Metalico Inc. (MEA)

[polkamatic]

IBD:Getting A Grip On Demand

Friday May 16, 5:56 pm ET
J. Bonasia

Orange sparks fly from welding torches, and molten steel glows white in furnaces around the globe -- fitting metaphors for the scorching-hot demand for metal by the developing world.
An unprecedented need for steel in China and elsewhere is fueling demand for all industries tied to steel production. That includes the diverse sector of metal processors and fabricators.

Metal processing and fabrication ranked No. 12 among IBD's 197 industry group as of Friday. Related sectors such as steel producers (ranked No. 2) and metal ores firms (No. 13) are performing similarly well.

Metal processors and fabricators don't include the companies that operate mines to extract raw iron and other ores. That job falls to the big integrated steel makers such as United States Steel (NYSE:X - News).

But many processors and fabricators -- known as metal service centers -- also run steel minimills that recycle scrap metal from old cars and appliances. This stock group includes Metalico (AMEX:MEA - News), Schnitzer Steel (NasdaqGS:SCHN - News), Gerdau Ameristeel (NYSE:GNA - News) and Commercial Metals (NYSE:CMC - News).

In addition, some fabricators sell materials made from aluminum, copper, brass and other alloys. But steel remains by far the most important industrial metal.

1. Business

Metal processing service centers act as middlemen that buy steel in bulk. They store long bars or huge coils of flat steel in warehouses. The service centers cut and shape the steel into smaller, more useful forms before selling it to builders and manufacturers.

Two Ohio-based companies, Olympic Steel (NasdaqGS:ZEUS - News) and Worthington Industries (NYSE:WOR - News), supply lots of heavy-gauge, flat-rolled steel for heavy equipment manufacturers and aerospace clients.

Los Angeles-based Reliance Steel & Aluminum (NYSE:RS - News) also sells to some equipment makers. But Reliance is focused on small manufacturers and machine shops. More than half its jobs come from "callers today who want deliveries of processed materials tomorrow," says Reliance CEO David Hannah.

"Our business is based on quick turnarounds for small orders," he said. "We need to be in position with just the right inventory and stock, and we need enough truck fleets that are ready to deliver in time."

Reliance is perhaps the nation's most efficient service center, says Sal Tharani of Goldman Sachs. He rates the stock as neutral, but calls it his favorite pick in the sector.

"Reliance runs a very competent company with a lean organization in their central headquarters and an expansive network of shops," Tharani said.

The Reliance business model hinges on an ability to quickly deliver quality service in high volumes on very small deals. The company posted record revenue of $7.3 billion last year -- on an average order size of just $1,350 per deal.

Name Of The Game: It may sound obvious, but the goal through all steps of the steel producing and metal fabrication process is to buy low and sell high, says John Lichtenstein, executive partner of the Accenture metals industry practice.

"Wherever you are in the value chain, it's about the spread between what you pay for materials, and what you can charge your customer for the value you've added," he said.

Prices fluctuate, so service centers need to turn their inventories over quickly. Those who try to speculate too long can get burned, Tharani says.

In addition, the best service centers are able to pass along any added costs to their customers, says Bob Richard, a steel industry specialist with Longbow Research.

"When the price of steel goes up, these companies hope they can sell at that replacement cost above what they paid," he said. "In times of rapid price escalation, these companies do very well."

2. Market

A massive industrial buildup is under way in China, creating a nearly boundless demand for steel there.

Almost overnight, this trend has shifted industry dynamics for steel firms around the world.

China now gobbles up some 35% of the 1.3 billion tons of steel consumed worldwide each year.

Until recently, foreign steel makers often undercut the U.S. mini-mills.

But now, with the dollar so weak and fuel prices so high, most overseas producers have cut shipments to the U.S. as their products grow comparatively expensive.

That has created an opening for the American minimills. Some are even exporting steel for the first time in years. Even though scrap steel prices are still relatively high at roughly $600 per ton, the service centers can thrive by passing on cost increases to their customers.

The American market is mature, growing at about 2% per year. Gains are not derived so much from growth in volume as from price increases.

The U.S. consumes roughly 125 million tons of steel per year. About 20% of that amount goes into cars, 35% into nonresidential construction and 20% into machinery and manufacturing.

The remainder goes toward other uses. The U.S. housing downturn has not had much impact on this market, as few metals are used to build homes.

3. Climate

Some big steel makers have renegotiated labor contracts in recent years to bring down the costs of health care and pensions. But the most important recent trend in this decade has been a steady shakeout for the industry.

Lots of cheap foreign steel was being dumped into the U.S. market in the early part of the decade, resulting in more than 30 American steel mills going bankrupt from 2001 to 2003.

But the situation has improved, thanks to a steadily falling dollar and mergers and acquisitions that have cleared out the field.

Two years ago, Arcelor merged with Mittal Steel in a $38 billion deal that created the world's largest steel maker. U.S. Steel, Nucor (NYSE:NUE - News) and ArcelorMittal (NYSE:MT - News) now control about two-thirds of the world's steel supply.

In turn, the service center field has been whittled down. For instance, Reliance bought rival processors Earle M. Jorgensen Co. and Yarde Metals in 2006. This consolidation is not yet over, predicts Bill Larson, chief financial officer of Commercial Metals.

"The field needs still more consolidation to give producers greater pricing power," he said.

The biggest survivors have already helped stabilize prices for everyone, says Larson. He adds that it's best for each fabricator to join forces with a minimill to supply the needed steel.

"The fabricators that are going to prevail will be the ones that have steel mills behind them, because they have a profitable parent," Larson said. "All the other pure fabricators (without minimills) then become our other customers."

4. Technology

Not much has changed in the way of steel production over the past century. More computer systems and automation have been applied to the process. Yet the bedrock technology still involves the brute-force process of melting down metal and shaping it for users.

Recently, Nucor has refined a new way of making metal sheets by pouring molten steel directly into molds. This Castrip method allows steel mills to forgo bulky, expensive steel rollers that usually squeeze the metal into sheets.

The approach, developed in conjunction with partners from Japan and Australia, saves energy and makes it possible to build much smaller mills.

Nucor pioneered the industry's minimill breakthrough in the 1960s. Rather than rely on raw ore, producers started recycling old scrap metal.

Today the mills are working to make their processes more environmentally friendly by cutting down on carbon pollution and other emissions.

5. Outlook

Despite a poor domestic economy, this market remains resilient. Steel prices roughly doubled in the U.S. in the first half of this year, yet sales have still grown based on unequalled demand overseas.

"The important thing to know is this environment is unprecedented in our industry's history," said Reliance CEO Hannah. "The environment is different because there is no cheap import alternative."

Upside: Shareholders are flocking to this sector due to growth even with rising steel prices, says consultant Lichtenstein.

"Investors view the global steel industry positively," he said. "In North America, the industry is expected to maintain profits despite a market slowdown, due to a high degree of vertical integration and reduced imports due to the weak dollar."

Risks: Rapid improvement in the dollar's value could invite a flood of steel imports.

Another potential problem is China, which imports much of its steel from India and the Middle East and has been boosting its domestic production.

Though that country's growth remains strong, a slowdown could flood the world with a glut of cheap steel.

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