Iron ore miner
Cleveland-Cliffs
shocked the steel establishment with a surprise all-stock buyout of
AK Steel.
The move has AK Steel shares up this morning while Cliffs shares are tumbling, down more than 12% in midday trading.
Untangling the logic of the deal will take some time and requires a dive into raw material markets and the nature of steelmaking. For now, investors are panning the deal. The combined value of both firms is lower than it was before the deal was announced. One plus one is equaling less than two for these steel-based companies.
First, the details. AK Steel (ticker: AKS) shareholders will receive 0.4 shares of Cleveland-Cliffs (CLF) for each AK share held. That works out to about $2.95 per AK share, a small premium over the $2.89, based on Monday closing prices. AK Steel stock is up about 5% to $3.04 a share, above the value of the Cliffs bid.
Cliffs stock is down for two reasons. The first is technical. When an all-stock deal is announced, merger arbitrage investors will sell the buyer’s share—Cliffs in this instance—and buy the target’s stock, locking in a spread, a profit earned if the deal closes as originally envisioned.
The merger-arb aspect of this deal, however, isn’t why Cliffs share are down a lot. Cliffs investors were happy owning iron ore capacity, but aren’t very happy to be owning steelmaking capacity. Iron ore margins, over time, have been better than margins for U.S. steel producers. The deal creates a far more complicated company with a more complex profit margin structure.
It gets more complicated still. AK Steel is a customer of Cliffs, and that means part of Cliffs’ profit was derived from AK Steel. Now both companies are slated to become one, so AK Steel’s costs go down—in theory. AK doesn’t have to pay a spread above Cliff cost for iron ore any longer. That pushes up AK earnings, but it reduces iron ore profits—again, in theory. The profitability of the overall entity isn’t changed when a supplier buys a customer.
Cliffs says it earns $30 to $40 per ton of iron ore pellets shipped to AK Steel in the merger presentation available on the company’s website. What’s more, the presentation says the combined companies have a more competitive cost structure by having captive iron ore supply. But the majority of the U.S. steel industry has captive iron ore. And the supplier-buying-customer paradox still exists. AK Steel margins are more competitive at the expense of Cliff profits.
The deal’s cost synergies will approach $120 million in savings a year, according to the companies. Management said synergies come mainly from eliminating duplicate costs and cutting administrative expenses. AK Steel will also forego some closure costs because the steel producer won’t have to close a blast furnace. Now AK has access to lower-cost raw materials. That is, again, predicated on the supplier-customer paradox. What’s more, additional pig iron supply isn’t good for overall industry pricing.
United States Steel
(X) shares, for instance, are down 5.3% in Tuesday trading, far worse than declines of the overall market.
The deal benefits are far from certain. And there is financial leverage to consider too.
The deal is all-stock because both companies have a lot of debt. The combined enterprise value of both firms—the debt plus market capitalization—is about $8 billion. The combined market cap of both firms is less than $4 billion. More than half of the total firm accrues to debtholders. More debt means, at minimum, the stock reactions will be more violent than comparable deals with less financial leverage.
The deal might make strategic sense in the long run, but based on the initial reaction of markets, management of both companies have some convincing to do.
Management defended the deal on a conference call, saying the deal was accretive to per-share earnings. “This transaction truly creates a best-in-class company,” said Cliffs CEO Lourenco Goncalves. “The nature of our two businesses allows Cliffs to maximize the potential of our differentiated iron ore assets while building upon the key strengths and resolving the weaknesses that remain.” Weaknesses like high-cost ore for AK Steel.
Cliffs, responding to questions, said it has no intention of subsidizing AK’s profit though low-cost iron ore. But analysts sounded skeptical, asking many questions about synergies and ore pricing. The Street isn’t buying the deal’s benefits yet.
This merger comes at an interesting time for the industry. Steel stocks are down a lot from all-time highs and the industry is seeking ongoing protection from foreign producers. The industry has a point. China makes about half of the 1.8 billion metric tons of steel made annually—more than it needs for its internal consumption. What’s more, most of the steel capacity is government-owned. It wasn’t financed with private market funds.
The last time steel mergers picked up was more than a decade ago, when Chinese demand for steel was ramping up and China wasn’t exporting as much product. Back then, China’s insatiable demand for steel products pushed up raw material costs raising the value of U.S. firms—like Cliffs—that operated existing iron ore assets. Cleveland-Cliffs stock’s all-time high is more than $100 a share, set back in 2008 before the financial crisis hit.
AK Steel stock is up about 35% year to date after rising almost 47% over the past three months, better than the comparable gains of the
S&P 500
and
Dow Jones Industrial Average
over the same span. It has been a wild ride for steel investors as tariffs and demand have whipsawed steel prices. Despite the recent rally, AK Steel stock is still down 7% over the past 12 months. Cleveland-Cliffs shares are down about 4% year to date.
Write to Al Root at [email protected]
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