On Strategy: How to Deal With Steel
Steel has not been the most attractive industry over the past 35 years. The grinding decline of the steel business since the early 1970s has been painful for shareholders, communities, government officials and employees. Investors fret that the industry has yet to earn the "required rate of return on equity." But much has changed in the steel industry over the past 12 months. The publicly listed companies that comprise the Dow Jones U.S. Steel Index have bettered the Standard & Poor's 500 Index by 150%. Historically, steel has been priced on a "boom-and-bust" cyclical pattern. However, a change in that pattern began in January 2004, when the price for hot-rolled steel, according to Purchasing Magazine, jumped about 13% from the previous month. And prices continued to increase such that the annual price increase (September 2003 to September 2004) for hot-rolled steel had soared from $290/ton to $756/ton—a whopping 161% increase.
The automotive industry has been forced to absorb the higher costs, while it continues to face cost pressures on the retail and supply sides. Clearly, higher steel costs place yet another strain on profit margins for vehicle producers and suppliers. Facing these circumstances, its conceivable that the automotive industry would make considerable efforts to source other materials, particularly since substitution of steel in automotive applications has been significant over the past 30 years. It is not, however, the case.
STEEL SUBSTITUTION. Like any product, steel competes with alternative materials like plastic and aluminum. In the late 1970s, sky rocketing oil prices caused the industry to reconsider the decades-old dominant use of steel in vehicles. During this time, synthetic materials, engineered plastics and composites were used to lower the weight of vehicles and drive down fuel consumption to meet CAFE (Corporate Average Fuel Economy) standards, even though material costs increased over steel. In the 70s, the typical family car had about 2,202 lb. of steel. Prompted by CAFE standards, the amount of steel in vehicles decreased steadily over the next decade; and by 1990, the amount of steel per vehicle had dropped to 1,717 lb., a 22% decline. Steel did regain increasing automotive presence during the "go-go '90s" right along with the high growth trend of SUVs. By 2004, steel accounted for 1,842 lb. per vehicle, a 7% increase from 1990. However, despite the moderate gain in the 1990s, the long-term trend has been a decrease in steel use per vehicle by 16%. The winners were plastics and aluminum. In 1977, plastics accounted for 168 lb. per vehicle, and by 2004 consisted of 258 lb. per vehicle, a 53% increase. Aluminum experienced an even stronger growth during the same period, rising from 97 lb. to 290 lb.
Will these long-term trends continue over the next decade? Will future vehicles consist mostly of plastic and aluminum components? Roland Berger believes it is not the case, and that despite major steel price increases over the past 12 months, steel will maintain its current position in the make-up of vehicles.
STEEL'S CONTINUING IMPORTANCE. Steel has been the primary raw material for vehicle production since the invention of the automobile. The choice of steel is not because it was the all-around perfect material, but rather because it was better than other options. Imagine what would have happened if early automotive industry pioneers had more material options to chose from for the mass production of cars. Steel would not have been the obvious choice. Its drawbacks include:
- Steel is difficult to form or press
- Steel is heavy
- Steel needs elaborate paint processes to prevent rust.
Despite its deficiencies, steel continues to maintain several advantages over plastics:
- Steel enjoys lower material costs
- Steel can provide faster production rates
- Steel is more easily painted than plastics and provides a superior surface finish
- Steel is easily recycled. In fact, most mini-mill steel producers around the globe rely on recycled scrap materials as the primary input for steel production.
Aluminum also holds an edge over plastics in the production of automotive components:
- Aluminum is lightweight.
- Aluminum is recyclable.
- Aluminum is corrosion-resistant.
Over time, with the aid of computer modeling to create optimum structures, steel has been able to respond to the threat of aluminum. The result has been a decrease in steel sheet thickness, which decreases part weight and maintains strength.
Steel is also cost efficient when the combination of price per pound, strength, stiffness and resistance against fatigue are factored in. Steel has maintained its position in body and chassis applications where stiffness and strength of steel are necessary, by applying steel in well-engineered shapes for stress-bearing parts.
STEEL'S SUPPLY. Several factors have unlocked shareholder value for steel investors. On the demand side, for example, China and India require increasing levels of steel for infrastructure development, urbanization and industrial growth. And steel, like other high fixed-cost industries, is highly sensitive to real U.S. GDP growth, which is projected to be above 3% throughout 2005. The supply side is more complex. Historically, the steel industry was highly fragmented and suffered from over-capacity. Then, steel company bankruptcies from 2001 to 2003 allowed opportunistic managers to begin consolidating the industry. In 2002, seven steel companies owned about 50% of the U.S. market and by the following year, three companies made up about 53% of the market. Today, three companies—Mittal, U.S. Steel, and Nucor—comprise more than 55% of the U.S. steel market. The result is that bargaining power has migrated to the remaining steel companies, with producers changing their position from price takers in a competitive market to price setters to their customer base. The concentrated supply of steel production is at long last starting to rationalize the quantity of steel provided on the U.S. market.
Steel company profitability has improved dramatically over the past few years, and perhaps the most significant reason is because of the dramatic increase of hot-rolled steel prices, which is the industry benchmark for pricing. Hot-rolled steel prices have moderated slightly in 2005 to around $600/ton from the highs reached in September 2004 of $756/ton. On a historical basis, however, these prices remain high, and we expect prices to settle at $500/ton to $550/ton for hot-rolled steel throughout 2005.
MANAGING COSTS. The overall effect of increased steel prices is that automotive OEMs and suppliers must find ways to better manage steel costs. Automotive managers should focus on two things to manage steel input costs, benchmarking and complexity reduction.
Benchmarking: There is still a high degree of secrecy involved in the actual pricing of steel. Other non-ferrous metals have futures markets that offer OEMs immediate price transparency when determining their commodity purchases. While steel spot prices are extremely volatile, what OEMs actually pay and what producers actually receive is largely determined by a pre-defined contract. These contracts are unique to each steel supplier and customer. The actual price that an OEM pays to procure steel, therefore, is a blend of various contract prices along with spot prices. A variety of analytical modeling techniques can be used to determine the best-in-class price for particular grades of steel for a given specification. These tools are important as steel prices appear to remain high into the foreseeable future.
Complexity reduction: Steel products are notoriously complex and the various grades and types are innumerable. Engineering departments scan through a complex matrix of steel types to determine the most appropriate grade to use in an application. A thorough internal audit of the varying grades of steel currently used can identify potential cost savings by reallocating demand across different applications. Such an approach can be accomplished with support from the engineering department.
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