Algoma Steel (ASTL) is a deeply discounted security. The tag line is simple – at current spot prices for steel - Algoma earns ~9% of its market cap per month in free cash flow and has no net debt.

I understand why an investor might be reluctant. Steel prices are very high, and cyclical companies should trade at very low multiples on peak pricing. But the situation with Algoma takes that view past its logical breaking point – at this point it is very difficult to construct a case for steel prices where ASTL doesn’t have significant upside from today’s price. The stock could double and have a 50% current free cash flow yield.

The key elements of the thesis:

• ·         As a result of a recent restructuring, ASTL has a superior cost structure and a pristine balance sheet
• ·         ASTL came public via a SPAC, and remains off the radar for the moment
• ·         ASTL received a sizeable government loan / grant to effectively pay for its one large upcoming capital project (EAF conversion)
• ·         ASTL realizes its steel sales on a lag to spot price, and has already entirely booked 2021 and is well into Q2 2022. As such there is a lot of visibility into cash flows that quickly become a sizeable portion of the current market cap
• ·         ASTL is absurdly cheap under almost any commodity price scenario

Restructuring

ASTL was formerly owned by Essar, and entered CCAA (Canadian bankruptcy) in September 2014 amid falling steel prices and rising legacy costs. They had also sold their port in a sale/leaseback transaction to raise cash – but too little too late.

ASTL was in creditor protection for four years, which ended when the senior lenders acquired 100% of the equity of Algoma and exited in November of 2018.

A few key elements of the restructuring:

• ·         Debt was significantly reduced, resulting in essentially one $300m 10% loan
• ·         Environmental liabilities were substantially reduced and restructured, now requiring a payment of less than $10m per year
• ·         Restructuring pension with cash costs less than $10m per year
• ·         Invested $200m in modernizing downstream operations and plate mill
• ·         Recaptured the port via a fraudulent transfer mechanism and eliminated port rental payments
• ·         Overall cash costs now in the bottom 10% of North American steel production

Algoma was in CCAA during some bad times for the steel industry, including the industrial recession of 2015 – and so the restructuring was focused on making sure ASTL could survive – and even thrive – at low steel prices.

The remaining shareholders of ASTL are sophisticated credit and restructuring funds, notably Bain Capital, Goldentree, Contrarian Capital, etc.

SPAC

In January – when spot steel prices were around $1000/ton vs today’s $1800/ton, Algoma began negotiating with Legato Merger Corp – a Canadian SPAC sponsor – about coming public via SPAC. The deal was signed May 25, 2021 with an equity price of $10.00, implying a market cap of $1.53bn for ASTL.

The PIPE here is limited - $100m and has already gone effective. The existing shareholders have lockup provisions, but can sell a portion of their shares if the stock stays above $12.50 for 20 days out of any 30 day period. That said, these are sophisticated holders who may be reluctant to sell at the valuations you will see below.

The transaction closed on October 19^th and ticker changed from LEGO to ASTL.

This de-SPAC is obviously unique – a steel mill instead of a high growth company! As such the stock remains off the radar despite its meaningful market cap – zero coverage as of today. While it will take time, it should lose the SPAC label over time and start to trade on fundamentals.

Government Loan

An important development between the signing of the SPAC deal and closing was ASTL’s receipt of government loans to help fund their coming EAF transition.

ASTL currently produced steel via blast furnace, where inputs include iron ore pellets and coking coal. As you might expect this is a very dirty process. They are planning to build a large electric arc furnace (EAF) on site and in late ’23 move all steel production to an EAF process. There should be very little downtime as they just turn the BF off and the EAF on.

The EAF is dramatically better from a greenhouse gas perspective as it essentially uses raw power to melt down scrap steel and convert it to new steel. The Canadian government is gung-ho on climate goals, which has allowed Algoma to effectively get Canada to pay for a good portion of this coming capex.

Algoma will receive ~$340m  (USD) in loans and grants from Canada. About 50% of this is a grant from Canada’s Strategic Innovation Fund via their Net Zero Accelerator – and if ASTL hits their carbon reduction goals – which should be just purely a function of physics – they will not have to repay this grant.

The other 50% comes from the Canadian infrastructure bank and I believe the loan is about 1% for 10-15 years (final terms should be announced shortly).

The total Capex expected for the EAF over a 4 year timeframe is about $500m US, so Canada goes a long way to funding the main capital project here at ASTL. Although this may turn out to be almost irrelevant given how much cash ASTL is generating currently.

Spot Steel / Lag

One element that increases the margin of safety at ASTL today is that the company realizes is revenue and cash flows on a 3-4 month lag vs the spot price. While they are generally exposed to spot, 55% of their revenues are on contracts with lagging price adjustment (1-3 months), 10% are on fixed yearly contracts, and the rest are sold on spot, although given lead and delivery times these also effectively lag.

At this point, with steel at $1800-1900/ton, this is great news for ASTL.

·         Given the heightened demand for steel, lead times are now 12+ weeks, vs 6 weeks in a normal environment

·         They are likely beginning yearly contract negotiation right now, and will be able to lock in prices on that 10-15% of their business for the entirety of 2022

·        Even if prices were to decline substantially today, the lag dynamics and lead times imply they would not start to see a decline in realized steel prices until Q2 2022. Two more quarters at these peak levels = 50% of the market cap in cash!

Valuation

This is where the rubber hits the road. Given the transformation in restructuring and the dirt cheap SPAC deal – negotiated during much lower steel prices – ASTL is extraordinarily cheap.

Some high level scenarios:

First, as 2021 is locked in, ASTL will likely earn between $650-$750m in free cash flow (excluding the seasonal working capital build from the lake freezing over) by year end. This brings our EV down to around $900m by year end 2021. Once again – no net debt.

Then – at current spot prices, in 2022 ASTL will generate about $3bn in EBITDA and $1.9bn in free cash flow. So, 0.3x EBITDA and a free cash flow yield of 200%. This depends on spot staying at current levels – of course given the lag and booking cycle, we are well into 2022 as we speak.

If we instead just assume they will receive the HRC curve in 2022 – which has steel falling precipitously and has been entirely wrong about this rise in steel from the get go – they will generate $1.8bn in EBITDA and $1bn in free cash flow in 2022. So, negative EV by the end of the year. In reality this assumes that things are worse than the curve because of the aforementioned lag.

For fun, let’s say that they run at spot for Q1 2022 and then steel goes to $500 the next day. They will still generate 50% of their market cap before April 1, 2022 and then you’re still looking at a $500m EV that will do $400m+ of EBITDA with steel prices down 75% instantly. At this point this scenario is about as bad as one could possibly conceive given the lag. So you’re buying ASTL at 1.2x EBITDA in the downside case with all their upcoming capex paid for by the Canadian government.

Capital Allocation

So how do you get this cash? I’ve been fortunate enough to spend a good amount of time with management and this question is front and center. While the government loans will place modest restrictions on capital returns (likely they have to keep a minimum cash level on the balance sheet – can’t just give government dollars to shareholders), I expect significant special dividends to begin coming our way in 2022. They may also be able to do a tender to take out some of the chunkier shareholders, although I doubt there are many sellers near this valuation.

Risks

• ·         Steel prices are too high – demand destruction is real – they will come down. Will the stock fall when that happens? Maybe. This is the completely obvious risk, but does seem priced in here. On top of it all, the recent 232 adjustment wasn’t horrible for domestic steel, we now have a giant new infrastructure bill, and a lot of capex on the way. Bullish for at least maintaining elevated steel prices for a while. One should also feel free to hedge this exposure via the spot market or other steel companies that only trade at 30% free cash flow yields!
• ·         SPAC dynamics – hard to handicap these but can weigh on the stock as PIPE sellers may want liquidity. The lockup (above $12.50 for 20/30 trading days) may also spur some incremental selling but at this valuation it doesn’t seem apocalyptic
• ·         Working capital – they build working capital during the winter while the lake is frozen and it gets released in Q1/Q2. Will somewhat dint near-dated cash numbers but then massively inflate early 2022. More a perception thing than a reality thing.

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