Metals & Mining Industry Outlook (March 2011)

Overview

The Metals & Mining industry encompasses the extraction (mining) as well as the primary and secondary processing of metals and minerals such as aluminum, gold, precious metals, coal and steel. The industry is oligarchic in structure, with a few producers accounting for the lion’s share of the output.

The largest segment of the global metals market is iron and steel, followed by aluminum. The iron and steel segment comprises more than half the industry in terms of volume. This industry includes metal ore exploration and mining services, as well as iron and steel foundries for smelting, rolling, forging, spinning, recycling, stamping, polishing and plating of iron and steel products such as pipes, tubes, wire, spring, rolls and bars.

The precious metal and mineral industry consists of companies engaged in the extraction and primary processing of gold, silver, platinum, diamond, semi-precious stones, uranium and other rare minerals and ores, along with the cultivation of pearls.

Historically, the automotive and construction markets have been the largest consumers of metals, accounting for more than 50% of total demand. Other metal consumers include energy, electrical equipment, agricultural, domestic and commercial equipment and industrial machinery. Large automakers such as General Motors Company (GM), Ford Motor Co. (F), Toyota Motor Corp (TM) and Honda Motor Co. Ltd (HMC) are big consumers of metals, chiefly of steel and aluminum.

Overall Outlook

The global metal industry is cyclical, highly competitive and has historically been characterized by overcapacity (excess of supply over demand). Metal producers are subject to cyclical fluctuations in London Metal Exchange prices, general economic conditions and end-use markets. Individual company profitability depends on volume and operating efficiency. Large producers with huge resources are able to discover and develop new deposits, thereby boosting reserves, while the smaller ones devote their attention own fewer mines.

Mergers and acquisitions (M&A) have historically been a critically important growth strategy for mining companies. 2009 experienced a lull in M&A activity under the impact of the global economic downturn with deal value almost halving compared with 2008. The focus for M&A activity shifted from business growth to business survival, as companies looked to safeguard their teetering balance sheets rather than seeking expansion.

However, reversing the trend, 2010 witnessed a surge in mining deals as the rise in commodity prices, economic recovery, demand in developing markets, growing scarcity of resources and refreshed balance sheets spurred merger activity.

We expect the momentum in M&A to be maintained in 2011. Armed with healthy balance sheets and with reduced economic uncertainty, we expect the companies in the industry to accelerate deal activity with renewed focus on consolidation. This would ensure raw materials supply and expand the frontiers of such mining companies into growth markets.

In an industry plagued with rising energy and raw material costs, increasing productivity and reducing costs are the keys to success. Given the cyclical nature of the metals industry, low-volume, high-cost producers need to generate sufficient cash or ensure a strong borrowing position during market peaks to survive the market troughs.

Continuing consolidation supports the sector’s ability to influence the price of input costs and companies can also obtain synergies and economies of scale through the operation of vertically integrated raw materials sources. Expansion in low-cost countries will ensure lower labor costs and also help tap their growth potential.

Geographically, the Asia-Pacific region, in particular China and India, is witnessing higher production and consumption of metals. Per capita consumption levels in both these countries are calibrating to U.S./European levels, which could, theoretically at least, double metal demand in the longer term. China is the world’s largest consumer of metals and is expected to remain so. Further, developed regions such as the US and Europe are showing signs of recovery. Overall, we expect global metal demand to improve in the long term with the recovery of user industries.

Demand as well as production for industrial metals in Japan has been recently affected as factories have been shut down in the aftermath of the country’s earthquake and Tsunami. Japan is the biggest buyer of aluminum and the second largest buyer of copper ore. We, however, believe that metal demand will be boosted by the construction industry triggered by the country’s reconstruction efforts.

A Detailed Look into Metals

Steel

As the major shareholder (about 60%) of the metals market, the steel industry was severely bruised by the global economic downturn. However, according to the World Steel Association, world crude steel production in 2010 reached a record 1,414 million metric tons (mmt), a 15% increase compared with 2009. All the major steel-producing countries and regions showed double-digit growth in 2010.

The U.S. produced 80.6 mmt of crude steel, 38.5% higher than 2009. U.S’s share of world steel production improved to 5.7% from 4.7% in 2009 catapulting the country to the third position in 2010 from the 5th rank in 2009. The growth trend continues in January 2011 with world crude steel production increasing 5.3% to 119 mmt from January 2010 levels. United States crude steel production rose smartly by 9.4% to 6.8 mmt compared with January 2010.

Reflecting on 2010 data, we see a sharp increase in revenues and shipments across most companies. Sales of ArcelorMittal (MT), the world’s largest steel-producing company, increased 28% to $78 billion and a 22% jump in steel shipments. Sales for United States Steel Corp. (X) soared 57% to $17.4 billion and steel shipments went up 49% to 22 million tons. Nucor Corporation (NUE) recorded sales increase of 42% to reach $15.8 billion with shipments increasing 25%. Steel Dynamics Inc. (STLD) reported a 59% increase in revenues to generate $6 billion with shipments rising 33% to 5.3 million tons.

In terms of profitability, ArcelorMittal stood tall with its fiscal 2010 EPS of $1.93, a substantial improvement over 11 cents in 2009. Nucor and Steel Dynamics reversed their year-ago losses to earn a respective 42 cents and 64 cents per share. United States Steel, though remaining in the loss territory, narrowed its fiscal 2010 loss per share to $3.36 from the year-ago loss of $10.42.

The steel industry is emerging from the gloom of the global recession as is evident from the above figures. However, given its economic sensitivity, we expect global steel demand to improve only gradually, in line with the recovery in the user industries, especially automotive and residential construction.

Although steel prices have been stabilizing since the latter part of 2009, it is significantly below the pre-crisis level. We believe that a sustained recovery in steel prices remains uncertain in the backdrop of sluggish economic activity.

Currently, Steel Dynamics has a Zacks #1 Rank (Strong Buy) for the short-term (1 to 3 months) while U.S. Steel holds a Zacks #2 Rank (Buy). ArcelorMittal currently retains a Zacks Rank #3 Rank (Hold). We maintain our Neutral recommendation in the long term for ArcelorMittal and United Steel while we have recently upgraded our long-term recommendation on Nucor from Neutral to Outperform, given its upbeat first quarter guidance.

Gold

As per the World Gold Council, gold pricesw rose for the tenth consecutive year in 2010, ascribed to recovery in key sectors of demand and continued global economic uncertainty. In 2010, gold prices jumped 29%, reaching $1,405 per ounce as of December’s end.

During 2010, the price of gold rose to record levels on several occasions, trading as high as $1,420 per ounce. Gold’s performance was strong and volatility remained low. The World Gold Council suggests that the increase was not only driven by driven by inflationary forces but was also inflated as both the private and public sectors of India and China rushed into the gold market.

Gold demand went up 9% over 2009, showcasing a 10-year high of 3,912.2 tons, driven by the rise in jewelry demand, the revival of the Indian market and strong momentum in Chinese gold demand. Moreover, central banks became net purchasers of gold for the first time in 21 years, hiking the demand for the yellow metal.

Major demand came from India and China. India bought 746 tons, a 69% increase over 2009, and China bought 400 tons of gold of jewelry. China bought 179.9 tons of gold in the form of bars and coin, a 70% increase over 2009.

Gold remained a coveted asset given its long-term supply and demand dynamics and influenced by macro-economic factors. Concerns regarding economic growth in developed countries made gold an attractive and safe investment option. The European sovereign debt crisis made European investors use gold as a currency hedge. Pressure on the US dollar against various currencies coupled with higher inflation expectations in many countries, including India and China, also pushed up gold prices.

The value and wealth preservation attributes of gold continue to attract investors and consumers. Jewelry and investment demand in non-Western markets continues to rebound while industrial demand has started to recover in response to an improvement in economic conditions. India, which alone consumes nearly 45%−50% of the world gold production, should drive demand for gold along with China. Chinese gold demand is expected to double in 10 years.

Even though gold price dropped 7% in January this year, it again recorded a rise in February. We believe gold demand and prices will strengthen in 2011. As China and India continue to grow rapidly, their demand for gold will also rise in tandem.

Higher prices bode well for gold producers, which should benefit giants such as Barrick Gold Corporation (ABX), Agnico-Eagle (AEM) and Goldcorp Inc. (GG). However, gold producers like Newmont Mining (NEM) and Kinross Gold Corporation (KGC) suffer from lower ore grades that subdue production levels, increase mining costs and offset the benefits of rising gold prices.

Overall, the stock prices of gold producers are not expected to benefit much from this favorable commodity-price backdrop. This is reflected in our overall long-term neutral view on the space. As major economies continue to recover, investors’ confidence will be restored to invest in stock markets, which could cause gold prices to fall. However this is not going to happen in the near future. We have a Zacks #3 Rank (Hold) on Barrick Gold, Agnico-Eagle, Goldcorp and Kinross Gold Corporation. However, Newmont Mining has a Zacks #4 Rank (Sell).

Aluminum

The aluminum industry is highly cyclical, with prices subject to worldwide supply and demand forces along with other influences. The global economic downturn had a historic, negative impact on the aluminum industry, leading to an unprecedented decline in LME-based aluminum prices, weak end markets, fall in demand, increased global inventories, and higher costs of borrowing and diminished credit availability. The economy has however recovered from the crisis of the economic downturn.

Alcoa Inc. (AA), the world leader in the production and management of primary aluminum, in response to the global economic downturn implemented a number of operational and financial actions to improve its cost structure and liquidity, including curtailing production, halting non-critical capital expenditures, accelerating new sourcing strategies for raw materials, divesting non-core assets, reducing global headcount, suspending its share repurchase program, reducing its quarterly common stock dividend and resorting to other liquidity enhancements.

In the first half of 2011, Alcoa plans to restart certain idled potlines at three smelters. These restarts are expected to increase Alcoa’s aluminum production by 137 kmt during 2011 and by 204 kmt on an annual basis thereafter. Such measures are surely to meet anticipated growth in aluminum demand.

Alcoa expects demand for aluminum to grow 12% this year. China, India, Brazil and Russia are all expected to register double-digit increases in aluminum demand. Market conditions for aluminum products in all global markets are expected to improve, particularly in aerospace, automotive and industrial gas turbine. On the cost side, however, energy prices and currency movements are expected to keep posting challenges. Overall, Alcoa believes that the long-term prospects for aluminum remain bright and envisions that global demand for aluminum will double by 2020.

Since the sudden decline from peak prices in mid-2008, aluminum prices have increased over the last 2 years. In 2010, global aluminum prices have increased 13%. Alcoa increased its fiscal 2010 profit on the back of higher prices and continued strengthening in most end markets. Aluminum Corporation of China, or Chalco (ACH) swung back to profit in 2010 after posting a loss in 2009, attributable to increased global aluminum prices.

In the medium-to-long term, aluminum consumption will improve globally with improving automotive and packaging industries, one of the key consumer markets. Aluminum is widely used for packaging, beverage cans, food containers and foil products. The automobile market is also becoming increasingly aluminum intensive, benefiting from the recyclability and the light weight of the metal.

Further, the surge in copper price this year is triggering a switch among manufacturers aluminum. Automobiles, air conditioners and industrial components manufacturers are now shifting toward the much economical aluminum.

We expect aluminum demand to increase in the long term, outstripping supply growth with the improving end-markets. China and India are undergoing rapid industrialization. Both these factors are positive for underlying aluminum demand. Leading aluminum producers such as Alcoa, Paramount Gold and Silver Corporation (PZG) and Aluminum Corporation of China should benefit from the improving demand outlook.

Currently, Alcoa, Paramount Gold and Silver all hold a Zacks #3 Rank (Hold) supported by our long-term Neutral recommendation.

Copper

Copper prices have shown a rising trend in 2010 benefitting copper producers like Freeport-McMoRan Copper & Gold Inc. (FCX) and Southern Copper Corporation (SCCO). Although copper demand was down 10% year over year in 2009, global copper demand is seen to be growing again.

Chinese demand for copper was still robust and imports of the metal were rebounding, which was supported by steady construction and infrastructure activity in the country. The improvement in copper prices would be supported by limited supply and increased demand from China.

With copper prices at near all-time highs, outlook for copper prices is still strong. Not denying volatility in prices that are bound to remain, we have a bullish stance on copper prices, long term. However, as discussed earlier, manufacturers might now resort to aluminum as a substitute. Market conditions are expected to be positive for copper in the next couple of years due to higher consumption of the metal in the developing nations. Companies that have a high leverage to copper prices will benefit immensely from the potential demand for the metal in the developing markets.

We currently have a Zacks #3 Rank (Hold) and long-term Neutral recommendation on both Freeport and Southern Copper.

NUCOR CORP (NUE): Free Stock Analysis Report
STEEL DYNAMICS (STLD): Free Stock Analysis Report

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