Image Shown: A tale of two charts, with Cleveland-Cliffs Inc in blue and AK Steel Holding Corporation in orange, after the announcement was that that the former would acquire the latter in an all-stock deal.
By Callum Turcan
On December 3, Cleveland-Cliffs Inc (CLF) agreed to acquire AK Steel Holding Corporation (AKS) through an all-stock deal, creating a vertically integrated producer of iron ore and steel products in the US. Cleveland-Cliffs operates three iron ore mines in Michigan and Minnesota, along with a hot briquetted iron production plant in Ohio that’s under-construction, and AK steel operates steel mills in North America along with related facilities in Western Europe.
Deal Overview
Cleveland-Cliffs is offering 0.4 share of CLF for every share of AKS, a decent premium at the time of the announcement before CLF marched significantly lower during trading hours on December 3. Shareholders of Cleveland-Cliffs will own 68% of the pro forma company’s outstanding common stock on a diluted basis and shareholders of AK Steel will own the remaining 32%. The deal is expected to close during the first half of 2020.
Starting at the top, the most important thing about this deal is the expected synergies. Within 12 months of closing, management thinks the pro forma company will realize $120 million in annual cost savings. Most of that will come from “consolidating corporate functions, reducing duplicative overhead costs, and procurement and energy cost savings, as well as operational and supply chain efficiencies” and we see headcount reductions as likely playing a key role here given the first two sources of expected cost savings.
Too Much Debt
While an interesting move, it’s clear investors are pricing in the significant dilution Cleveland-Cliffs shareholders are facing. The deal comes with an enterprise value of ~$3.0 billion, with AK Steel carrying a total debt load of almost $2.0 billion as of the end of September 2019, offset only by a marginal cash position (less than $0.05 billion). AK Steel generated ~$0.05 billion in free cash flows during the first nine months of 2019, down sharply year-over-year. It’s possible investors are worried about the combined firm’s net debt load, which is another reason why shares of CLF fell sharply on December 3. While an all-stock deal, Cleveland-Cliffs is effectively agreeing to take on a lot of debt as part of this transaction.
At the end of September 2019, Cleveland-Cliffs had a net debt load of $1.7 billion (total debt of $2.1 billion offset by $0.4 billion in cash and cash equivalents), but note that this doesn’t include $0.2 billion in ‘environmental and mine closure obligations’ or $0.2 billion in ‘pension and postemployment benefit liabilities’ (both long-term liabilities). Cleveland-Cliffs has secured a $2.0 billion financing commitment from Credit Suisse Group AG (CS) via a new asset backed loan that will be used to refinance AK Steel’s 2023 senior secured notes according to the press release.
Cleveland-Cliffs generated -$60 million (negative $60 million) in free cash flow during the first nine months of 2019. That’s due to the capital investments the firm is making to bring its hot briquetted iron production plant online by 2020, with output expected to be ramped up through 2021 once online. Construction at the $830 million project in Toledo, Ohio is proceeding smoothly.
Tough Industry
We in general are not optimistic on the ability for the steel industry to generate shareholder value. AK Steel is heavily exposed to the state of the cyclical domestic auto market. As US auto sales have plateaued over the past couple years, that severely limits its ability to grow given pressure from imports (tariffs are a key consideration here). Here’s how we view the industry:
Firms in the steel industry face strong international competition, especially from China, which can often produce steel at rock-bottom prices thanks to lower-cost operations and structural advantages. Steel producers operate at the whim of the prices of volatile raw materials used in production, namely iron ore, coal, natural gas and scrap. Products are sold on the spot market, while other shipments can often be sold under agreements that do not allow for recovery of changes in input costs. Labor unions and the threat of structural overcapacity add more uncertainty. We think the industry structure is very poor.
Being vertically integrated mitigates some of these risks/concerns, but at the end of the day, the combined company will be heavily indebted while operating in a ruthlessly tough industry. Industrial subsidies in other countries, chronic global overcapacity problems, and rising macroeconomic headwinds (such as slowing industrial activity around the world) paints a very bleak outlook for the steel market in the medium-term. Synergies will provide some support, but even so, cost reductions can only do so much before top-line pressures overwhelm.
Iron ore prices will likely face a lot of pressure if US-China trade talks falter, however, prices have firmed up materially in 2019 versus 2015-2018 levels due to supply-side troubles (such as the Brumadinho disaster in Brazil that occurred in January 2019). This is another possible reason as to why shares of CLF sold off aggressively on December 3. Investors liked Cleveland-Cliffs for its exposure to that upside (higher iron ore prices), upside that’s now being diluted.
Trade Update
Very recently, President Trump announced he was going to restore Section 232 tariffs on US imports of steel and aluminum from Brazil and Argentina. Trade war considerations come with both positive and negative implications depending largely on how far the pendulum swings in favor of protectionism for the US steel industry. Negative effects from retaliation and ultimately slower global economic growth are key concerns as well.
Concluding Thoughts
We are staying far away from these two names as the steel industry remains under siege, iron ore prices could come under serious pressure from exogenous forces in the near-term, and the pro forma company’s net debt load will be quite large. Free cash flow generation should improve once Cleveland-Cliffs’ iron plant is brought online allowing for capital expenditures to shift lower while a new revenue stream comes into play, and synergies will further enhance cash flows, but serious deleveraging activities are needed.
Shares of Cleveland-Cliffs yield 3.2% as of this writing, which is primarily a function of its weak share price action as its annual dividend payments on a pro forma basis will still only come out to roughly $0.1 billion. Dividend growth will likely take a backseat to other capital allocation priorities over the coming years. Please note Cleveland-Cliffs resumed paying a common dividend in 2019 after halting its payout back in 2014. There are better income generating investment opportunities out there than Cleveland-Cliffs, in our view.
If you may wish to add the High Yield Dividend Newsletter to your membership, please click here.
Steel Industry – AKS MT GGB NUE PKX STLD X
Diversified Mining Industry – BHP FCX NEM RIO SCCO VALE WPM
Related – CLF, IYM, JJU, FOIL, SLX, XME
—–
Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.
Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.