We believe that the value of U.S. Steel’s (NYSE:X) iron ore pellet assets is significantly in excess of the company’s market value, and with activist chatter picking up, the stock could be revalued meaningfully upward in the coming months. An acquisition of X is also increasingly possible given the company’s depressed valuation, strong balance sheet, reversible misallocation of capital and coveted high-grade iron ore assets. An activist induced or voluntary reduction in X’s capital expenditure plans through 2020 could enable the company to repurchase more than 100% of its outstanding shares at the current valuation. 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. We believe that X’s iron ore pellet assets and its Tubular segment alone are worth $24 per share, which ascribes no value to the company’s 22 million net tons of raw steel production capacity.
On April 17, activist chatter was picked up on X following two apocalyptic ratings downgrades by Credit Suisse and Bank of America. The downgrades cited worse than expected domestic steel market conditions, a weak competitive position, and X’s “cash burn” over the next two years driven primarily by a large capital expenditure ramp.
X has a strong liquidity profile, with almost $700 million in cash and no meaningful debt maturities until 2025, and its tangible book value of $23.38 is 49% higher than the company’s current market value. To put this into context, Nucor (NYSE:NUE) trades at a 145% premium to its tangible book value, a multiple that would imply in excess of $57 per share of X. NUE is obviously a superior company to X, with a low-cost footprint of electric arc furnaces (EAF) that process recycled scrap metal into a diverse array of steel products. But X has been quietly transforming its capacity towards more efficient mills, including EAF steelmaking facilities, and its captive low cost iron ore pellet operations support a more competitive cost structure for its integrated facilities than the market realizes. In fact, X’s EBITDA margins are within spitting distance from those of NUE. In the first quarter, for example, X’s adjusted EBITDA margins were 8.1%, just 3.6% lower than NUE’s EBITDA margins. We believe that X’s primary competitive advantage revolves around its captive high-grade iron ore pellet assets in the United States.
X’s Undervalued Iron Ore Pellet and Tubular Assets
Minnesota’s iron ore operations have production capacity of approximately 40 million tons of high-grade iron ore pellets annually, which comprises approximately 75% of total iron ore production in the United States. 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. In 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 United States, 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 enterprise value is $4.6 billion versus $4.4 billion for all of 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 (NYSE:VALE) 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 its first quarter 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 these 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 high-grade pellet deficit environment.
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 $300 per ton while oil prices went parabolic. Since then, however, tubular margins have plunged. While X’s Tubular segment is finally improving from the doldrums and recently turned profitable, its 2018 gross margins in this division were just 1%. In the first quarter of 2019, Tubular segment sales were $343 million, up 29% year-over-year. More importantly, gross margins in the Tubular segment increased to 7% in the quarter. If X’s Tubular segment gross margins in 2019 were to improve to 15%, matching those of its Flat-Rolled and USSE segments in 2018, it would yield well over $200 million in additional EBITDA for the company relative to last year. The market is likely valuing X’s Tubular segment at virtually nothing given its lack of cash flow in recent years. Assuming a 15% gross margin, adjusted EBITDA margins for the Tubular segment would rise 8 points from the first quarter run rate. If the Tubular segment maintains 29% sales growth in 2019 and an 8.5X EV/EBITDA multiple (we would argue that this multiple is appropriate given the segment is far from its cycle peak) is applied to our projected segment EBITDA, X's tubular assets alone could potentially be worth almost $11 per X share.
In February 2019, X announced that it will restart construction of the electric arc furnace (EAF) steelmaking facility at its Tubular operations in Fairfield, Alabama and that it will restart the No. 1 Electric-Weld Pipe Mill at its Lone Star Tubular Operations, enabling the company to accelerate its tubular growth beginning in the second half of 2019.
What is the Activist Angle to Unlock Value in X?
The market has hammered X’s share price to 3-year lows for several reasons. While concerns about recent weakness in flat-rolled steel prices, uncertainty about a trade deal resolution with China, and potential sheet oversupply in the United States beginning two years from now have had a profound impact on sentiment, the most significant damage to X’s share price has arguably been a function of spending decisions made by its management team. Such decisions may be reversible if recent rumors of activist involvement prove to be true and external pressure to replace the company's management team, reduce capital expenditures, accelerate share repurchases or sell the entire company is exerted.
In stark contrast to the market’s bearishness on the steel industry, X’s management team believes that it is experiencing a golden era of growth and innovation, as reduced import pressure has allowed domestic steelmakers to invest in their operations. Correspondingly, the company is in the midst of spending $2 billion on an asset revitalization program (ARP), and it recently announced an additional $1.2 billion investment to construct a new sustainable endless casting and rolling facility at its Edgar Thomson Plant in Braddock, Pa., and a cogeneration facility at its Clairton Plant in Clairton, Pa. This equates to in excess of $3 billion in capital expenditures beyond the $500 to $600 million in maintenance capex that X’s facilities require. To put this in perspective, X could repurchase in excess of 100% of its total outstanding shares at the current stock price over the next two years if it were to scrap the ARP and new Pennsylvania facility improvements.
While the company is aggressively repurchasing its stock, a reduction in capex could enable X to take the entire company private at a premium. We acknowledge that a reduction in capex would make X’s steel operations less competitive, but we believe the company's iron ore pellet operations and Tubular segment alone are worth $24 per share, which is comprised of $3.96 billion for X’s iron ore assets (14% lower than CLF’s current enterprise value) and $1.9 billion for its tubular operations, less $1.65 billion of parent company net debt. Hence its nonsensical for X not to divert some of its recently announced capex to accelerated stock buybacks at the current depressed share price.
Apparently, we are not the only investors who believe that X is undervalued. On May 7, X Director Stephen Girsky purchased a small amount of stock in the open market at $16.17. Mr. Girsky was General Motors’ (NYSE: GM) former Vice Chairman and a top senior research analyst for Morgan Stanley covering the Global Automotive and Auto Parts industry, X’s most important end market.
Risk Factors and Conclusion
While it is possible that X does not alter its capex plans and continues to aggressively spend on improving its competitive position, we believe that the risk/reward profile is asymmetrically compelling given the value of X’s assets relative to its current market capitalization and its lack of meaningful debt maturities for the next 6 years. We believe that the stock is akin to a long-term call option with multiple ways to win before meaningful debt maturities approach. A positive trade resolution with China and a near-term improvement in steel prices could be additional upside near-term catalysts. Recent commentary from NUE, Steel Dynamics (NASDAQ:STLD) and CLF on their first quarter earnings calls indicates a recent demand rebound for sheet and optimism about the remainder of 2019. X’s short interest has soared from 17.3 million shares at the end of March to 22.4 million shares, or 13% of the company’s shares outstanding, currently.
While there is a risk that pessimism towards X persists as a result of a depressed steel market, economic weakness, further tensions with China, and a lack of activist intervention to force the company to reduce its capital expenditures, we believe the upside in X’s share price far exceeds the downside. We acknowledge that meaningful capacity is coming onstream in the United States over the next several years, but steel production is being aggressively reduced in China. China has nearly half of the world’s raw steel capacity and has already eliminated more than 150 million tonnes of capacity in the past three years. Last Thursday, China’s economic planner announced that the country will tighten approvals of steel capacity swapping between companies and ban all new steel capacity in any form in order to streamline the sector and reduce pollution. 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. Meanwhile, 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. Further capacity reductions in China could bolster the entire global steel market.
Additionally, it seems that President Trump is focused on moving auto production to the United States from overseas, a development that could be particularly positive for the sheet market and X. At the end of April, for example, President Trump said at a rally that Japanese Prime Minister Shinzo Abe told him Japan is investing $40 billion in new car factories in the United States.
In conclusion, while certain risk factors loom for X, we believe the stock is significantly undervalued and has an easy path to unlock billions of dollars in additional shareholder value by reducing capital expenditures, divesting its Tubular segment and aggressively buying back its stock at current levels. If the recent activist rumors prove true, X’s stock could more than double from current levels. Lastly, VALE’s iron ore production woes could draw attention to X’s high-grade pellet operations from potential acquirers of the company. If X does not accelerate its buyback and help propel its stock towards its intrinsic value, the company could be a sitting duck for a hostile takeover.
Disclosure: I am/we are long X. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.