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November 1, 2007

CREDIT CROSSROADS

For many, the subprime mortgage collapse was more bark than bite.

Tremors from the recent credit crisis continue to be felt throughout the metals industry. But the major shockwaves that many expected never came.

Mary Valenta, executive vice president and chief financial officer for O’Neal Steel in Birmingham, Alabama, says credit providers remain “very supportive,” even as the steel market softens slightly.

“We do see a slowdown in some markets that mortgages impact, such as new construction, and some construction equipment has slowed down,” she says. “A little bit of impact, but not a whole lot.”

Mark Breckheimer, executive vice president of Namasco Corp. and president of its subsidiary Primary Steel, both in Middletown, Connecticut, says the credit crunch has minimally impacted the company, but he’s watching developments closely and preparing to adjust inventories and make sure costs are in line for a potentially sluggish market.

“As home prices drop 5% to 6% this coming year, people won’t be able to access home equity as readily to buy cars, and that will impact build rates for automobiles produced in North America,” he says.

Manufacturing growth moderated in September, says the Institute for Supply Management’s (ISM) national manufacturing report, which aggregates data from purchasing and supply executives nationwide. Softening new order and production growth held back economic activity. The New Orders Index fell 1.9 percentage points to 53.4% in September, and the Production Index dropped 1.5 percentage points to 54.6%. Inventory levels also slid, reports ISM’s Inventory Index, falling 3.8 percentage points to 41.6%, its lowest reading since January. Any index reading above 50% is considered positive for growth.

CONTINUED WEAKENING
Not surprisingly, in the aftermath of the subprime mortgage debacle, demand for building materials, construction equipment and autos weakened, continuing their longterm downward spiral. Construction spending slipped 3.4% to $657.7 billion for the first seven months of the year, compared with $680.9 billion for the same period in 2006, says the Census Bureau of the U.S. Department of Commerce. Building permits fell 5.9% to 1.3 million in August, and housing starts dropped 2.6% to roughly 1.3 million in August from a year ago, according to a joint release of the Census Bureau and the U.S. Department of Housing and Urban Development.

But other sectors have offset much of the softness related to housing market woes. The Federal Reserve reported strong aerospace and electrical equipment growth across several districts. Companies in the Fed’s Chicago district reported steady steel exports, and Dallas, Kansas City and San Francisco were bolstered by high-technology manufacturing’s performance. Every district that reported on mining and energy remained keen on those industries’ outlook, as well.

Still, private equity firms are having a tougher time raising funds, and some speculate that the pace of consolidation within the metals sector may slow as a result.

Richard Marabito, chief financial officer of Olympic Steel in Bedford Heights, Ohio, says lenders are becoming increasingly conservative and doing more due diligence. Private equity firms in recent years were able to put less equity into deals at much cheaper rates and with fewer restrictions than previously, he says, but all three factors have reversed as a result of the credit crisis.

“The pendulum has swung back to what makes sense, and deals that make sense are going to get done,” he says. “If you want to get a deal done, you need more equity in the game, with normal covenants and a higher price.”

Deals exceeding $500 million have been hurt by tightening credit more than smaller deals, says Bill Peluchiwski, managing director of investment bank Houlihan Lokey in Chicago. “A lot of smaller deals were what we call ‘club deals,’ and there was no question of getting credit,” he says. “Pricing [of credit] has gone up 50 basis points, but there’s been no massive change in the market vis-à-vis the late summer/early fall curtailment of credit.”

TOUGH SELL
Expect the M&A landscape within the metals industry to change as a result, says Robert Wujtowicz, managing director of Chicagobased InterOcean Financial Group LLC. “It’s going to be tougher now for companies who want to sell their businesses or get some outside capital from private equity because that money won’t be as readily available as it was before,” he says. “The private equity firms had bid up prices in transactions, so not only are we going to see M&A volume come down, we’re going to see M&A pricing come down as well.”

The U.S. loan market fell 36% to $373 billion in the third quarter after strong second-quarter performance. The leveraged loan market, which serves riskier borrowers, plummeted 46% to $119 billion from the previous quarter. Hedge funds, mutual funds and collateralized loan obligations (CLOs), no longer backing as many leveraged buyouts, contributed to that segment’s 17% fall to $52.6 billion. In all, loan investors purchased just $66 billion in the third quarter, down 55% from the second quarter.

Bid prices have fallen right along with loan volume. Platinum Equity, a Beverly Hills, California-based private equity firm, cut its initial bid price for Ryerson Inc. twice before settling on $34.50 per share in late July, a Securities and Exchange Commission filing shows. Ryerson shares traded around $32 in August and September.

“As money gets tighter in a credit squeeze, and credit terms become more expensive, construction goes down, corporate capital spending goes down and—the biggest element of all—consumer spending begins to go down,” says Stephen Fraser, chairman, president and CEO of ADS Logistics LLC of Homewood, Illinois, a metals-focused supply chain company. “All those reductions have a negative impact on demand for things that use steel, like consumer durables and home and related construction.”

Analysts and executives alike believe the housing market downturn may continue to drag on the rest of the economy, particularly if consumer spending slows dramatically. Recent employment data and consumer confidence polls bode poorly for future spending.

The Conference Board Consumer Confidence Survey, a poll of U.S. households, revealed a public whose enthusiasm had been diminished by financial market turmoil, housing market concerns and labor market issues. The number of respondents who said conditions were “good” decreased to 25.7% from 26.2%, and the percentage that called conditions “bad” rose to 17.9% from 16.3%. More tellingly, the percentage that expected business conditions to worsen in the next six months jumped to 11.8% from 10.2%, while the proportion that thought conditions would improve edged up only slightly to 15.6% from 15%.

Paul Kasriel, senior vice president and director of economic research at Northern Trust Co. in Chicago, says many don’t fully appreciate how much influence housing sector issues have on consumer spending and the broader economy by extension. “Everyone views housing like Las Vegas,” he says. “What happens in Las Vegas stays in Las Vegas; what happens in housing stays in housing.”

Housing played a much larger role in creating jobs and funding consumer spending in this expansion than in previous ones because of exceptionally low interest rates early on, the advent of new types of mortgages that allowed households to borrow more relative to their income, and the unprecedented ease with which households could refinance their mortgages and use home equity to finance spending.

Together, these factors will play a significant role on the downside of the bubble as well.

“In the last recession, in 2001, consumer spending was hardly affected negatively at all,” Kasriel says. “I believe that this slowdown, which could turn into a recession, will be one in which we finally see consumer spending being negatively affected.”

In a September speech, Federal Reserve Board Governor Frederic S. Mishkin spoke of subdued consumer spending in the coming months. “This summer’s retrenchment in equity markets and the sharp deceleration in house prices have damped gains in household wealth this year and are likely to restrain consumer outlays,” he said. “Moreover, at least some households are likely to find it more difficult or expensive to borrow, and consumer sentiment—which turned down in August—could soften further if households become more anxious about recent financial market developments.”

LESS PAIN
All that could be bad news for business, since consumer spending accounts for more than two-thirds of U.S. economic activity. “If we go into recession, the metals industry is going to feel it along with everyone else,” Kasriel says. “But because this expansion has seen fewer excesses in the manufacturing metals sectors, the pain will be somewhat less than in other sectors.”

Certainly metals companies that do a great deal of business abroad are likely to feel the effects of a lethargic domestic economy less than others. Companies that supply equipment and materials to industries such as agriculture that have strong exports will fare better as well. “The rest of the world, especially the developing world, is getting wealthier and can afford to buy more food, and we are one of the premier agricultural products producers in the world,” Kasriel says.

Regardless of the niche a company occupies, a sober assessment of the impact a sluggish economy could have on business and how long it might last is vital. “Let that realistic appraisal inform one’s preparations with respect to cost reduction and new market exploration,” Fraser says. “One doesn’t get out of an economic downturn by just reducing costs. One has to keep growing and looking for new opportunities—maybe even beyond the boundaries of U.S.-dollar-denominated opportunities.”