|Shares Out. (in M):||173||P/E||5.2||3.52|
|Market Cap (in $M):||2,714||P/FCF||7||7|
|Net Debt (in $M):||1,316||EBIT||1,400||1,400|
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We believe that U.S. Steel’s (NYSE: X) intrinsic value is several times its current market value, and with activist chatter picking up and potential catalysts on the horizon, the stock could be revalued meaningfully upward. An acquisition of the company is also increasingly possible given the company’s depressed valuation, healthy balance sheet, impending misallocation of capital and coveted iron ore assets. We believe X’s iron ore pellet operations alone are worth more than the company’s entire market value, and an activist induced or voluntary reduction in X’s CAPX plans through 2020 could enable X to repurchase a large portion of its outstanding shares at the current valuation without straining its balance sheet. X could also seek to divest its Tubular segment at a time when oil prices are surging and OCTG margins are set to continue expanding.
It is likely that U.S. steel prices are set to rise in the coming months, as recent commentary from Nucor, Steel Dynamics and Cleveland Cliffs indicates a recent demand rebound for sheet and optimism about the remainder of 2019. Several industry catalysts, including a potential infrastructure bill, the migration of auto capacity to the U.S. through bilateral trade deals, and healthier capacity utilization in China driven by infrastructure spending and capacity reductions could result in a much healthier steel industry than the market is currently contemplating. X’s short interest has soared from 17.3 million shares at the end of March to 22.2 million shares, or 12.8% of the company’s shares outstanding, on April 15. We believe that X’s short interest likely increased further through the end of April, and a host of imminent catalysts could result in a major squeeze higher.
On April 17, activist chatter was picked up on X following two apocalyptic ratings downgrades in recent weeks by Credit Suisse and Bank of America. The downgrades cited worse than expected U.S. steel market conditions, a weak competitive position, and X’s “cash burn” over the next two years driven primarily by a large CAPX ramp.
X has a strong liquidity profile, and with an alternative spending and divestiture strategy we believe the company could comfortably acquire the majority of its outstanding shares in the next two years. X ended 2018 with $1 billion in cash on hand and total liquidity of $2.8 billion. Its tangible equity exceeds $4 billion and current assets exceed current liabilities by more than $1.6 billion. This contrasts with X’s market cap of just $2.7 billion. The company’s CAPX is expected to rise to $1.2 billion in 2019 from just $505 million in 2017. X indicated on its 4Q 2018 conference call that baseline CAPX is in the $500 - $600 million range, implying that its $2 billion asset revitalization program (ARP) and growth initiatives are consuming $600 - $700 million in CAPX in 2019.
The market obviously believes that X’s elevated CAPX is a nonsensical use of capital in the current environment, and the company may soon succumb to increased pressure to divert cash from capital spending to additional share repurchases, a catalyst that would likely cause the stock to soar. Even if X’s adjusted EBITDA were to revert to 2017 levels of $1.15 billion from $1.76 billion in 2018, it could generate $650 million of free cash flow if it were to decrease its CAPX to the baseline and scrap its ARP. This free cash flow, in addition to $250 million from X’s balance sheet, would enable the company to repurchase one-third of its outstanding shares over the next year while maintaining very healthy liquidity ($750 million is the minimum cash balance with which X’s management indicated it feels comfortable on its Q4 conference call). The company repurchased $75 million in stock in 4Q 2018 and an additional $25 million in January of 2019.
While X’s EBITDA expectations have declined recently, commentary last week by Nucor (NYSE: NUE) and Steel Dynamics (NASDAQ: STLD) indicates that the worst may be over for the sheet market. On April 23, NUE’s CEO indicated the following “…We've mentioned that we see demand pretty consistent. In fact, maybe a little bit growing in -- on the sheet side, on the hot band side, when we look at our order entry over the last couple of weeks, marginal growth, small growth, but a good sign”. He subsequently indicated that “a lot of the service center inventories are coming down quickly and they are getting to pretty low levels, and still a good amount of into sales between service centers, as they continue to work off the numbers from the end of last year. So you see some of that activity taking place, the weather, as I said, impacted the first half of the year, we see that's moving up now, as we go forward”. A day earlier, STLD’s earnings press release indicated that “A downward trend in flat roll steel prices began in the second half of 2018, and continued through mid-first quarter 2019, reaching an inflection point in February 2019… The continued stabilization and improvement in flat roll steel prices are having a positive impact, resulting in increased flat roll order activity and solid order backlogs. We are seeing continued strength in the automotive, energy and industrial sectors, and as evidenced by strong steel fabrication backlogs, strength in non-residential construction.” Based on commentary last week from NUE and STLD, it seems like a rebound in sheet prices may be imminent.
X’s Iron Ore Treasure & Tubular Operations
Minnesota’s iron ore operations have a production capacity of about 40 million tons of high-grade iron ore annually, which is approximately 75% of total U.S. iron ore production. X has iron ore pellet operations located at Mt. Iron (Minntac) and Keewatin (Keetac), Minnesota with annual iron ore pellet production capability of 22.4 million tons. During 2018, these operations produced 21.8 million tons of iron ore pellets. In conjunction with X’s share of Hibbing Taconite Company, total iron ore production for the company in 2018 was 23.1 million tons. X is vertically integrated in the U.S., and the company is a net seller of iron ore pellets.
Cleveland-Cliffs (NYSE: CLF), which is the leading iron order producer in the U.S. with 26.3 million long tons of pellets produced in 2018, exceeded X’s production by just 14%. Yet CLF’s EV is $4.6 billion versus $4 billion for X, implying that the market may be ascribing a negative value for X’s 22 million net tons of raw steel production capacity. X and CLF have neighboring iron ore production in Minnesota’s Mesabi Iron Range, where low-grade ores are beneficiated and upgraded to high-grade iron ore concentrates with an iron content of approximately 65%. Recent supply disruptions from key mines in Brazil and Australia and China's fiscal stimulus resulted in a sharp increase in iron ore prices of 16% in Q1 2019. Following Vale’s Brumadinho dam rupture, all of Vale’s upstream tailings dams in Brazil were decommissioned and operations at several mines temporarily suspended. High-grade ore produced by the likes of Vale is the preferred choice of Chinese steel mills, as it allows them to maximize output from their blast furnaces and limit the amount of coal used and the air pollution created per ton of steel produced. As the CEO of CLF indicated on last week’s earnings conference call, “The distraction of multiple very costly and very serious lawsuits, including criminal liability, related to the loss of life of hundreds of Brazilian systems should only continue to confirm throughout this year and next that Brazil as a supplier of iron ore to the world has become a totally unreliable supplier. There is no short or medium-term solution for this massive shortages, and as such, iron ore and pellet prices should remain elevated for the foreseeable future. That will not get better or easier anytime soon and it might get worse. Welcome to the new normal, get used to the new normal.”
We believe that X’s iron ore assets could make it a compelling acquisition candidate, especially in the current deficit environment. Alternatively, activists could seek to force the company to reduce CAPX, shutter high cost steel production and increasingly focus on external sales of iron ore pellets.
Another overlooked component of X is its Tubular segment. In 2007, X made what in retrospect was an awful acquisition of Lone Star Technologies near the peak of the energy cycle for 8.5X EBITDA or $2.1 billion (almost equivalent to X’s current market cap). In that period, OCTG margins were up to $200 - $300 per ton while oil prices went parabolic. Since then, however, margins have plunged. While X’s tubular division is finally improving from the doldrums and recently turned profitable, its 2018 gross margins in this division were just 1%. If X’s margins were to improve to match those of its Flat-Rolled and USSE segments, it would yield >$170 million in additional EBITDA for the company. X’s EBIT for its Tubular segment was negative $58 million in 2018, implying that the aforementioned gross margin improvement could yield potential EBITDA in excess of $100 million. The market is likely valuing this division at virtually nothing, but if the oil market continues to improve, it is conceivable that X’s Tubular segment could be divested for up to half of the company’s current market cap in the coming year or two.
Beyond improving recent demand trends, potential activist intervention, or a sale of the company, a number of near-term catalysts could positively impact X’s share price. The U.S. steel industry’s capacity utilization in 2018 was approximately 78%, the highest since 2008, and with companies like X reactivating blast furnaces that have been idled over the past decade, the industry is clearly optimistic about the cycle and Trump’s continued support for U.S. steel.
While skeptics point to a wave of new steel capacity coming onstream beginning in 2021, there has been little speculation of positive developments like a massive infrastructure bill soaking up this capacity and keeping the upcycle alive for much longer.
Firstly, on Tuesday, House Speaker Nancy Pelosi and President Trump will be meeting to discuss an infrastructure bill. Pelosi recently indicated that she is seeking $1 trillion - $2 trillion in funding for the package and there are indications that President Trump may see eye-to-eye with her on this issue. Importantly, sources indicate that Democrats will require that materials used be American-made, a proposition that comports with Trump’s “Buy American” policy.
Secondly, it seems that Trump is focused on moving auto production to the U.S. from overseas, a development that could be particularly positive for the sheet market and X. On Saturday, for example, Trump said at a rally that Japanese Prime Minister Shinzo Abe told him Japan is investing $40 billion in new car factories in the U.S.
Lastly, Chinese steel capacity utilization levels continue to rise to in excess of 70%, as the Chinese-led Belt and Road Initiative for building ports, highways and railroads and the government's focus on further infrastructure development is underpinning demand for steel. Meanwhile, there is the potential for additional capacity shutdowns in China this year. In mid-April, China’s top steelmaking city of Tangshan in Hebei province issued a second-level pollution alert in response to a wave of smog expected to blanket the region. Steel mills in the city were ordered to halt operations of sintering machines by at least 40% and all mills were forced to halve their shaft furnace operations. The combination of increased infrastructure spending, fiscal stimulus targeting the auto sector and additional pollution related shutdowns could result in continued rising utilization rates in China, which accounts for half of the world’s crude steel production.
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