Tuesday, August 23, 2022

United States Steel Corporation ($X)

One of the best investment strategies we have found is to look for market prices that imply mutually inconsistent outcomes. You could call these types of situations, "markets that aren't talking to each other." 

In October 2020, we wrote about what we would buy instead of Tesla, pointing out that for the same ~$0.45 trillion market capitalization as Tesla, which gave you $25 billion in annual revenue and no profit (in fact, cash burn), you could buy - in their entirety - a group of eight other high quality companies, which had combined sales of about $400 billion (trading for a much more reasonable 1x revenue) and net income of around $30 billion a year.

While Tesla has appreciated since that October 2020 post so have the undervalued companies to which we compared it. More importantly, it was so overvalued that it was possible to buy the undervalued companies and express the bearish Tesla side of the trade via a relatively small position in long term put options, because they had (and still have) a very asymmetric risk-reward payout.

There are other markets that are not talking to each other. Our Canadian oil majors are trading for less than five times earnings because, supposedly, there is going to be an electric vehicle transition that brings us battery electric vehicles powered by "renewable" (wind and solar) energy.

Well if that is true, we are going to need vast quantities of steel, copper, concrete, and other basic materials. Yet when we look, we find that the investors who espouse this transition have not invested in the production of any of those materials, and shares of those companies are going begging at very low valuations. Professional investors seem to have lost the ability to translate a worldview into a portfolio if it involves natural resources.

An example is United States Steel Corporation, with shares that trade for the same price as they did in October 2003, almost two decades ago. No compounding has happened here. The market capitalization of United States Steel is $5.5 billion, compared with a book value of $10.2 billion and a tangible book value of $8.8 billion. Total liabilities exceed current assets by only $500 million as of June 30th - very little financial leverage. The total enterprise value is around $6 billion.

U.S. Steel earned $900 million on $6.3 billion of sales in the second quarter, and has earned $1.8 billion on $11.5 billion of sales year-to-date. (Trading for 1.6x annualized earnings and 54% of book value.) For the first half of the year, free cash flow has been $2.1 billion, which is an annualized FCF/EV yield of something like 70%.) (Note that sheet steel prices have fallen significantly since the first half of the year, though.)

Just for sake of comparison, the electric vehicle scam company Nikola still has a $2.5 billion market cap and revenue of $20 million (not billion). The 16th largest cryptocurrency by market capitalization ("TRON") has a bigger market capitalization than U.S. Steel.

It is particularly interesting to see this undervaluation in an industry besides coal or oil. That means it's not just the "energy transition" or fossil fuel divestment. (In fact, those themes should be bullish for steel demand.) Over the past 15 years, couldn't go wrong buying a "compounder," couldn't go right buying a "cyclical."

Company Background
In 2020 U. S. Steel was the third largest steel producer in the United States and the thirty-eighth largest steel producer in the world. During 2021 they had raw steel production capability of 26.2 million net tons (21.2 million tons in North America and 5.0 million tons in Europe). U. S. Steel has four reportable segments: North American Flat-Rolled, Mini Mill, U. S. Steel Europe (USSE), and Tubular Products.

The Flat-Rolled segment consists of U. S. Steel’s integrated steel plants other U.S. operations involved in the production of slabs, strip mill plates, sheets and tin mill products, as well as all iron ore and coke production facilities in the United States. These operations primarily serve North American customers in the automotive, appliance, construction, container, transportation and service center markets. During 2021, Flat-Rolled had aggregate annual raw steel production capability of 17.0 million tons and production was 9.9 million tons.

The Mini Mill segment consists of U. S. Steel's Big River Steel facility and a new mill under construction in Osceola, Arkansas. It produces hot-rolled, cold-rolled, and coated sheets and electrical steel, serving North American customers in the automotive, appliance, construction, container, transportation, and service center markets. Mini Mill has aggregate annual raw steel production capability of 3.3 million tons at the Big River Steel facility and produced 2.7 million tons in 2021.

The European (USSE) segment consists of U. S. Steel KoŇ°ice (USSK), U. S. Steel’s integrated steel plant and coke production facilities in Slovakia. It conducts its business mainly in Central and Western Europe and primarily serves customers in the European transportation (including automotive), construction, container, appliance, electrical, service center, conversion and oil, gas and petrochemical markets. USSE produces and sells slabs, strip mill plate, sheet, tin mill products and spiral welded pipe. It has annual raw steel production capability of 5.0 million tons and produced 4.9 million tons in 2021.

The Tubular segment produces and sells seamless and electric resistance welded (ERW) steel casing and tubing (commonly known as OCTG), and standard and line pipe and mechanical tubing, and primarily serves customers in the oil, gas and, petrochemical markets. It has annual raw steel production capability of 900 thousand tons and produced 464 thousand tons in 2021.

The biggest and most profitable segment is flat-rolled, with $6.9 billion of sales year-to-date and $1.3 billion of EBIT. The next most profitable is mini mill, which has earned $550 million on $1.8 billion of sales. The European operation earned $540 million on $2.6 billion of sales. Tubular is high margin but a small contributor to sales and earnings.

Competitors of U.S. Steel include other integrated producers, which use iron ore and coke as the primary raw materials for steel production, electric arc furnace (EAF) producers, which use steel scrap as raw materials, and slab re-rollers, who purchase mostly imported, but some domestic, semi-finished products and convert them into sheet products. The EAF producers typically require lower capital expenditures for construction and operation of facilities and may have lower total employment costs; however, these competitive advantages may be minimized or eliminated by the cost of scrap when scrap prices are high. 

In January 2021, U.S. Steel acquired Big River Steel, which increased their annual raw steel production capability by 3.3 million net tons. In addition, they began construction on a non-grain oriented (NGO) electrical steel line at Big River Steel in August 2021, a $450 million investment. The 200,000 ton NGO electrical steel line is expected to deliver first coil in September 2023 and be available to meet the growing electric vehicle demand expected in North America. In January 2022, they announced Osceola, Arkansas as the site of a new highly sustainable and technologically advanced steel mini mill, which is expected to have 3 million tons per year of EAF steelmaking capability.

The average realized price of flat rolled and mini mill steels for U.S. Steel YTD was about $1,350/ton, while the current price of sheet steel is under $800/ton. That level is more like the 1H of 2021 when the average realized price for U.S. Steel's flat-rolled was under $1,000. Segment earnings for 1H 2021 were only $725 million as opposed to $1.3 billion the first half of this year. So, be prepared for Q3 2022 earnings to be lower than recent quarters.

Historically (e.g. past decade) U.S. Steel has not been all that profitable. The market price of X basically implies that this spike in steel prices and company profits will be short lived. (And the spike in steel prices was truly anomalous.) But the question is, how can that be true if we are going to have a renewable energy and electric vehicle transition that requires vast quantities of basic materials?

Further, what if some old economy industries are going to experience durably higher profits because of reductions in capacity? Nobody ever thought that refineries and sawmills were going to sustain these levels of profitability. Crack spreads are now much higher than they used to be. Lumber prices are much higher than they used to be, while sawlog prices have barely changed. The same thing happened with airlines.


CP said...

Something else to consider - if there is ever a reactionary / restorationist government in the U.S., it would undoubtedly decide to re-industrialize the country and de-offshore industrial production. That would mean a U.S. steel boom, and companies like U.S. Steel would print money.

But, the 2022 midterm election prospects look bad because of the SC decision on abortion and because of Biden's massive "emergency" release of crude oil from the SPR.

CP said...

Regarding CLF:

When Cleveland-Cliffs acquired AK Steel in March of 2020, AK Steel, as a stand-alone company, was ready to walk away from electrical steel. It was ready to shut down Butler Works in Pennsylvania. Butler Works produces electrical steel, a type of steel used to make transformers. If AK Steel had done that as a stand-alone company, today the U.S. would not be able to produce any grain-oriented electrical steel for transformers or nonoriented electrical steel, among several other things. That was the scenario that I inherited at Cleveland-Cliffs, as far as electrical steel goes, when we acquired AK Steel. Then, I made the decision not to shut down Butler Works, and now Cleveland-Cliffs is the only producer of grain-oriented steel products in the U.S.

Note that U.S. Steel is expanding into this area:

Integrated steelmaker US Steel will build a 200,000 short ton (st)/yr non-grain oriented (NGO) electrical steel line at its electric arc furnace (EAF) minimill steelmaking operations in Arkansas. The $450mn investment at Osceola-based Big River Steel, which US Steel acquired at the beginning of the year, will target the electric vehicle (EV) industry. The facility will be built next to Big River Steel's finishing line and is expected to be online by the third quarter of 2023, according to an investor presentation.

Anonymous said...

CP excellent point on the industrialization of the US, my bet it will happen in a big way.

Beg to differ on the abortion noise will allow they Dems to soften the Red Wave, the only way the Dems win is if they cheat, Don't believe for a second that in NY Hudson Valley special election Ryan the Dem won becasue of abortion, Molinaro is a Trump hating, tax raising, wear your mask and get your shot or die Republican and he still almost won, that race is no bell weather.

CP said...

It's concerning how much X is spending on expansion.

Not sure that we can find capital expenditure discipline in the steel industry.