Cleveland-Cliffs Decides To Buy AK Steel: Who Is The Real Winner?

In December 2019, Cleveland-Cliffs (NYSE: CLF) announced that it has entered into a $1.1 billion all-stock deal to buy AK Steel. Post the deal closure in the first half of 2020, CLF is likely to hold 68% of the vertically integrated steel company, with AK Steel holding the other 32%. CLF’s stock price dropped about 11% on the deal announcement as the market is not sure about the benefits far outweighing the negatives. The two primary factors in favor of the deal are the $120 million annual reduction in cost due to synergies, and ensuring revenue stability as AK Steel is one of CLF’s largest customers. To see how Cleveland-Cliffs’ revenue is expected to trend following the acquisition, view our interactive dashboard Cleveland-Cliffs’ Revenues: How Does CLF Make Money?

Below, we have tried to enumerate the advantages and challenges of the deal.

A] Advantages

a) Avoiding Loss of Revenue

• AK Steel is the second largest customer of CLF, accounting for about 29% and 25% of CLF’s total revenue in 2017 and 2018, respectively.
• By acquiring AK Steel, CLF would ensure that 25% of its production does not disappear for any reason, mainly a financially weak customer falling prey to a difficult market.
• In the absence of AK Steel buying pellet from CLF, Cleveland-Cliffs’ total revenue base could shrink by 25% to $1.65 billion in 2020, as against the current projection of $2.21 billion.
• This could, in turn, lead to a corresponding drop in net income, with its shares losing more than 25% of its value.

b) Cost Reduction

• The company estimates $120 million annual cost reduction due to synergy benefits.
• As it would have control over 25% of demand for its products, it can alter production to avoid demand-supply mismatch in a better way based on market conditions.
• Even if we account for annual savings of $60-$70 million in 2020, it would still enhance shareholder returns.

B] Challenges

a) Made Losses for Long Time

• AK Steel turned profitable in 2017, with it reporting positive earnings in 2018 as well, and is expected to end 2019 in the green.
• However, this was after the company lost money for eight years in a row (2009 to 2016).
• The steel industry did suffer a prolonged downturn during this period, but AK Steel was the most affected and the last to recover in the steel space.

b) Financially Weak Target

• AK Steel is one of the weakest steel companies in the US.
• AK Steel is a highly leveraged company, with its debt-to-equity ratio of roughly 4.3x being significantly higher than its close peers US Steel (0.6x) and Nucor Steel (0.4x), as of September 30, 2019.
• Additionally, AK Steel’s projected Debt-to-EBITDA leverage ratio for 2019 is 3.3x, which is significantly higher than 1.0x for Nucor Steel. US Steel is the only major steel company which is expected to have a worse debt-to EBITDA ratio of 4.3x in 2019.
• However, US Steel’s leverage ratio deteriorated only recently due to lower profitability as the company is investing more on its asset revitalization program, leading to lower sales. On the contrary, AK Steel has been a highly-leveraged company for a couple of years.

c) Financials Could Deteriorate

• The deal is being signed when the steel industry is still going through an upturn, which is making AK Steel look better than it actually could be.
• As observed in the previous downturn, AK Steel could be the hardest hit in case of another downturn in the steel industry, which could drag CLF along with it.

C] Conclusion

With AK Steel’s stock price having lost about 95% of its value in a decade from its high in 2008, the price that CLF is paying looks cheap. However, looking at the financial position of the target, the deal seems to be a bailout for AK Steel, with its bond holders being the biggest beneficiary as the company’s debt will now be backed by financially stronger CLF. As for Cleveland-Cliffs, the only notable advantage seems to be the 25% of its products’ demand being secured, and the access to AK Steel’s Ashland facility (which is closed currently) which will help CLF explore pig iron manufacturing, along with pellet and hot-briquetted iron.

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