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| *final draft, check against delivery |
David Sutherland President and CEO IPSCO Inc. |
1. Introduction
Welcome to our 2004 Annual Meeting. It's a pleasure to be here this morning, having just announced earlier this week, record quarterly sales and earnings.
Our Annual Report asserted some two months ago that, unlike last year when we described ourselves as only "Ready" in our "ready, set, go" theme, this year we are truly "Set to Go" and I thought this morning I might spend some time explaining why that is the case. The effective date of our comments in this year's Report was February 27, 2004 and as you will see from my remarks this morning, a lot can happen in two months. Indeed one of the main features of our industry at the moment is things have been changing with a speed never seen before.
Unlike the situation over recent years, it has been easier to sell steel at a profit these days. With our best start to a year ever, the real question on everyone's mind is whether these results are sustainable. While no one can give you a definitive answer to that question, I can give you some facts and analysis which will explain what sets IPSCO apart from other steel companies and why I am more confident today than I have been in a long time about your company and much of our industry.
2. These are Revolutionary Times in the Steel Business.
We are witnessing structural changes in the steel industry, the likes of which have not been seen in years. Much of the change in this mature industry has been evolutionary. But what we are seeing today can more accurately be described as "revolutionary". These are not just slow evolutionary changes nor are they short-term cyclical changes. The root cause is global and will have a pervasive impact on all steel and steel related businesses.
The events of the last three years in the North American steel industry, while largely taking place on the labor and consolidation/financial fronts are, in my opinion, as significant as the introduction of continuous casting and the flat roll mini-mill technology which transformed the production of steel over the last twenty years. The combined effect of these recent structural changes and their implications for the future is so fundamental that it is imperative to understand the basic parameters of this sea change as the starting point to any analysis.
As our shareholders well know, IPSCO has itself undergone a significant transformation over the last few years. First, we pioneered an approach to making steel plate using a combination of metallurgical expertise and steel making know-how developed here in Regina. Using this approach we invested over a billion U.S. dollars in new steel mill facilities to make plate, and developed a successful strategy to take this plate to market. This growth, together with the coincident expansion of coil processing and tubular production, resulted in sales of 3.1 million tons in 2003. Moving from a regional pipe company to a truly North American plate and tubular business is a noteworthy achievement, particularly as we are now beginning to show the fruits of that investment from a profitability perspective
But the changes that I want to speak to you about this morning are not so much IPSCO's transformation, but the revolution, in which IPSCO has played a role, in the industry as a whole and how that will impact IPSCO's future performance. This change is best understood chronologically, by tracing a number of steps starting with the transformation of the North American industry over the last few years and ending with recent structural changes in the world's supply of and demand for steel.
3. Transformation of the North American Steel Industry.
For much of the last decade, there has been a massive transfer of wealth in the form of below cost prices from the Canadian and U.S. steel producers to downstream manufacturers and to consumers. To the extent that lower prices resulted from improved technology and productivity, this transfer of wealth was a good thing. However, the transfer became destructive when competitive pricing was pushed well below cost, including below world competitive costs like those we enjoy at IPSCO. If you look at plate pricing for example, you would see that in the last 5 years the average pricing in our markets has been below the 25 year average by 15% and in some individual years by as much as 25%. Conditions such as these led to more than 40 steel companies going bankrupt in recent years resulting in consolidation, rationalization, closure or liquidation of failed producers. The last three bankruptcies were Canadian companies which are still either in a restructuring or liquidation phase.
In the face of historic price depression resulting from excess supply - in particular the surges of imported steel, the U.S. adopted the much-publicized "Section 201 Tariffs". These tariffs ultimately created a lot more controversy than they deserved. The 201 Program was described as a stool with three legs, only one of which was the tariffs themselves. The other two legs consisted of a plan to eliminate subsidies on a worldwide basis through negotiations at the OECD (which are still ongoing) and a program to induce the American industry to restructure. With hindsight, we can now see that the greatest achievement of the 201 program-one for which the US administration deserves much credit-was that the import tariffs were presented to the steel industry with the quid pro quo that at the same time, both management and labor had to use the relief granted by the remedy to take dramatic steps to restructure the industry, steps that had been long overdue. Three years later much consolidation and financial restructuring has happened, although it is by no means complete.
For much of the past 25 years, that part of the steel industry represented by the "old" integrated steel companies (now reduced to about 50%) was moribund, unable to change, and caught in all kinds of catch 22's resulting in years of losses, no new capital investment or technology and no change in worker productivity to speak of. The U.S. Administration effectively challenged "Old Steel" to institute the radical changes necessary to build a "New Steel Industry". Today that has happened, to a large extent, as our industry consists of both the mini-mill sector made up of companies like IPSCO which for some time have been both modern and profitable as well as a partially-and I stress "partially"--rebuilt integrated sector, which now boasts a new form of labor agreement with their unions, wiped out legacy costs and consolidated production facilities. Canadian steel producers are under the same industry pressures and those Canadian companies that have unproductive structures-including a reliance on an undervalued Canadian dollar-- will have to adopt some form of restructuring to stay competitive. The changes effectively triggered by the 201 Program are ongoing and consolidation continues as I speak.
In that part of the industry I know best-namely the plate sector--- there has also been a rationalization of failed producing facilities. The plate production facilities of Gulf States, Geneva Steel, and Stelco have all been shut down and will not come back to life again, at least in North America. In addition, Bethlehem Steel-once one of IPSCO's biggest competitors and at one point, North America's largest plate maker-- no longer exists and its plate production facilities are operated by a new owner, ISG. ISG subsequently took over US Steel's plate facilities and shuttered them. In fact, the rebalancing of plate supply and demand is creating a more sustainable market than for other steel products.
What we are witnessing here is simply the operation of fundamental economic principles. Once steel prices drop to the cost of production, the ability to sustain further price decreases ends - as it does in any sector of the economy. Producers are unable to supply at below cost pricing, investors withdraw and the supply and demand pendulum shifts back towards demand exceeding supply, with all the pricing power that goes with that. This is in fact the situation that is occurring in North America: companies were ultimately unable to supply at depressed prices, some companies went bankrupt, facilities were shuttered, and eventually consolidation and some rationalization of production facilities occurred. More is likely to take place.
Today for the first time in many years, we are seeing the beginnings of more significant consolidation in North American markets, where three companies (namely US Steel, Nucor and ISG) together could produce about half of the raw steel produced in the U.S. in 2004, or more than 50 million tons. By many other industry standards this is still not a very concentrated market. In addition, several other major North American steel producers (Gerdau, Inland and Rouge) are foreign owned and part of larger global steel companies.
Earlier this year I was honored to be elected Chairman of the American Iron and Steel Institute, the largest steel industry trade association in North America with a long and very visible history in Washington. From this perspective, it appears to me that our industry has truly recreated itself and looks at its future with a renewed vigor. I am not the only one to sense this new attitude. Many metals analysts and industry commentators hold this view with one recently stating, and I quote, that the industry's new leadership had changed the dynamics of the game. "These guys aren't interested in making steel," she said. "They are interested in making money. There is nothing wrong with that…. that's what's happening with steel. . . And they are not afraid of raising prices….Steel is a finance-driven industry now"-I might add - as it should have been in the past.
4. The Structure of the World Steel Industry
It is worth noting that it is not just North America where this type of change has occurred. The largest American steel company, the expanded ISG, will produce around 18 million tons of steel per year. Several steel companies outside of North America such as Posco in Korea, Arcelor in Europe and the Lakshi Mittal group of worldwide steel companies each produce in the range of 50 million tons of steel. It seems apparent that these changes will continue with predictions that a few global steel companies will each control production of 80 to 100 million tons.
That is important. Economists will tell you that in any market, unless a few large companies account for a large proportion of the industry, there will tend to be an imbalance in power as between the buyer and seller, resulting in suppliers exiting the business until a more equal balance of pricing power returns to the market. There is a tendency for suppliers to match the size of their customers. For example, the world auto industry has consolidated into a few very large firms, and it is anticipated that steel suppliers to that industry will evolve in a similar fashion. The aluminum industry has continued to follow this pattern and economists will tell you this is a natural economic tendency.
So the revolution in North America just mirrors the changes that were underway in the global steel industry. These changes mean that once this rationalization and consolidation has completed this chapter, we are likely to see a more stable and profitable steel industry as a whole. This is a radical change from the past 25 years all over the world. It can only be good for IPSCO.
As significant as these worldwide changes in the supply of steel appear, there are new forces at work in global steel demand, particularly demand in China. We are looking at the initial stages of in the industrialization of China and India which is causing a large increase in the world demand for steel and steel making supplies. One well-regarded industry observer refers to the demand for metals as entering a "super-cycle" by which he means an extended period of high demand based on economic recovery globally with the added impact of the industrialization of countries like China and India.
5. The Impact of the Chinese Industrial Revolution.
For many years, the "Asian Revolution" referred to the extraordinary growth of the "tigers" including Hong Kong, Japan and Taiwan and later Malaysia, Singapore, Indonesia and Korea. Today, however, that growth looks like a mere prelude to an industrial revolution in China and India that will make the original Asian revolution pale by comparison. Although any meaningful comment on this topic is beyond the scope of my presentation this morning, there are a couple of points that we should all understand.
The first fact is that everything about China is "BIG". So even though their growth is not much different in percentage terms from the growth experienced in other countries like Japan or Malaysia, because there are 1.3 billion people involved, the 8-10% growth each year has a huge impact on the rest of the world. To meet this growth in steel for example, China has become the largest steel producer and the largest importer, simultaneously, in the world.
The second important point about China is that its high demand for steel is likely to last for some time. The population of that country is just starting to gain access to, for example, cars, bridges and appliances. The magnitude of this is hard to exaggerate. For example, per capita steel consumption in China is only 14% of consumption in Korea. If the per capita consumption of steel in China were to equal that of Korea the overall Chinese market would be approximately seven times bigger than it is today. There may be bumps along the road-and they could be significant - but the long-term trend is upward for several years to come. As Metal Bulletin recently stated, "Barring unforeseen circumstances, higher consumption and prices will continue; China will be the first wave and India will follow…forget the economic cycles….it is the evolution of new industries like shipbuilding and automobiles in China that will drive the international steel sector."
Thus a very significant change in the nature of the demand for steel is in its early stages and is likely to affect world markets for some time to come - as it is for many base metals. Periodic adjustments to deflate bubble elements may occur, but these will not change the underlying trends. China affects the entire steel value chain from raw materials to consumer products, inclusive of shipping and transportation.
6. Steel Price Rises
The consequence of these shifts has been the rapid rise in prices over the past six months, which has resulted in a return to profitability for the steel industry in general. In a sense, recent price levels follow naturally from the sequence of events described earlier, with the simultaneous impact of several different forces. Bad economic times lead to restructuring. As that process was underway world demand picked up, imports previously destined for North America found more attractive markets and prices rose.
Over the last eight months there has been a fundamental shift in the global balance of supply and demand resulting in North America not being the most attractive market for internationally traded steel. The re-valuation of the high US dollar was significant in this change. Coupling this demand shift with the domestic supply reduction has lead to increasing upward pressure on the price of steel. At the same time all manner of input costs began a similar price acceleration such as steel scrap for mini-mills, coke for the integrated companies and natural gas for everyone. The input costs were rising much faster than steel prices and the disconnect between input costs and final selling prices caused steel producers, including IPSCO, to impose "surcharges" which were designed to recover these extraordinarily increased costs and enable us access to these materials.
We do realize that the rate of change in steel prices is disruptive in the steel buying community. Some steel buyers have been unable or unwilling to accept these increases or to pass these costs on to their customers resulting in financial stress in their business. However, the ability of steel producers to effectively subsidize the steel using sector or the final consumer by selling below cost was clearly not sustainable. As it has turned out, the end to the long period during which that had been the case ended violently, driven by global forces converging with a local impact.
Over and above the normal commercial challenges for the steel industry, there is the added challenge to preserve our customer base, which some say is being eroded by the manufacturing prowess of countries like China, unfairly aided by the manipulation of their currency as I alluded to earlier. There is a widespread political movement which has identified this threat to the manufacturing base of the Canadian and American economies and this movement, although beyond the scope of my remarks this morning, might well be supported by our shareholders. I will leave this topic for another day, but I ask all of you to ask yourselves in what way you can make a contribution to the movement to preserve our manufacturing base. It is integral to not just IPSCO, but to our whole standard of living in North America.
7. Conclusion
I started by telling you that we are living through revolutionary times in the steel industry, times that have lead me to renew my optimism about IPSCO's future. I am reminded of the Charles Dickens quote from the beginning of A Tale of Two Cities where he states "It was the best of times, it was the worst of times…" Although Dickens was describing events surrounding the French revolution, his words aptly describe the current volatility in metal markets. If you are a buyer of steel, the chaos, uncertainty and volatility looks for some like the worst of times, especially if you no longer have access to below cost steel or have not developed the relationships to access steel at any price. However, from the perspective of an IPSCO shareholder, I am very hopeful that the structural changes in our industry which underlie much of this uncertainty and volatility, combined with our proven manufacturing and commercial approach, will ultimately translate into a very positive future for IPSCO shareholders.
Standing back from these events, this is what I think you see:
- The IPSCO model works. IPSCO's expansion, undertaken while much of the market was depressed, has proven to be very successful even in very difficult times. Our product is being made in record quantities from our mills, it is well accepted in the marketplace and it is being sold at good prices, albeit only over the past few months. Unlike some of our competitors, who concentrate only on a low cost model, at IPSCO we have also focused on taking our products further along the value chain and we market them with what has proven to be an extremely sound commercial approach all across the North American continent.
- The Industry has restructured. The transformation of the North American steel industry is likely to provide investors in many steel companies a more stable and prosperous future than we have seen over the last 25 years due to consolidation that has occurred or that is yet to occur. The significance of the recent consolidation is that in the next downturn of the steel demand cycle, much of the industry, and particularly that sector where IPSCO competes, should do much better than it has in the past.
- A new, global steel demand structure has arisen. The world steel industry is significantly engaged in meeting the needs of China. Those needs will increase significantly over the next few years at a pace faster than their own new production can match, due in part to shortages in raw materials and the supporting infrastructure that will keep China as a net importer of steel for the immediate future. This, combined with the cyclical pick-up around the world, will deflect tons from North America and reduce the tendency to seek to sell excess internationally traded steel at dumped prices.
- Fundamental economic principles still rule the market for steel. The elimination of over-capacity on the supply side of the equation combined with a positive structural shift on the demand side not surprisingly has lead to meaningful price increases.
So to return to the theme I started with at the beginning of my talk, IPSCO is "SET to go" in a way we have never been before. As was evident from my remarks at our quarterly conference call earlier this week, our immediate future is clearly positive. However, my optimism for IPSCO is not limited to the next quarter, but extends to both the medium and the long term for the reasons indicated above.
I do know that the cyclicality of our industry ensures future troughs as well future peaks and unfortunately I cannot guarantee the future. Perhaps the main conclusion to draw from my remarks this morning is that as business cycles work their way through the economy in the years to come, there is reason to believe that the steel industry as a whole has the opportunity to fare better than it has in the last 25 years as a result of the structural shifts I have described on both the supply and demand side of the basic economic equation. In particular, IPSCO's model will prove, as it has in the past, to be sustainable throughout the economic cycle.
I would be glad to entertain any questions shareholders may have.
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