Cleveland-Cliffs Stock Slumped After AK Steel Buy. Why the Market Is Wrong. – Barrons

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They may have gotten it wrong. In fact, the iron-ore miner may have hit a “home run” on the deal.

Cliffs (ticker: CLF) stock dropped almost 11% Tuesday. Merger partner
AK Steel
(AKS) stock rose 4.3%. The combined value of both companies fell by more than $200 million, or 6.4%, despite plans indicating the deal can yield synergies, or benefits, of $120 million a year.

Usually when companies combine and announce cost savings, investors will make the merged entity worth more than the sum of its parts, effectively giving the new company credit for higher profits in the future. That wasn’t the case Tuesday with the steel deal.

Investors might be worried about higher supply pushing down prices for all U.S. steel producers.

Cliffs and AK management said the deal would mean an AK blast furnace could still produce pig iron, a precursor of steel, because it will have access to low-cost iron ore. Restarting that blast furnace would bring more steel products onto the market.

Some on Wall Street, however, see merit in the deal.

Cliffs “CEO Lourenco Goncalves will lead the combined company, and we think his leadership and commercial capabilities will be a clear positive for” AK, wrote J.P. Morgan analyst Michael Gambardella. He still has some questions about the logic behind the deal, including Cliffs’ decision to move from the relative stability of the iron-ore business to the more volatile steel industry. He rates Cliffs shares the equivalent of Hold and has a $7 price target for the stock.

But he isn’t too worried about the restarting of the AK blast furnace, pointing out that the market for U.S.-produced pig iron could grow as companies add more electric arc furnace, or EAF, steelmaking capacity.

Electric arc furnaces are a lower-cost option for making steel than the traditional blast-furnace method. They generally remelt scrap steel, but pig iron can be substituted for scrap. That enables electric arc steel producers to produce higher-quality products.

Companies such as
Nucor
(NUE) use only EAF technology.
United States Steel
(X) announced recently it was investing in EAF technology, adding it to its older blast-furnace operations.

Gambardella also upgraded shares of AK to the equivalent of Hold Wednesday. He believes the deal will close, saying the risk is low that antitrust issues could derail the transaction, while another bidder for AK isn’t likely to emerge.

Longtime steel analyst Aldo Mazzaferro went further than Gamberdella, saying Cliffs might have hit a “home run” on the deal.

“I think there are tons of synergies to be had between an iron-ore and a steel company,” Mazzaferro told Barron’s. He also sees the potential for AK pig iron to find a home in EAF furnaces, especially since President Donald Trump just put tariffs on slabs of Brazilian steel. Output from U.S.-based EAF furnaces can replace that Brazilian metal, which is turned into finished products by other companies further down the manufacturing chain.

“Cliffs is paying about $450 a ton for the AK capacity—including debt assumption—which we find reasonable.” wrote Mazzaferro in a Tuesday research report. “Taking that stated capacity and actually running it rather than letting it sit idle or at low run rates, will make a great difference in revenue generation from more tons and from the lower costs per ton as the fixed costs are spread over more” volume.

He is positive on Cliffs stock, but doesn’t have a price target.

Steel, as this deal shows, is complicated, with many intermediate products and lots of imports into the U.S. market. The initial reaction of investors was very negative. Maybe investors should rethink the impact of an old, blast furnace-based steel company selling pig iron into the EAF market.

Cleveland-Cliffs shares are down about 2% year to date, far worse than the comparable gains of the
S&P 500
and
Dow Jones Industrial Average.
The stock trades for about 9 times estimated 2020 earnings, a big discount to the overall market. Of course, U.S. steel markets are volatile with little top-line growth.

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

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