Brazilian Steel Girded for Growth

Rising raw materials costs are squeezing the margins of some Brazilian steel companies, reducing their ability to expand as fast as competitors on their home turf. The battle for iron ore is intensifying.

Brazilian steel companies are in rude health owing to domestic expansion, high prices and export growth. New production is being added at dizzying rates. However, progress is thwarted by ballooning raw materials costs.

Brazilian steel companies are reaping the rewards of modernization and proximity to the lowest-cost iron ore in the world. From 1994 to 2007, the industry was focused on revamping to overcome inefficiencies accumulated during years of state-ownership which had seen Brazil lag behind steel-producing competitors, says Marco Polo de Mello, executive vice president of the Brazilian Steel Institute.

But by 2013, Brazil may be producing as much as 86.6 million tons annually of steel, more than double its current annual capacity of 41 million tons, says de Mello. The investment cost is a hefty $45.7 billion to get there, he adds. It will also entail a radical shake-up in the industry.

There are two significant trends. The first is vertical integration, with steel companies moving downstream to snap up iron ore assets, while iron ore companies – in other words, Vale – step up to produce steel. This is pulling the sector back closer to what prevailed in the 1940s and 1950s, when Brazilian steel companies typically owned iron ore mines, notes Reginaldo Takara, an S&P analyst in São Paulo.

The second theme is joint ventures between foreign and Brazilian firms. Rio-based Vale, one of the three giant iron ore producers in the world, is playing a starring role in both trends.

There are three types of investor, adds de Mello. Firstly, companies already present in Brazil – such as Gerdau, Usiminas and CSN. They are expected to spend $20.1 billion by 2013 to increase steel production by 15.3 million tons. [JC: figure of 41 million, above]

The second group consists of new entrants building capacity from scratch. They are slated to invest $5.8 billion and add a further 6.8 million tons, if all the projects get off the ground, says de Mello. These include the creation of Siderúrgica do Atlântico, the new Brazilian steelmaking subsidiary of ThyssenKrupp Steel, and a large number of joint ventures. Vale, for example, is developing a partnership Dongkuk Steel Mill of South Korea, where Vale supplies iron ore over long contracts and holds a minority share in the steel plant.

The last group includes projects that are already being studied. They could add a further 17.5 million tons of steel at a cost of $12.8 billion, says de Mello.

Why Iron is King
The magnitude of this steel expansion, which is matched in other parts of the world – China produced 8.6% more steel in the first three months of this year over last -- points to continued high iron ore prices.

The soaring cost of iron ore in Brazil is no secret. It is mostly attributed to a large concentration of mining firms and relative fragmentation in the steel industry, putting pricing power firmly in the hands of the former. Market leader Vale pushed through 71% price increases for companies based in the Far East and 61% for others earlier this year.

Coking coal price leaps are also impressive, with a 200% hike this year, after prices doubled last year. The material is used along with iron ore in blast furnaces to make steel.

The huge increases in the cost of raw materials means that vertically integrated companies are making better margins out of mining than steel manufacturing. “One of the main sources of profit in the steel chain is the mining component and not the manufacturing,” says Rodolfo Riechert, head of investment banking for Brazil at UBS Pactual in São Paulo.

The meteoric rise of iron ore prices – they were trading at 65 cents per dry metric ton unit in 2005 and are now at 140.6 -- makes it even more urgent that steel producers secure a proprietary supply. And it is not just the locals scrapping for assets. Europe’s Arcelor and India’s Tata are also on the prowl.

“Companies that have more iron ore resources today deserve to achieve a share price premium and better credit ratings,” says Marcelo Aguiar, natural resources analyst at Goldman Sachs in São Paulo. They are reducing exposure to a scarce commodity and, in some cases, selling surplus, he adds.

CSN Comes out Punching
The big beneficiary of the vertical-integration model is CSN, which is rich in iron ore assets thanks in part to an earlier acquisition of nearly 42% of Vale shares, a tie-up unraveled in 2001. With a contentious division of iron ore assets between the two companies almost complete, CSN is in a position to sell off minority stakes in its mining assets at what is likely to be at or near the peak, as well as export iron.

The firm will sell 29 million tons of iron ore this year. It is also divesting a stake in mining company Nacional Mineração (Namisa) and has discussed the idea of an IPO for part of the vast Casa de Pedra mine. A person close to the company says a Namisa sale, which is being targeted at strategic buyers and advised by Goldman Sachs, could net up to $11 billion by the third quarter. However, bankers away from the deal say CSN is overestimating the value in order to bolster the stock price.

Buoyed by this cashflow, the firm has revealed a $10 billion expansion plan and it pugilistic CEO, Benjamin Steinbruch, says CSN will be the world’s second largest steel producer by July. It is currently Brazil’s third largest. One of Steinbruch’s boasts is of the iron ore cash cow. Margins are 70% at Casa de Pedra while steel is generating between 40%-50%, he points out.

“Based on the levels at which recent M&A transactions have been completed, CSN’s mining assets [alone] should be worth between $25 and $30 billion,” says CSN CFO Otavio Lazcano.

Cash flow for steel companies has been strong and that means access to funding is still generally favorable. But the situation for CSN is unique, says Riechert. He expects CSN to tap international bond markets at longer tenors, up to 30 years, as well as raise money in local markets. The firm is also following Vale’s model by looking to build a steel company in the north of Brazil with long-term contracts from buyers enabling it to securitize receivables.

Galvanizing Balance Sheets
Brazil’s largest steelmaker Gerdau, meanwhile, is constrained by elevated debt and a recent aggressive global acquisition spree, which left it leveraged. Indeed, Fitch had toyed with the idea of downgrading Gerdau to junk territory from BBB-, putting it on negative watch in November, although it has since relented and moved it to stable in May.

Gerdau is now moving aggressively to stabilize its balance sheet and has been busy raising long-term money. Investors are showing some resistance. A May $500 million re-tap of its 7.25% coupon 2017 came well wide of the sovereign at 309 basis points over Treasuries, versus 140 basis points for a Brazil tap in the previous session for the same size and tenor. And its equity deal in April which raised $1 billion, needed to be skillfully marketed to find buyers as, at first, there was some skepticism.

One senior investment banker in São Paulo close to the equity deal says investors were only won over when they were shown that Gerdau was becoming self-sufficient in iron ore, the extent of steel price increases and the possibility that it now makes economic sense for its plants in the US to start exporting steel products. Another banker says that the smaller-than-expected transaction size helped boost investor appetite and reassure them that the firm’s capex needs were not overwhelming.

Finally, Usiminas the country’s second largest steel company, will be less active in capital markets after an aggressive start this year that saw it issue 500 million reais in local bonds and $400 million in international bonds. It acquired Brazilian mining concern J. Mendes for $925 million in February only after a bruising battle. Usiminas has said that it will look to multilaterals and export credit agencies in future fund raising. The firm is renowned for being conservatively-run and has been loathe to pile on debt.

The re-emergence of iron ore as one of the key factors in deciding the margins of steel companies, thanks to sky-high prices for this key raw material, should suit Brazilian firms well, sited as they are near massive reserves. But it is benefitting some more than others. CSN, in particular, is already selling iron ore from its mines and will be able to sell assets or ramp up iron ore production. It is using that cash flow to accelerate its steel business without taking on debt. Gerdau and Usminas, which did not have the resources that CSN did, are having to pay through the nose to make good their iron ore shortage and will only reap the benefits later. That will act as a drag on profits in this steel super-cycle.
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