What does the deal between ArcelorMittal and Cleveland-Cliffs mean?

The leader is out of the running for the number one producer. Instead, efficiency is a new priority

In late September, ArcelorMittal and Cleveland-Cliffs entered into a definitive agreement according to which Cleveland-Cliffs will acquire 100% of the shares in ArcelorMittal USA. Six steel mills, eight finishing plants, two iron ore mining and pelletizing facilities and three coal and cokemaking facilities will also come under Cliffs’ control as part of this deal. The transaction is expected to close by the end of 2020, once it is approved by the regulators.

Few doubted that the 2020 year will bring a new leader in the steel industry. Last year, ArcelorMittal with its 97.3 million tons was close to losing its world leadership. Number two was the Baowu Group. The difference in their production results was as little as 1.8 million tons. As COVID-19 made ArcelorMittal idle some of its facilities worldwide, and China keeps breaking production records, Baowu is quite likely to become ‘the new king’ by the end of this year anyway. However, the sale of the US assets de facto means that ArcelorMittal is not going to struggle for retaining its top position in the world’s largest steelmakers ranking.

There was a time when the ‘number one’ status made a difference. In the mid-2000s, when the steel market was rapidly growing, companies competed for mergers to expand their influence and take the leadership. It is exactly because Lakshmi Mittal wanted to be number one, Ukraine managed to sell Kryvorizhstal at a really good profit. At that time, Arcelor and Mittal Steel jacked the price up 2.5 times, to $4.8 billion.

Times have changed. Today, the race for volumes brings no additional advantage. The market is suffering from a long-term recession and excess capacity. Corporate strategies tend to target not growth, but higher sustainability, efficiency, return per unit.

Leadership turned out to be a burden in such conditions. In 2019, number one in production volumes meant number 74 in EBITDA margin and number 42 in net debt to EBITDA (4.1) among 85 public steelmaking companies.

One could say that the company is now facing the consequences of its aggressive M&A policy in the early and mid-2000s. ArcelorMittal’s assets in the US were concentrated in the period from late 1990s to 2004. Today, these assets’ annual capacity is 20.3 million tons of steel, 90% of which is produced by the conventional BF-BOF route. These plants were built in the 1960s–1970s and need investment. According to the mass media, the Company’s assets in the US can hardly boast of high efficiency and have been losing out to more modern EAF mills. They also face difficulties in logistics in the finished products segment. The mass media also point out the great influence of trade unions on these companies’ activities, which made it difficult for them to optimize costs. ArcelorMittal USA’s capacity utilization rate in 2019 was only 60% against the industry-average 80% in the US.

The purchase of Italian bankrupt Ilva and Indian Essar hardly made ArcelorMittal any stronger. This is another proof of the fact that M&A transactions in the steel industry bring more benefit to sellers than buyers. These assets looked like a growth opportunity. But in the time of crisis, they turned out to be more of a burden. In May, the Company had to raise additional capital — a pretty expensive one. It issued shares for the amount of $0.75 billion and convertible bonds for the amount of $1.25 billion with a 5.5% coupon.

ArcelorMittal had to make a choice and sacrifice something for the sake of maintaining competitiveness and sustainability. In July, ArcelorMittal announced its business restructuring plan aimed at mitigating the consequences of the COVID-19 pandemic and raising up to $2 billion as a result of sale of its assets. That was an absolutely reasonable step.

And the Company chose to sacrifice its US assets. Importantly, according to Citibank, ArcelorMittal’s assets in Canada and Mexico are more efficient than its US business and brought the Company $95 per ton of steel in 2018–2019 compared to $60 per ton of steel in the US. According to the mass media, the Company started considering the sale of ArcelorMittal USA back a year ago.

However, ArcelorMittal actually did not just disposed of its assets, but rather exchanged them for a stock in the already integrated business in which it will get 16% of shares. The Company will get only $500 million in cash. But what is more important is that the transaction will enable it to deconsolidate (remove) a debt of $2 million off its balance sheet.

The value of the deal, including ArcelorMittal USA’s debt, will amount to about $3.3 billion. In its press release about the opportunities opened by this deal, the Company wrote that the transaction valuation for ArcelorMittal USA equates to an EV/EBITDA multiple of approximately 6x through-the-cycle, based on an average annual EBITDA from 2017 to 2019. This is higher than the industry-average 5x. And it is especially impressive in such a hard time for the industry.

But the price is not sky high at all if we look at how much Cleveland-Cliffs paid per ton of steelmaking capacities, namely $162 per ton. That is 6 times less than the cost of construction of new EAF facilities (around $1,000 per ton). While the value of the deal includes the debt, it excludes the cost of other assets covered by the deal (iron ore mining, coal mining). That means that the price paid for the mining & metals assets was even lower.

The terms of the deal seem favorable for the buyer. In addition, obsolete and inefficient assets should not be a problem for Cleveland-Cliffs. An integrated model is supposed to let the Company sufficiently utilize these assets even when the market is down. For Cleveland-Cliffs, it is important to get a stable sales market as ArcelorMittal USA was its largest client accounting for around 50% of its sales. The client’s problems are the seller’s problems too. So, it is not improbable that for Cleveland-Cliffs, it was impossible to stay aside. ArcelorMittal’s decision to sell its US assets simply left no choice for Cleveland-Cliffs.

This is the second similar M&A deal for Cleveland-Cliffs over the past 12 months. In March this year, the Company purchased another large US steelmaker, AK Steel. The reason for the deal was the same, i.e. keep a troubled large buyer that accounted for some 30% of the Company’s sales. In a word, Cleveland-Cliffs is now the second largest steel producer in the US and a happy owner of bad assets. However, an integrated model can give the Company a chance to boost sales and complete with smaller and more effective EAF mills.

The shareholders of both Companies believe that the deal is a success. The shares of both the seller and the purchaser grew by more than 10% in the first days after the deal. The only party unhappy with the deal is the creditors. Moody’s placed all ratings of Cleveland-Cliffs on review for downgrade.

Another interesting aspect is that the deal was announced right before the presidential election, which creates some risks for the purchaser. Earlier, the market players expressed their concerned about the future import duties on steel in case the Democratic candidate wins. On the other hand, the large-scale protectionism has fragmented the world market so badly that giving up this system is already virtually impossible.

In conclusion, I would like to point out that the deal is an important milestone for the whole industry. The leader is out of the running for the number one producer. Instead, efficiency is a new priority. The iron ore producer is changing its business model completely and is entering the steel market. Perhaps what we see in the US today is the future format of the steelmaking industry. Integrated mills are losing out to flexible EAF mills, especially in the context of the path towards the sustainable development goals. Integrated iron & steel companies need vertical integration as much as suppliers of iron ore the demand for which will be under pressure in the long-term perspective.

The article is also posted here.