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Credit Suisse downgrades entire US steel sector on likely overcapacity

New York — Credit Suisse has downgraded the US steel sector because of concerns over the market becoming oversupplied and demand eroding as a result of rising interest rates, the investment bank said Monday.

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"We are downgrading our US steel sector weighting to Market Weight from Overweight owing to our concerns with new supply entering the sheet market as well as increased concerns on US demand as interest rates rise," Credit Suisse said in a note to clients.

The bank also said it sees limited potential for expansion "given late-cycle fears." It also said "capital allocation has disappointed relative to investors' 'wish lists.'"

On supply-side risks, Credit Suisse noted US Steel was about to restart the second blast furnace at its Granite City, Illinois, works later this month, meaning "the full 2.1 million mt of [hot-rolled coil] will soon be in the market."

It also said JSW is expected to restart its 1.5 million st/year electric-arc furnace in November as scrap sourcing and power arrangements have been completed. But the bank said it would not be surprised to see further expansion by JSW pushed back if the economy starts to soften.

ArcelorMittal has just completed maintenance at its Cleveland Works, while US Steel has just completed maintenance at its Great Lakes facility, it said.

The bank said data from the American Iron and Steel Institute showed domestic production recently hit its highest level since 2014 and production rates are up around 6 million st annualized since June.

Credit Suisse said HRC prices "continue to grind lower" and large order sizes are at $800/st or below. "We don't expect Nucor's price hike to be successful, given supply/demand factors in [the fourth quarter]."

The Platts/TSI hot-rolled coil daily price assessment began the year at $652/st, ex-works Indiana, peaked at $920/st in July, and was assessed Monday at $836.50/st.

NAFTA, SECTION 232 RISKS AND CAPACITY RISKS

Credit Suisse ruled out an early agreement with Canada over import tariffs. Nevertheless, the "odds are in favor of a deal being sorted out by early 2019." The bank said if US import tariffs against Canadian steel are replaced by quotas, it sees around 700,000 st of HRC supply moving back into the US market and potentially another 500,000 st if Canada's Stelco can source steel slab at reasonable prices.

"Our historical arb work suggests that tariffs on Canada/Mexico were, by far, the critical factor resetting US HRC premia and we find investors don't appreciate potential rollback risks," Credit Suisse said.

The bank said three major planned EAF expansions could flood the US market by 2020-2021 -- Big River Phase II, JSW Phase II and Nucor's Gallatin expansion.

It said BlueScope was also evaluating expanding North Star by about 800,000 st, while over the border in Canada, it said Stelco is likely to restart its Hamilton, Ontario, plant (1.2 million st/year) by the second half of 2019. Combined, these expansions represent around 4.5 million st/year of capacity.

It said BRS and JSW will have added 3 million st/year, while Granite City will be an additional 2 million mt.

Tariffs exemptions for imported slab could also allow another 500,000-750,000 st at JSW. And downstream rolling capacity is set to ramp up in 2019-20, Credit Suisse said. "Investor reaction to late cycle concerns + new capacity = discounted valuation multiples," the bank said.

"There is no question all of this new capacity is bearish for sheet prices and valuation multiples for the equities. Investors don't like aggressive capital spending, especially this late in an economic cycle," Credit Suisse said.

The bank said all the expansions or restarts are coming at low, incremental operating and capital costs. But as one executive had pointed out to the bank, EAF operators always generate cash, even at the bottom of the cycle.

CAPEX/M&A ACTIVITY ESCALATION

Capital expenditures have surged in 2018, and more is expected next year, it said. Merger and acquisition activity has also increased "and the pipeline for large-size deals remains very full." It added, "we fully support high [internal rate of return] growth, but believe the industry should have better balanced capital return."

Credit Suisse said while some companies have announced share buybacks, investors may remain disappointed. "We find these factors to further limit investor excitement in the sector, given peak margins and cycle fears," it said.

Despite the overall downgrade, Credit Suisse did have some exceptions and said "now is the time to own AK Steel," because the bank believes the company has successfully negotiated higher contract pricing of automotive sheet to the major automotive manufacturers. It said around 25% of AK Steel's automotive annual contracts reset October 1 and about 50% are due to reset January 1. The bank said it is also very bullish on US Steel's prospects in long-term contract negotiations in automotive.

The bank also said, having spoken to buyers, electric-arc furnace operators, while making progress in the automotive market, are still not heavily exposed to this segment compared with integrated steelmakers.

--Anthony Poole, anthony.poole@spglobal.com

--Edited by Valarie Jackson, valarie.jackson@spglobal.com