In this episode of Industry Focus: Energy, Nick Sciple and Motley Fool contributor Tyler Crowe are doing a listener-inspired deep dive into the steel industry. Learn about metals and minerals and raw materials mining, the cyclical nature of the steel industry, modern production processes, and the current state of the industry. Our hosts also talk about the major players in the industry and share some stocks to keep on your watchlist and much more.
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This video was recorded on October 8, 2020.
Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. Today, we're tapping into the listener mailbag and taking a look at the steel industry. Returning to Industry Focus to help me break it all down is Motley Fool contributor Tyler Crowe. Tyler, great to have you back on the podcast.
Tyler Crowe: Great to be back.
Sciple: Yeah. For new listeners to Industry Focus podcast, Tyler has been with The Motley Fool for a long time, used to be on the podcast all the time. And since about two years ago, it's been almost two years since we last saw you on the show, what have you been up to these past couple of years, Tyler?
Crowe: Well, I went away from the show for quite a while when I moved overseas. And two years ago, I just happened to be in the U.S. at the time. I've moved a couple of times since then. I was living in Southern Africa at the time. I have moved to West Africa, as you can imagine, my wife works for the State Department, so we move quite a bit. And right now, we're currently in California. We've been here for a couple of months for the birth of our first child. He was born on August 11th, Raymond Tyler Crowe.
Sciple: Congratulations! I was going to ask you, you know, being a new dad, obviously, just a few months into that, what's the biggest thing you've learned in these few months being a new father?
Crowe: Scheduling. Better at scheduling. Trying to find time to get the work in, while at the same time being present for my family.
Sciple: Awesome. Yeah, I mean, you know, there's not enough time in the day as it is, and then you've got a whole other person now to keep their priorities going. So, as I said off the top of the show, we're going to be diving into the steel industry, we got a listener question that really inspired that one. I remind our listeners, if you've got a question you'd like us to answer on the podcast, you can write to us by emailing [email protected] or you can tweet us by tweeting @MFIndustryFocus on Twitter.
The question we're answering this week comes from Laura in Wisconsin. Laura writes, "Dear, Nick, Jason, Emily and team, I'm really enjoying your podcast. I'm new to investing this year and have learned so much from all of you and I'm investing for the long-term. As a topic suggestion, I'm curious to learn more about metals and minerals or raw materials mining."
One area in particular that Laura asked about is the steel industry. She writes, "In addition to looking for a better general understanding of the industry, I've heard the steel industry is cyclical. What does that mean and what are your recommendations in that industry?" That's what we're going to dive into today here with Tyler. So, just to take Laura's first question off the top, when people say that the steel industry is cyclical, what are they talking about?
Crowe: Yeah. Well, steel, like a lot of other industries that involve commodity, so you have energy, other types of mining, basically anything where you can't really have a brand or a premium to a product. Cyclical is basically when you have these situations where supply and-demand get out of balance. It can happen in just about anywhere. In particular, with something like steel and commodities, they are a relatively slow growth business. And so, what ends up happening is, because of economic conditions, in many cases, blooming construction or waning construction, you get times where that actual growth starts to dip. And these are what you call "cyclical," rather than a straight-line growth that you'll see in a lot of other industries, you'll get an undulating trajectory.
Now, you can get cyclicality on both sides of the coin, you can have a demand cyclical business or something, where the economy is going to really dictate the demand for it, and therefore, that's how you get changes in prices, but you can also have supply cyclicality, which is, say, for example, you have a very high growth business in commodities where a bunch of players in that space will invest heavily for a few years, they'll bring on a lot of new supply, and then all of that production outstrips actual demand, then you see a price crash. You see it across a lot of different commodities and a lot of different things. And you can use that as a very valuable tool when looking at investing, because it can apply to so many other things.
For example, I find this one is a great one, for the past 10 years the solar panel industry has actually been a cyclical industry. We talk about it as a growth industry because the demand and the growth of solar power has been huge and the growth in installations has grown very fast every year, but you have so many players for so long that have gone through these phases of major buildout, then you get really cheap prices and then you see a lot of bankruptcies in the industry. And so, you get that undulating supply which, in that way, makes it similar to a commodities business.
Sciple: Right. The market can never figure out how to get everything in balance, there's always too much or too little, and so the market has to find its level.
Crowe: Everybody sees the opportunity all at once, they try to go grab it, and then you get situations like this. Particularly this happens in steel a lot, because steel is much more of a demand cyclicality kind of business. Let's just use North America as an example, we're not building a whole lot of brand-new steel production facilities relative to demand for it. So, what ends up happening is, the demand for steel in the United States, which is mostly dictated by construction and automotive manufacturing, are the two biggest drivers of steel demand in the United States. When you have periods of up-and-down in that particular industry, you're going to see that make steel earnings, sales overall production levels wax and wane with those cycles.
Sciple: Right. They're going to be very much driven by the economy. And so, as an investor in steel companies, how do you identify where you are in the cycle? And relative to where we are in the cycle, where's the good place to buy and sell?
Crowe: That is the million-dollar question when it comes to anything cyclical, anything commodities, anything where you're trying to determine a good time to buy into the industry, because it goes through those times of waxing and waning. And as much as, when we talk about growth investing buy and hold for the long term, when it comes to industrials, when it comes to commodities where you have these major, major up-and-down cycles, valuation matters and it's a hard thing to really pin down, because you're trying to figure out which way the wind is blowing, and it can be very, very difficult. Just look at this year as a great example, and you never know when a pandemic is going to hit everybody and demand is going to tank. So, it's really a good guessing game, and if you can nail it, you're better than 99.999% of investors in this space.
Sciple: Absolutely. And we might dive a little bit more later into the podcast into where we might be in the cycle and some opportunities there. One last thing I wanted to get into before we moved on, though, is in addition to the cyclicality you see in the steel industry more generally, there's been some technological changes over the past few decades that are continuing to play out in steel. This transition to the electric arc furnace from the traditional blast furnace style of making steel. How significant is this for the industry and for investors, what should they know?
Crowe: Well, particularly for the North American market, it is the biggest driver that has been moving the -- or the biggest story in the steel industry of the United States for the past 30 to 40 years. As Nick mentioned, blast furnaces have been the traditional way of creating steel. It's where you take an iron ore input, such as, sinter feed or pellets or anything you want, it's put into a large blast furnace, it's hit with immense amounts of heat, it's called reduced, it's basically introduced with a whole bunch of gases to remove impurities. And they're massive facilities, they produce tons and tons of steel every year.
But some of the downsides are, they have to be incredibly efficient to operate, they're huge. And so, they're not very nimble and they are kind of limited in scope in what they can do. Now, in the 1970s we created a relatively new technology, it's called electric arc furnace, where what we can do is we could recycle steel from waste construction, things like that. It's put into a holding tank where electrical nodes are actually put into it and it is remelted, they can add different components, either a raw steel input or some additional alloys, to help remove some of the impurities from the recycling from having scrap steel, things like that. And it also tends to be a more nimble process, because you can make them smaller, you can make them more efficient, they can start-up and shutdown relatively quickly compared to a blast furnace. And it made the North American steel industry much more nimble at a time when it had been a rather sclerotic kind of business for a very long time. And it has been moving quickly across the United States to become the dominant method of steel production. In 1990, electric arc furnaces were only about 37% of total steel manufacturing, and today it is at 68%, with that number increasing pretty much every day.
Sciple: Right. Yeah, that nimbleness within the cycle is really important, and then, you know, [laughs] one of the things that's [...] today, Nucor (NUE 0.42%), I think I have the number on that, they were one of the earliest companies to pioneer electric arc furnace technology, and they're, I think, the largest steel recycler in the world, in the U.S. for sure. And in a world of ESG [Environmental, Social, and Corporate Governance] investing more focused on sustainability, you know, there's the benefits technologically as well as environmentally that look attractive.
So, that's the steel industry from a high level, to drill deeper into the industry specifically, I think one great example of where the industry is today and the transition that it's undergoing is Cleveland-Cliffs (CLF +1.77%), the ticker for that company is CLF. Tyler, what does Cleveland-Cliffs do?
Crowe: [laughs] Well, it depends on when you ask that question. A year ago, they were just an iron ore producer, but in the past year or so they have been very, very active consolidating the market in steel by acquiring two major steel companies. Back in, I believe, December of last year, they acquired AK Steel, which was the nation's largest automotive steel manufacturer in the United States. As well as, just last month, only a couple of weeks ago, they acquired the U.S. operations of the global steel giant Arcelor Mittal. The combining of AK Steel and Arcelor's U.S. assets under Cleveland-Cliffs now makes them the largest flat-rolled steel producer in the United States at about 16.5 million tons per year, now making Nucor, one you just mentioned, the second largest at 12.7 million tons.
There is a lot to, kind of, sift through and digest, because you can kind of look at this deal and see all of the things that we just mentioned. You know, the aspects of cyclicality, the transition to EAF and what that means, both, on the upstream side from recycling and raw component inputs down to the downstream and the actual what it's being used for. So, it's a fascinating jump-off point to look at the entire steel industry today.
Sciple: Right. I mean, the transition is really significant. This is a company that just a few years ago was an international iron ore supplier, and now it's becoming a fully integrated steel company, one of the big drivers of that has been their CEO, Lourenco Goncalves. How significant has he been in just transforming this business?
Crowe: Yeah. So, a little over five years ago, he was brought in by an activist-investor, I believe. I can't remember specifically the name of the activist-investor, but basically, prior to their entry into the business, Cleveland-Cliffs was this big, sprawling mining company, had several interests overseas in Australia, Canada, elsewhere. They also, in addition to doing iron ore, they did metallurgical coal, alloy mining. And they had a lot of prospective mines, and did a lot of buying at the top of the Chinese commodity boom back in 2010, if anybody remembers, they've been investing that long, there was a mad rush for commodities at that time; bought a lot of overvalued assets, leveraged up, got in a lot of trouble.
The activist-investors got involved, they installed Goncalves as the CEO. And basically, he went and took that thing and gutted it. Took all of its international aspects of it and looked at this business and said, the one profitable enterprise that you have here is U.S. iron ore production, so I'm going to cut the whole thing down to that. Really focusing on high-quality pelletized steel or pelletized iron ore, which is a high-quality input for steel manufacturing, and is a lower CO2 emissions source of iron ore, depending on the quality of the iron or how much carbon is in it and how much processing it takes to do it, tends to lead to how much CO2 is emitted when processing it. So, that was the play there.
Now, five years later, they've helped to repair the balance sheet, they started looking a little bit better, and we had this big downturn. And the company saw this as an opportunity to start integrating, where instead of creating one single element within the entire value chain of going from iron ore to steel, they said, well, instead of just selling the pellets, now we can actually go from pellets to refining it into a steel product. And then also, little bit further downstream with either rolling it or processing it in a way to create a finished product. You can see it across a lot of different industries, where you'll have pure players in an industry that do one aspect of the entire value chain, and you have integrated. Oil is a great example, ExxonMobil is an integrated company versus, you know, you have a pure play producer like ConocoPhillips, and examples like that. And so, they're looking at it and saying, we can have better margins, we can have a more stable business across the up-and-downs of the cycles by controlling the production of iron ore, controlling the refining of the steel, and creating some of the downstream products such as the lightweight high -- I can't think of the word precisely -- but basically a very strong, but lightweight steel for specialty manufacturing, such as automotive today.
Sciple: Right. And so, you talked earlier about the coronavirus, how that has really impacted the market. Do you think that's driven why they made this acquisition of the ArcelorMittal assets right now?
Crowe: It's possible. ArcelorMittal has been for years looking to kind of shake up their business and they were looking to clean up their balance sheet a little bit. So, one of the things that they had available was their North American assets, so this was up-play by, you know, it was kind of an opportune time for them to sell, it was an opportune time for Cleveland-Cliffs to buy, because the market has been a little bit down, valuations were low. And you can look at in two ways, maybe somebody is exiting, when we have a low demand time, we don't really know when it's picking back up, or it could be a very, very opportune time with somebody saying, this is going to pass over time and we're going to control a very, very large portion of not only the steel manufacturing, but also the iron ore business. Because with this deal, ArcelorMittal also had its own iron ore production facilities, which means Cleveland-Cliffs now owns almost two-thirds of all iron ore production in the United States.
Sciple: Right. And so, when you own all the supply in an environment where the economy works along with you and the cycle moves your way, that's a significant opportunity for them. And that kind of raises the question for me of what has to happen for this investment to work, for CLF either making this aggressive move to transition their business into being a fully integrated steel producer, becoming the largest steel producer in the U.S., what has to happen for this to work. And if this goes wrong, you know, what happened, how did it blow up?
Crowe: For this to go well, what needs to happen is we have to see a modest uptick back in steel demand. You know, it's going to go through the cycles. But trying to navigate a major integration like this in a down market doesn't make things any easier, certainly. Obviously, integrating three companies within the past 18 months isn't exactly the easiest feat. Fortunately, I guess the three companies that we're talking about here already had significant commercial agreements in place. AK Steels was one of Cleveland-Cliffs' largest buyers, as well as ArcelorMittal, so you have some advantages there, but bringing them all together and doing so in a way that they can be efficient. Because one of the biggest challenges, of course, with an acquisition or integration like this is the actual bringing them together into an efficient one system, you've seen across many, many industries where making acquisitions can tend to be less about efficient allocation of capital and more boasting the ego of the CEO. I think this one's the former, but it could fall into the latter.
Sciple: Yeah, the aggressiveness during this point in the cycle always gets my ears perked up, because I find it really interesting, just kind of counterintuitive to what you'd expect. And then, obviously, you have all these conversations we hear, with maybe there's more manufacturing rehome to the U.S., both Presidential candidates have America First-type provisions in their campaign platforms, which would suggest a boost for companies that are helping support construction and manufacturing in the U.S. We shall see.
I want to ask you before we go away, we open the show talking about cyclicality in the steel industry and how this is something we see over a number of decades. Now, we talk about Cleveland-Cliffs today rolling up a number of operators in North America, structuring its business to be focused around integrated steel production in the U.S. Do you think this is something new and interesting or is this just another chapter in these decade-long stories of cycles in the steel industry?
Crowe: So, as a shareholder of Cleveland-Cliffs, I will fully admit that I may be a little bit biased here, but I do think this is something interesting. We have seen previously, there was the deconsolidation of integrated companies where they all want to become pure producers, become focused. And now we're seeing that roll back upcycle again, looking at cost efficiencies and higher margins per ton produced, that's one of the biggest arguments for Cleveland-Cliffs.
It'll be interesting to see how they fit into a lot of things that are going on, because while having a lot of electric arc furnace production now with the ArcelorMittal deal, they also have a lot of blast furnaces. And how they're going to transition those assets to either to better produce steel, if they're going to make those changes in the EAF or if they're still going to be using traditional blast furnaces, probably the latter, because you still need raw product production to meet all of our steel needs. And I think it's something I think it's most definitely worth following and it's something that I will keep up on.
Sciple: Yeah, I think the acquisitions are interesting, the timing is interesting, just being opportunistic. And the environment, you can tell a story, as I said, of more manufacturing coming home to the U.S. or more -- you know, we talk about this transition of our energy grid. That's going to require a lot of steel to do all that manufacturing, and so you can certainly tell a story about this industry snapping back over the next several years.
To go back to Laura's question off the top about investing in this industry, we mentioned Nucor, that's a company we've talked about a number of times on the show; and then Cleveland-Cliffs, which is, kind of, a newcomer as far as a fully integrated steel company, but one that's doing a lot of exciting things. If you're going to go invest in steel today as between those two companies, which one would you be most excited about investing in and why?
Crowe: Sure. Well, I own both new Nucor, I also own Cleveland-Cliffs, a couple of other players in the space, U.S. Steel and Steel Dynamics. When it comes to investing in the space, if you're looking for conservative exposure, you're looking to understand the market pretty well and look for a good quality company, and that's something that The Motley Fool has espoused for decades and, yeah, decades now actually, it is quality-run businesses. And if you want to say that the one that has stood the test of time as one of the best-run steel businesses in North America is Nucor. They are probably some of the best capital allocators in this industry. They were smart to start with electric arc production. They have kept all their facilities very nimble, able to adapt to the market. They have a very interesting labor force agreement where every employee is paid with bonus structures that basically wax and wane with the profitability of the company. So, you know, shared pain, shared gains, things like that. So, it's a very interesting company to follow. And for years it's been stable, been a great investment for anybody that can get in on it.
Cleveland-Cliffs, as I mentioned, several years ago was a bit of a mess, it was almost on the brink of bankruptcy when Goncalves came over, but it's a completely transformed company. So, right now Cleveland-Cliffs has been a bet that CEO, Lourenco Goncalves, knows what he's doing, and that he can execute the plan that he has envisioned for this company. Based on the track record of the past six years of taking what was then Cliffs Natural Resources, transforming it into today, does give the impression that he knows what he's doing, and it's certainly something I am interested in owning and seeing where he takes it from here.
Sciple: Yeah, I think both of them look interesting, I think the Cleveland-Cliffs' story is probably going to be much more like an action movie and Nucor is going to be much more, kind of, steady Eddie regular procedural show, you know what you're going to get every quarter.
Crowe: If you want to invest in steel and sleep at night, you invest in Nucor; if you want to stay up late with popcorn, you invest in Cleveland-Cliffs.
Sciple: Yeah. And for our listeners, we've done a show on Nucor in the past, I'll track down a link to that and throw it in the description of the show if you want to dive deeper into that company, before I let you go, Tyler, I wanted to talk about some of the work you all are doing at Millionacres, that's something that you do here at The Motley Fool. What have you all got going on over there?
Crowe: Yeah. So, a couple of years ago we started looking at it. You know, The Motley Fool's mission is to make the world smarter, happier, and richer. And we have done it for years and years and years in stock investing and I think we have a pretty good track record of doing it so far. And we looked at a lot of the developments in the real estate market lately, where commercial real estate and residential real estate are being carved up and being able to be invested in, much more similar to stocks and equities and what people have been used to. And we really saw an opportunity to make people smarter, happier, and richer through real estate investing. And that's why we started the genesis of that.
It's been a great journey so far, we've been able to really explore a whole lot of new topics and bring a fresh voice to an industry or an asset class, particularly, that has been either behind closed gates for a lot of investors, because of the amount of money that it takes to get involved in something like commercial real estate or something that has a lot of misinformation and a lot of not so great reputation for, you know, you've heard plenty of real estate scams and things like that before. So, being an honest broker has been a great thing for us, and yeah.
Sciple: Yeah. Exciting stuff. If you want to learn more about what Millionacres is doing, you can check them out. And any other stuff Millionacres is doing that's new that folks should pay attention to, Tyler?
Crowe: Yeah, also, you know, we had our free site going for a long time, but also Millionacres has launched a new service called Real Estate Winners, to help individuals profit from real estate investments like REITs and real estate equities. And you can learn more about it by visiting Real.Fool.com.
Sciple: All right. Real.Fool.com. I'll throw that in the description of the podcast if you want to check that out, or check out any of the stuff folks are doing at Millionacres make sure to check them out online.
Tyler, thanks, as always, for coming on the show. I'm so excited to have you back on again it needs to be less than two years before we have you back on the show.
Crowe: Thanks for having me, it was a lot of fun.
Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stock's discussed, so don't buy or sell anything based solely on what you hear.
Thanks to Tim Sparks for mixing the show. For Tyler Crowe, I'm Nick Sciple, thanks for listening and Fool on!
