Specialty Steel: A Captive Market (CRS, ATI, AKS)

By Dean Lundell | May 17, 2007 AAA

There is now a "big three" of specialty steel. Industry consolidation has produced this oligopoly, and the last few years have been particularly good to this little cabal (keep in mind, we are talking about specialty steel here, not the plain, carbon variety). We're going to take a look at the specialty steel makers and try to discern what the future might hold.

Niche Player
Carpenter Technology (NYSE: CRS) is involved in the manufacture, fabrication and distribution of a line of specialty metals with high-performance alloys. This is not a particularly large market, but the products this market demands have no substitute. CRS's products are designed for high stress, extremely high temperatures and possibly very corrosive environments. End uses include jet engines, nuclear power plants and orthopedic prosthetic implants. There is no room for error in this business, and that translates into high switching costs for the customer and pricing power for CRS. (To learn more, see Competitive Advantage Counts.)

Financially, CRS has done well generating $1.7 billion in sales from a market capitalization of $3.5 billion. That translates into a 12.7% net margin from a gross of almost 25%. Its return on equity came in at 24% last year, along with a 50% growth in earnings per share.

Of course, Carpenter Technology could suffer a slump in earnings, just as any company, given an economic slowdown in general or a market correction in particular. At 15-times earnings, it is in line with the market in terms of price volatility. As long as we continue to fly, turn on the lights and replace body parts, there will be a market for CRS's products.

Successful Turnaround
Allegheny Technologies (NYSE: ATI) is the largest company in this oligopoly with a market capitalization of $11.6 billion. ATI has turned its fortunes around, due, in no small part, to its acquisition of J&L Specialty Steel and an unprecedented demand of its products by the aerospace, power generation and construction industries. The company has also benefited from a cost reduction program that has saved it approximately $200 million per year in the past three years. Because of its operating leverage, ATI has seen an increasing level of profit contribution from its sales revenue of not quite $5.3 billion. Last year, ATI had a net margin of 12.7% out of a gross of 25.4% and a return on equity of 55%. (For more on operating leverage, see Operating Leverage Captures Relationships.)

ATI caters to the automotive, aerospace, power generation and construction markets and does have some correlation to its customers' businesses as well as some commodity price risk in the steel market. Although this risk is less than the risk faced by those companies that produce carbon-based ingots such as U.S. Steel (NYSE: X) and Nucor (NYSE: NUE).

Going forward, ATI plans on increasing its capacity (now that its restructuring is accomplished) and devoting more attention to research and development and what could amount to $400 million per year in infrastructure investment. Due to the critical nature of the materials that ATI produces for its customers, ATI also enjoys pricing power as there are just not that many places an end user can go. At 17-times earnings, ATI is in line with the market as a whole.

Not Out of the Woods Yet
AK Steel Holding (NYSE: AKS) recently skirted disaster, but it's still a long way from safe. The victim of rampant unionization with an adversarial attitude, the company was able to force concessions after an 11-month strike. Even with a robust demand for its products, ATI's financial results have been meager; a 1.1% net margin on a gross of 11.4%. Its sales of $6.3 billion with a market capitalization of $3.8 billion were interesting. That is a whopping 56-times earnings; far in excess of either of our other two subjects here.

ATI has some challenges ahead: It must reestablish a congenial atmosphere with the union; it has to pay-down some of its debt; it has to make contributions to an under-funded pension plan, and it has to make considerable investment in capital infrastructure.

No Substitutes
Specialty steel products are those that enjoy a market with a more vertical demand curve than many others. When a particular product is needed, nothing else will do, and switching suppliers is difficult and expensive for end users. The real risk for companies is not a slowdown in general economic activity, but their management's skill in the basic ins and outs of running a firm.

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