Canada Steel: Heavy Metal

Canada steel; Stung by falling prices, Dofasco, Stelco and Algoma now face hard realities.

The good times don't always just keep on rolling–at least not when you're in the business of rolling steel. Indeed, after months of strong demand and more than a few press releases boasting of record profits, the third quarter reminded Canada's $11-billion steel sector that it's a cyclical industry.

The spot market price of hot-rolled steel fell below US$450 per ton last summer, well under its US$740 peak about a year ago. And that pretty much killed profitability across the board. Even Dofasco Inc. (TSX: DFS)–one of the best-managed steelmakers in North America–surprised analysts with worse-than-expected Q3 results. For the three-month period ended Sept. 30, the Hamilton-based company posted a $5.2-million profit, or 7¢ per common share. That was down from a Q2 gain of $59.2 million and earnings of $115 million in the third quarter last year. Industry watchers had expected Dofasco to earn about 31¢ per share–which explains why even bulls were lowering target prices on the stock earlier this month.

Looking forward, Dofasco CEO Don Pether told analysts he expects a much better fourth quarter–thanks to improvements in mining operations. The company's steel business, which actually posted a Q3 pre-tax loss of $24.2 million, is expected to remain relatively soft.

Over at embattled Stelco Inc. (TSX: STE.A), Dofasco's unionized hometown cousin, management is making much out of the return of General Motors as a contract customer. What isn't being mentioned is that GM–now the smallest company by market cap in the Dow Jones industrial average–is in crisis mode after losing about US$4 billion this year. Stelco also isn't bragging about the fact that profits are no longer getting in the way of its 23-month-old restructuring.

If you recall, the steelmaker bolted from its debt obligations in January 2004, claiming it had to follow the example of U.S. steel companies that were cutting employees, slashing wages and shedding pension costs under U.S. bankruptcy protection laws. At the time, Stelco's newly minted CEO, Courtney Pratt, said Canada's largest steelmaker faced a looming liquidity crisis and wasn't competitive due to its high cost structure and a $1.3-billion hole in its pension plans. But soaring steel prices, which eventually resulted in a string of embarrassingly positive quarterly results, pretty much killed any chances for union co-operation. In fact, instead of coughing up concessions, the United Steelworkers of America (USWA) called Stelco's insolvency filing a fraud and sought to have its protection from creditors revoked. When that failed, solidarity melted. The company's largest union, which represents employees at Stelco's Hilton Works operation in Hamilton, continued to protest the insolvency claim by abstaining from restructuring talks. Union representatives from Stelco's Lake Erie Works, on the other hand, jumped into the process with the international arm of the USWA. They eventually stole the show from bondholders with a little help from taxpayers (Ontario has offered a $100-million loan, $75 million of which can be forgiven) by putting forward a plan that would dump $400 million into the company's pensions while wiping out shareholders and handing creditors about 66¢ on the dollar. To nail down the labour victory, Lake Erie workers actually negotiated a raise in the third quarter, when (drum roll here) Stelco lost $42 million or 41¢ per share. That's compared to a $58-million profit in the same three-month period a year earlier, not to mention a $40-million gain in the second quarter.

According to Stelco's court-appointed monitor, the 95-year-old company will probably be liquidated if bondholders fail to support the union-backed plan. If that happens, creditors will get less than 33¢ on the dollar. But furious lenders note it was government rules that allowed Stelco to underfund its pensions. They also remember earlier proposals to pay them in full. And since the lenders get the final say, they want a better deal, one that offers them tax dollars in addition to equity in a new Stelco. “This company's managers and directors are a bunch of misfits who couldn't run a doughnut shop,” insists independent bondholder Garry Milne, who has more than “lunch money” at stake. Milne and others turned out on Nov. 15 to vote down the company's controversial restructuring proposal. But the vote was put off after Stelco realized its survival plan would be shot down.

A frustrated Justice James Farley of the Ontario Superior Court issued yet another of his “real and functional” deadlines, promising to interrupt his vacation to consider alternatives if a plan isn't supported by all concerned on Nov. 21. A few hours later, union officials issued a less-than-helpful press release that urged bondholders to take the restructuring seriously. “Pensioners and workers at Stelco have had enough,” the USWA said. “The union has fulfilled its responsibility of defending our contracts and negotiating a down payment of $400 million to the pension plan, both of which are non-negotiable.” At press time, the two sides were still playing a high-stakes game of chicken. But if creditors cave or the company somehow manages to offer them more cash, a motion to sanction the plan will probably be heard in early December.

Meanwhile, at Algoma Steel Inc. (TSX: AGA), which has managed to wipe out investors twice to restructure in the past, the largest shareholder is screaming over the way CEO Denis Turcotte runs the Sault Ste. Marie, Ont.-based company. Nobody, of course, is complaining about Turcotte's ability to deliver Q3 net income of $30.8 million (down from $121.6 million a year earlier) despite the dip in steel prices. But believe it or not, Paulson & Co., an investment management outfit based in New York that controls about 19% of Algoma, is more than a little upset over money paid out to investors by the industry-dog-turned-cash-rich steelmaker.

In October, Paulson wrote Turcotte and Algoma chairman Ben Duster to raise awareness of its concerns over what it calls the steelmaker's “highly inefficient capital structure.” Paulson is unhappy with a $238-million special dividend distributed in the summer, noting that “non-Canadian shareholders were hit with a punitive 25% withholding tax” and that Algoma's share price declined as a result of the payout. To improve matters, Paulson has proposed a corporate reorganization. Simply put, the investment company wants Algoma–which is about 80% owned by U.S. interests–to hand $420 million more to shareholders by borrowing about $200 million and using a significant portion of cash on hand to buy back 40% of its shares for $26. Shareholders who choose not to sell would benefit from a higher stock price and larger stake. If Algoma thinks otherwise, Paulson–which considers itself a long-term investor after one year–noted it was prepared to go public with its demands, requisition a special meeting and “campaign for the election of a new shareholder-friendly board majority.”

Turcotte politely declines to say what he first thought when hit with the Paulson letter. Furthermore, he defends all shareholders' right to speak their mind and push for board-level changes. But he takes issue with anyone who calls his management team unfriendly to shareholders, noting Algoma's recent special dividend of $6 per share is virtually unheard of in the steel sector these days. And he suggests the tax hit taken by Algoma's largest shareholder could have been mitigated.

Before anyone tries to make Turcotte a puppet, he says they should “speak to my mother.” He also notes Algoma's directors have a legal duty to all stakeholders, insisting any new board member who does the job right will conclude that it would be foolhardy to risk another restructuring by giving up the company's hard-fought rainy-day fund during these uncertain times for the steel industry. Turcotte would rather focus on future challenges (like energy prices and auto-sector demand) without having Algoma's largest shareholder second-guess his every move. But then again, he admits, things could be worse–he could be CEO of Stelco.