typically benchmarked against the landed cost of imports.

Scrap prices, which account for around half the cost of secondary steel producers, generally move in tandem with finished steel prices and, thus, secondary players using greater proportion of scrap in comparison to sponge iron/pig iron have lower volatility in their margins.

However, efficiently running a scrap-based steel plant is a challenge because regular availability of scrap in the required amount is a challenge and in addition, the prices of scrap are also very volatile.

Criteria for the steel industry by CRISIL, February 2021, page 22:

both the cost and availability of scrap are concerns in India.

Concerns regarding the availability and cost of steel scrap are universal. Companies, both in India as well as in other countries like Japan, face challenges in sourcing the required quantity of steel scrap.

Rating methodology for minimills (ordinary and special steel) by Rating and Investment Information, Inc. (R&I), Japan, July 2019, page 9:

The amount of iron scrap generated, the key raw material for minimills’ steel production, is unsteady, and its prices fluctuate widely.

Therefore, even in the secondary steel players using scrap enjoy a natural hedge, and still, they face other challenges regarding the availability and price of scrap.

Summary

Overall, the steel industry is a highly capital-intensive sector with a strong cyclicity in performance. Steel companies face alternate boom and bust periods in their performance because most of their end consumer industries like automobile, housing, construction, infrastructure etc. are highly dependent on the state of the general economy.

Steel companies face intense competition from domestic as well as international players (low-cost imports) because steel is a globally traded commodity as it can be easily transported using sea trade. The prices of steel across all the countries are linked to international benchmarked prices and therefore, are significantly influenced by foreign exchange fluctuations.

Many large economies like China, Japan and South Korea have a surplus steel manufacturing capacity. As a result, companies in these countries have to export to other nations in order to grow and at times to survive. This creates strong competition for Indian steel players from low-cost imports. At times, the steel is imported at less than the cost of production, which leads to the imposition of anti-dumping duty by countries.

Steel manufacturing requires a large amount of capital for installing a steel plant as well as to maintain and regularly upgrade it. In addition, the operations of the steel plant need a large amount of working capital because it needs a significant amount of inventory at every stage of the process. Steel manufacturing is a continuous process i.e. a furnace once started is kept operating continuously without stoppage. As a result, steel plants need a continuous supply of raw materials; otherwise, they become inefficient operators. This large capital requirement acts as an entry barrier for new players in the industry.

Steel is a standardised commodity product, where a product of a particular grade from one manufacturer is non-differentiable from the same grade product from another manufacturer. Therefore, customers easily switch from one supplier to another leading to very low pricing power in the hands of steel players.

On the contrary, the suppliers of steel plants, iron ore and coal mining operators are large govt. owned companies without oligopoly. Therefore, the profitability of steel players is always under stress. To increase profit margins, the only way for a steel player is to become the lowest-cost producer.

Therefore, steel players go for captive mining rights or long-term supply contracts with mines. Steel manufacturers go for captive power plants for cheaper and assured power, waste heat recovery, use of renewable power etc. to reduce their cost of production. Steel producers strategically locate their plants close to raw material sources or ports to reduce their freight costs.

To reduce the cyclicity and risk in their business model, steel players go for diversification in terms of the geographical location of their plants as well as customers. Players prefer customers from varied industries so that they can protect themselves from issues in any particular end-user industry. Steel players also go for product diversifications to take advantage of the demand-supply dynamics of different product segments. Steel players producing higher value-added products and special steel have competitive advantages and can mitigate the impacts of cyclicity in their business.

Large steel players have a lot of advantages in the industry considering the benefits enjoyed by low-cost producers. Economies of scale and higher bargaining power help them survive cyclical downturns better. Due to their financial strength, they are able to acquire smaller troubled players and increase their business strength further. As a result, steel industries in India as well as abroad have witnessed increasing consolidation.

However, all the steel players face significant regulatory risk due to frequent policy measures taken by the countries to interfere in steel markets like tariffs, anti-dumping duties, export incentives etc. Any change in regulations related to land acquisition, mining and environmental norms affects steel producers significantly.

Therefore, an investor should always keep in mind these multiple aspects of steel manufacturing companies to understand the true picture of their business position.

• Cyclical nature of business
• Intense global competition
• low negotiating power with customers as well as suppliers
• Capital-intensive nature of business
• Focus on being the lowest-cost producer
• Essential to take benefits from geographical, customer and product diversification
• Big gets bigger; large size offers huge advantages in the steel industry
• Regulatory, environment & social and forex risk

We believe that if an investor analyses any steel producer by considering the above parameters, then she would be able to assess its business properly.

Regards,

Dr Vijay Malik

P.S.

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.