It’s not a market that anyone wants to bet the house on, but U.S. metal distributors are familiar with tough business conditions. This familiarity is causing industry analysts to predict that well-run service centers will come out on top in the long run.
Jim Forbes, global metals leader at Pricewaterhouse Coopers, says the current U.S. metals distribution industry is fairly healthy, despite the rising price of steel. "We’re still on an up trend and just hitting the peak," he notes. "There’s limited steel inventory around; therefore, I think the distribution centers tend to be significantly in demand. For the foreseeable future, they’re doing quite well."
High prices, low inventories
However, there are plenty of concerns. Forbes says the main issue is the price of steel. "We’re probably toward the peak of pricing. As long as that peak comes down in a relatively slow and stable fashion, it should be OK. The problem is going to be if the price drops suddenly and distributors are stuck with steel at a higher price. I think that the biggest threat is a sudden increase or sudden decrease in prices, and they end up mismatching their inventories with the prices."
He notes that two years ago, when inventories were high, it "exacerbated the problem, whereas now, inventories are maybe not at their lowest levels but they’re low because of the overall shortage of steel. So it’s not going to be as big of a problem."
David Miller, managing director, Macquarie Capital (USA) Inc., says, "In general, the industry is enjoying a strong period of profitability as commodity price increases have provided the opportunity for increased margins. However, companies are managing inventory much closer today than a few years ago. There are two reasons for the lower inventory levels: No. 1, management wants to minimize their inventory risk in the event pricing heads south, and No. 2, the weak credit markets, combined with commodity price increases, have constrained working capital availability. An important point on the working capital constraint is that it usually requires ownership to inject more equity, effectively doubling down to fund growth."
Independence, Ohio-based Longbow Research’s July Steel Distributor Survey reported, "Our distributor contacts continue to draw down inventory levels in July. Forty percent of our contacts were above target inventory levels, while 55 percent were on target, and only 5 percent intend to decrease further."
Shipments are down, as well, according to the July 2008 Metals Activity Report from the Metals Service Center Institute, Rolling Meadows, Ill. However, the report noted that although shipments of steel and aluminum products continued to decline on a year-over-year basis in July, the rate of decline has slowed. "Steel product shipments from U.S. metal service centers totaled 4.07 million tons in July, a decline of 2.1 percent from July 2007," the MAR pointed out. "Shipments for the first seven months of the year totaled 30.35 million tons, a decline of 3.6 percent from the same period last year. U.S. inventories of steel products, at 13.12 million tons at the end of July, were down 2.2 percent from July 2007 and, at current shipping rates, represent a 3.2-month supply."
The MAR also noted that U.S. service center shipments of aluminum products were down 4.6 percent from the same month last year. "For the year-to-date, aluminum shipments of 652,900 tons are down 6 percent from last year’s period. Aluminum inventories, which totaled 279,000 tons at the end of July, are down 13.1 percent from the same time last year and, at current shipping rates, represent a 3.1-month supply."
Nick Sowar, partner, global steel industry leader, U.S. Process & Industrial Products Group, Deloitte & Touche LLP, says that if prices stay high, it will absolutely have a long-term effect on service centers. "Low cost structure and value-added processes will be the keys to success," he says.
The economic climate itself is showing a lot of uncertainty. Sowar says that in addition to high steel prices, the continued slowdown in the economy and access to credit are top concerns for metals distributors. Longbow Research’s survey reported that respondents noted more of the same in regard to overall conditions with weakened steel product demand, falling lead times and a more pessimistic near-term demand outlook.
"Again, as in previous months, contracts indicate hot-rolled coil lead times have decreased and averaged 5.2 weeks in July, down from 6.8 weeks the prior month. Plate lead times also decreased slightly to nine weeks from 9.4 weeks previously. Lead times for long products decreased to 6.4 weeks in July versus 6.7 weeks in June. Sources note lead times from mini-mills are generally shorter than integrated."
Longbow’s survey also touched on the strength in specific markets. Strong end markets include commercial construction, manufacturing, industrial and defense. Weak end markets were reportedly residential construction, light commercial construction, automotive and transportation, and small fabricators.
Sowar says distributors are greatly affected by regional dips in the markets. "There’s not a lot happening in the auto-supplier region. Furthermore, housing construction remains a problem."
"Another potential threat is imports," Forbes notes. "Of course, that would require a dramatic change in the U.S. dollar. Right now, it’s kind of a good market for steelmakers and distributors because the dollar is so low in the United States. It’s a nice market alignment with demand starting to fall from the automotive guys. Prices are still high, supply is short and there’s an insulation effect from people importing, rather than buying domestically."
Mergers are still prevalent
Although the distribution industry has worked through some of the fragmentation, "the investment in real-time technology and access to customers throughout North America will generate further consolidation," says Sowar.
"All indications are that consolidation will and needs to continue in the sector," Miller says. "The metal distribution sector remains highly fragmented. Meanwhile, the mills continue to consolidate, gaining critical mass and pricing control. The pace at which M&A activity will occur is difficult to measure. The larger distributors are eager to fill in gaps in their business, whether it’s products, geography or human capital, but with distributors producing strong cash flows today, a seller’s valuation expectations might make a buyer uncomfortable. There needs to be a strong strategic fit to justify premium multiples. With that said, there’s been a good level of M&A activity in the first half of 2008, and we’re seeing the second half of the year being equally as active."
Forbes says consolidation within service centers will continue, but it’s "more likely that vertical integration toward steelmakers is going to happen. The traditional stand-alone is a North American concept. The integrated supply chain is much more of a European view. At the end of the day, given that companies are trying to run with lean inventories and leaner costs, I think the steelmakers will want to go down the value chain and get a little more for the end processing, the end use. It’s good value-add."
However, Sowar doesn’t see service centers "going around the world, nor do I see the European distribution model occurring in North America, notwithstanding the goals of Esmark [Severstal Wheeling Holding Co.]"
The continuing consolidation threatens the midsized service center, says Miller. "There will likely be a growing disparity in the number of small and large distributors, with the middle-tier companies being removed through acquisition. There will be a pool of small distributors supporting local or regional manufacturing, while on the other side, you’ll have a group of large national--global in some cases--distributors supplying everyone else. Additionally, it’s not unfathomable that in the not-too-distant future, we’ll see a global mill move into distribution. This model hasn’t worked in the past in North America, but after the mills become comfortable with their raw material supply, they may turn their attention to distribution channels. This type of strategy is making its way into mills’ long-term strategic thinking."
The consensus is that it’s an interesting time. No one can say with any certainty exactly what will happen, but overall, service centers will survive, says Sowar. "The best ones will keep their fixed costs low and balance sheets clean. Investments will be made in more value-added processes."
"I think the market is much more stable, organized and defined than it was 10 years ago," says Forbes. "If distributors have good strategies and good people, it will be easier for them to survive." MM