A strategic shift needed in the steel industry

Mervyn Martins, Partner and Pierre Mangers, Director PricewaterhouseCoopers Luxembourg
Lëtzebuerger Land, 20 Mars 2009

A strategic shift needed in the steel industry

The future of the global steel industry hangs in a delicate balance. The optimism that marked the “super cycle” of 2001 to mid 2008 has taken the industry far from the fundamental realities of the market and reasonable profit objectives.

Thanks to China’s rapid industrial development over recent years, the steel industry spread its wings and took flight. Now that China’s and other economies are in decline, there is a real danger of a crash landing. Having dominated in the good times China continues to dominate in the downturn, being responsible for the lion’s share of the 6.81% growth rate of the recent boom period.

Success in the post 2008 steel industry will require a so-called paradigm change, from a shareholder centric attitude to a more ethical and societal approach.
This new attitude should not be limited to conventional cost cutting medication, but calls for a new business model combining sustainable development with a sound bottom line.
The trick will be to align shareholders’ expectations and those of other stakeholders within this new truth, where product portfolios are adapted to the ecological challenges of the 21 st century.

Crisis – also an opportunity?

Players in the steel industry have expressed concern over the turmoil currently being faced in the industry. How long will it last, how deep and how broad will its impact be?
Even the most experienced industry experts and steel managers are having difficulty explaining the phenomena and thus in deploying adequate counter measures.

Indeed, between November 2008 and the end of February 2009, some of the world’s key steel players announced the lay-off of 5-10% of the total workforce and output cuts of in the region of 35% - 45%. However, will these measures be sufficient or the forerunners of upcoming, more drastic retrenching or realignment?

The financial crisis has impacted the fundamentals of the global economy and is now affecting the manufacturing supply chain.
The danger is that the crisis stands to wipe out those players that do not have the agility to adapt to the unstable business environment and/or the financial strike power to stand out in these unprecedented times. That is unless, of course, governments step in to bridge liquidity gaps – something to be seriously considered in order to avoid the too rapid increases in debt in certain states, which could lead to protectionist behaviour.

Today’s crisis can be viewed from two opposing points of view – damage mitigation versus new opportunities.

The Chinese steel industry, for example, is beginning to consolidate into national champions and its sovereign funds have been acquiring raw materials and energy assets all over the globe; thinking ahead instead of just fire fighting the current crisis. However in Europe so far Darwin’s “Survival of the Fittest” has been the rule of the game, which runs the risk of a short term industry shake up taking place. The question is: will Europe remain “Darwinian” or get more “bullish”, going forth to seek new opportunities?

To each crisis his own

In the past, the steel industry was able to better manage crises. This time, however, there are many different factors at play.
First is China’s phenomenal growth rate, which resulted in the production of 555 million tons of steel between 2000 and 2007; not far off that of the 30 year post war period, where 586 million tons was produced. This “too much too soon” growth rate has now been followed by a world economic recession, where China’s economy has joined others in decline, resulting in an almost equally dramatic drop in the steel industry. The industry now must bend its knee to forces such as lower GDP output, reduced demand for the industrial production from the automotive and construction sector, and therefore, fewer exports etc.

The current crisis differs from previous crises in three principal ways:

  • Following the post war increase in demand and the industrialisation of the former USSR and the Triad countries, there was an imbalance between supply and demand, due to uncontrolled capacity building and chasing tonnage to create economies of scale and selling at below cash costs.
    This led to an overcapacity on the European markets, which is no longer the case. Today, however, thanks to the industrialisation of coastal China (and the developing world), a modern overcapacity has moved to take up residence there.
  • The cost curves of European players are also much more competitive as the ratio of variable to fixed costs is substantially higher, preventing companies from immediate severe restructuring measures.
  • The consolidation efforts of the Chinese steel industry could support the closure of unproductive obsolete smaller-scale production facilities.

Despite these favourable differences, several steel producers still seem to fall back into the pricing habits of the 80s – volume before price, often below cash cost.
However, to weather the storm of the current crisis and come out of it as quickly as possible, the industry must learn from past crises.
It must get rid of overcapacities, practice strong pricing discipline and, above all support appropriate anti-dumping measures, with a punishment to fit the crime, in order to avoid protectionism.

Every crisis has a silver (or steel) lining

One benefit of this crisis is that it will allow the business community to question its fundamentals and challenge its ROCE (return on capital employed) expectation levels.
That is to say that the crisis could be the starting point for the emergence of a new, more sustainable ROCE level in order to match shareholder satisfaction with that of other stakeholders: socially responsible investors, local communities, employees etc.

It is an opportunity for the industry to counter balance the unrealistic profitability targets of the past and embraces a “societal model” based on appropriate ROCE targets.
Such an approach will not necessarily produce the high ROCE levels expected in the past, but these have proven to be unsustainable in a world economy which grows at, at best, 3%.
It is true, however, that these reduced ROCE levels (even if they were inflated by China’s dramatic increase in the first place) run the risk of deterring institutional investors.

Set realistic ROCE expectations

Investors have expectations about the value of ROCE according to the level of risk associated to both the industry and the company strategy.
There are three different options to be discussed:
  • Low profitability: where the ROCE would give the same yield as a government bond and the related risks are limited,
  • Medium profitability: where the ROCE would be higher than the level of government bonds and would hence earn at the very least the cost of capital.
  • High profitability: where a ROCE of anywhere far above the cost of capital is expected and is associated with higher, unpredictable risks that are beyond control.

As mentioned earlier, however, it is clear that the “super cycle” is over. This makes the third option likely in the short run. However, an expected ROCE level of greater than government bonds is not such an unreasonable expectation. The question then becomes how to ensure a yield above the government bonds level that will be sustainable in the long run. Thus the second is more possible, but also the most challenging since the value proposition of the steel makers needs to be adapted to the new upcoming challenges and opportunities.

New strategic windows post 2008

China’s steel industry looks set to come out as one of the winners in the after-crisis, thanks to its bullish stance described earlier. As discussed, this crisis is unlikely to be defeated via conventional cost cutting, but rather calls for a “brave new world” that addresses the sustainable development challenges, combined with a robust balance sheet.

There are new strategic windows for those players that embrace this “new world order”.
  • The key success factors of the future have been identified - limited impact on the planet, competitive advantage with low risk exposure, limited cash need and appropriate ROCE levels above the government bond rate, even if they do scare institutional investors away for a while. As a result four strategic options have been identified: value chain specialisation, backward integration into mining (ideal for commodities players), community wealth enterprises (i.e. the society orientation of the new business model), and IP (intellectual property) transfer of mature technologies to other industries. In fact the last two points scored highly in terms of all the key success factors for the future and represent a huge opportunity to industry technology leaders. Indeed if such companies’ specialists, like scientists and engineers, who are under occupied in the current crisis, started to transfer their mature technologies to other industries, these talents will be indispensible for the expected upswing.