The American steel industry has been through a rough patch for most of the past decade, with the exception of 2018, when the passage of the Tax Cuts and Jobs Act along with steel tariffs boosted U.S. steel prices for a bit. However, the party didn’t last long, as oversupply and the U.S.-China trade war plunged the industry into a recession soon after. The big steel bust in late 2018 and 2019 has continued into 2020 with the COVID-19 crisis.
However, U.S. iron ore producer, and now integrated steelmaker, Cleveland-Cliffs (NYSE: CLF), is betting big on a turnaround. After buying AK Steel Holding back in late 2019, Cleveland-Cliffs just inked its second large acquisition within a year, agreeing to buy the U.S. operations of ArcelorMittal (NYSE: MT) in a cash-and-stock deal that will create the largest flat-rolled integrated steel producer in the U.S.
Here’s the rationale behind the acquisition, and what CEO Lourenco Goncalves sees as the future of the U.S. steel industry.
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Since Goncalves became CEO of Cleveland-Cliffs back in 2014, he has completely reoriented the company back toward its core U.S. operations. Cliffs subsequently sold off its international mining operations, which had been acquired under prior management, then bought out partners in its U.S. mines, giving Cliffs a dominant position in U.S. iron ore mining.
Cliffs then constructed the second U.S.-based hot-briquetted iron (HBI) plant in the U.S. and the only one in the Great Lakes region, close to many steelmaker customers. HBI is a material made from iron ore and used in modern electric arc furnace steel production.
With the late 2019 acquisition of AK Steel, and now the coming acquisition of ArcelorMittal’s U.S. operations, Cliffs will have transformed itself from an international iron ore miner into the largest integrated flat-rolled steel producer in the U.S., ahead of soon-to-be second place Nucor.
The benefits of vertical integration
Cliffs expects $150 million in synergies and for the deal to be EPS accretive. While the transaction will increase Cleveland Cliffs’ gross debt, the combined company’s debt-to-EBITDA ratio will fall from 4.3 to 3.6, and the higher asset base will enhance Cleveland Cliffs’ secured borrowing ability.
More than the raw cost synergies, however, the deal gives Cliffs greater optionality. Before the acquisitions, AK Steel and ArcelorMittal were Cleveland-Cliffs’ biggest customers, leading to some concentration risk for Cliffs. At the same time, while ArcelorMittal does have some iron ore mining operations, both steel companies also had to worry about iron ore pellet supply negotiations every several years. This is especially true since iron ore prices have been higher over the past two years since the Brumadinho dam collapse in Brazil curtailed global iron ore supply beginning in early 2019.
As a much larger company with diverse assets in iron ore mining and metallics, blast furnaces and electric arc furnaces, and downstream finishing and customization, the new company will be able to optimize its assets more efficiently and deliver the kinds of steel that more closely meet market demand. A more efficient company will be necessary, since profits have been elusive for Cleveland-Cliffs, AK Steel, and ArcelorMittal over the past two years.
A bet on U.S. steel demand
AK Steel gave Cliffs large exposure to the U.S. auto industry and the ultra-strength steels needed to meet the needs of upcoming 2025 U.S. CAFE fuel standards. ArcelorMittal’s U.S. operations will augment that auto exposure and provide exposure to additional end markets including distributors and converters as well as energy, mining, water, and chemicals.
These end markets would get a boost from U.S. infrastructure spending, or any further legislation that incentivizes increased usage of U.S.-made steel. Fortunately, that looks likely to be the case no matter the political environment. The recent USMCA trade agreement with Mexico and Canada stipulates that 70% of the steel content in U.S.-made automobiles come from North America, and also requires strict labor and wage standards that should, in theory, push more buying to U.S. steelmakers. Meanwhile, Democratic presidential nominee Joe Biden’s economic plan contains an “America First” provision designed to invest in American manufacturing and infrastructure, which could be an added boost for domestic steelmakers.
A better house on a questionable block
Goncalves’ gambit will look brilliant if the American steel industry rises from the recent industrial recession, or if U.S. policies deliver their intended effect on domestic manufacturing. However, this cyclical stock will still depend on how the overall economy recovers from the COVID-19 downturn. Most analysts seemed to agree Cliffs is a better-positioned company from the acquisition, and the stock soared on the day of the announcement. Therefore, investors should certainly put Cleveland Cliffs on their “recovery watch list” in the wake of the transformative deal.
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Billy Duberstein has the following options: short January 2021 $4 puts on Cleveland-Cliffs. His clients may own shares of the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.