DJ Cleveland-Cliffs Should Sell Parts of AK Steel. That Would Get Investors Excited. -- Barrons.com

By Al Root

Cleveland-Cliffs is making a transformation deal, proposing to buy AK Steel. It is vertical integration in an old industry with iron ore -- a steelmaking raw material -- buying a finished-steel producer. It is a bold proposal.

Investors, however, aren't sure it is a good idea. Since the deal was announced early this month, Cliffs stock is up 9 cents, or about 1%, trailing the 2.4% gain of the S&P 500 over the same span. But if Cliffs can pull off another deal after buying AK (ticker: AKS), Wall Street might fall in love with Cliffs CEO Lourenco Goncalves, as well as Cliffs stock. It would involve selling some of AK's assets.

Steel is a technologically advanced industry. That may sound surprising, given the struggles steel stocks have had from time to time. But the industry is always adopting new chemistries to improve steel properties and adopting new technologies to drive down costs.

The largest U.S. steel producer, Nucor (NUE), was built, essentially, on the back of a new technology: the electric arc furnace, or EAF. Those furnaces, which mainly remelt scrap metal, have been around for a century, but Nucor took the technology mainstream. Nucor, short for Nuclear Corporation of America, wasn't a steel company to start. But under CEO Ken Iverson, it started up its first EAF -- also called a minimill because of its size relative to other steel making processes -- in 1969.

The EAF has come to dominate the U.S. steelmaking landscape. The American Iron and Steel Institute reports that two-thirds of steel making capacity the U.S. is now EAF-based.

(Don't forget, Steel Dynamics (STLD), another large, EAF-based steel producer was founded by former Nucor employees.)

Andrew Carnegie just might approve. After all, the man associated with the birth of the modern steel industry and founder of United States Steel (X) adopted new steelmaking technologies back in his day, at the end of the 19th century -- technologies such as newer blast furnaces, which make pig iron, and open-hearth furnaces.

EAF growth has been fueled by a curious fact about America. The U.S. is the Saudi Arabia of scrap metal. It is the largest producer, consumer and exporter of scrap steel in the world, according to the United States Geological Survey, or USGS.

The U.S. dominates scrap steel similar to how Saudi Arabian Oil Co. (2222. Saudi Arabia) -- more commonly called Aramco -- dominates in oil. Aramco, which just sold shares to the public and achieved a market value of more than $2 trillion, has more than 50 years of oil reported in its reserves, based on current production rates.

That doesn't mean there is an Aramco of scrap metal coming soon. Scrap metal isn't as valuable -- or as widely used -- as crude oil. Scrap steel can be had for roughly 10 cents a pound, cheaper than nice dirt. Gasoline is worth, again roughly, about 50 cents a pound. The U.S. consumes about 1 billion tons of oil annually and about 100 million tons of scrap metal.

The main supply of scrap is from used cars. That is a big reason the U.S. is big in scrap. America has a lot of vehicles on the road, more than 260 million.

All that scrap gave Nucor a big advantage. When the company was growing rapidly in the latter half of the 20th century, scrap was plentiful and cheap, trading at a discount to other metallics -- such as pig iron made from iron ore and coke, a processed form of coal.

As EAF production grew, the excess scrap was used up, raising the price of scrap metal relative to products such as pig iron. That dynamic is creating a new opportunity: "merchant" pig iron. Merchant is industry jargon meaning third party sales. EAF production is still growing, Even U.S. Steel is adopting EAF technology. As minimill production grows, more merchant pig iron will be demanded by steel producers.

What's more, pig iron is a purer form of metal, without impurities such as copper that can come with some grades of scrap steel, and enables EAFs to produce higher-quality steel products without higher cost.

This is the opportunity Cleveland-Cliffs CEO Goncalves sees by acquiring AK Steel and restarting its blast furnace.

Cliffs (CLF) has always been a steel supplier and its business has been a relatively stable, if not high growth, iron-ore business. U.S. blast furnace based steel production is down from all time highs, but U.S. iron ore produced around the Great Lakes is insulated, to some extent, from seaborne ore markets. It is difficult to ship foreign ore down the St. Lawrence rivers and into the Lakes.

Investors may be nervous about steel production, but Cliffs will remain a supplier, selling ore and pig iron.

To allay investor concerns, Concalves could sell the downstream steelmaking operations of AK to, say, U.S. Steel. That would mean consolidation in the finishing end of the steel industry -- the rolling operations that produce finished steel products. That could boost margins for U.S. Steel by giving the company greater market share.

Such an idea was floated earlier this year by longtime steel analyst, formerly of Goldman Sachs and Macquarie, Aldo Mazzaferro, when analyzing U.S. Steel's situation. He theorized U.S. Steel could stop making steel. But instead of an end to the company, he saw the merchant pig iron opportunity and his analysis recognized the best returns for U.S. Steel might be in the early stages of steel production. U.S. Steel also has company-owned iron ore ranges around the Great Lakes.

Asked whether U.S. Steel could take on AK's downstream assets, a Wall Street steel analyst said that "U.S. Steel would have to raise more capital." That could be problematic. U.S. Steel's balance sheet is stretched. But another company such as AreclorMittal (MT) taking an interest in AK could accomplish the same goal. "Pig iron demand is growing with EAF capacity ramping. I think [merchant pig is] the best use of North American pellet excess supply."

A U.S. Steel representative said: "We continuously evaluate opportunities to grow our market share in strategic end markets and generate value for our employees, customers and stockholders." Cleveland Cliffs didn't return a request for comment.

It isn't clear a deal like this could pass antitrust muster. But the steel industry is relatively small -- and volatile -- and better industry structure for the domestic steel business could be a compelling reason to let it happen.

Wall Street seemed to recognize the potential of the AK-Cliffs tie-up. Mostly, however, analysts including J .P. Morgan's Michael Gambardella upgraded embattled AK Steel to the equivalent of Hold. If Cliffs can pull off another transformational deal, this time selling some assets, the Street will warm up to the steel sector again.

Write to Al Root at allen.root@dowjones.com

(END) Dow Jones Newswires

December 19, 2019 15:00 ET (20:00 GMT)

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