Is U.S. Steel an Arbitrage Play?

The rumor mills are running hot as U.S. Steel (X) bashfully solicits proposals from potential suitors like a debutante.

So far, the famed steel-maker rebuffed offers from Cleveland Cliffs (CLF), which offered roughly $32.53 per share in cash and equity.

Esmark pulled its $35 per share offer, saying it respected the United Steel Workers, who want CLF to come out on top.

Right now, the stock trades just below $31. 

So, is there a way to make money on this play?

U.S. Steel’s Business

One of the oldest company’s in the U.S., U.S. Steel started back in 1901 from its famed investors Andrew Carnegie, Elbert H. Gary, Charles M. Schwab, and J.P. Morgan.

Today, the company operates one of the world’s largest flat-rolled and tubular steel operations. However, they also manufacture downstream products.

U.S. Steel segments its business into the following areas:

• Flat-Rolled (55% of total revenues) – Think hot-rolled coil sheets, cold-rolled sheets, and a bunch of other sheet-like products. These are the bread and butter of their operations.
• Mini Mill (23% of total revenues) – Through their majority-owned subsidiary Big River Steel, this segment focuses on hot-rolled coils and downstream products.
• Tubular (13% of total revenues) – Here we’ve got seamless and electric resistance welded steel casing and tubing, standard and line pipe, and mechanical tubing.
• Other Businesses (9% of total revenues) – This is where they get eclectic, with mining operations, railroad services, and even a sprinkle of real estate and engineering services.

Inflation can be good and bad for U.S. Steel.

Raw materials and energy costs certainly eat into their bottom line. However, they can raise prices for their end customers to offset those issues.

That’s why revenues and margins have done so well since the pandemic but have started to slow, as they can’t pass along as many price increases.

The chart below highlights the unusual dynamic between U.S. Steel’s share price and that of hot-rolled steel futures (a near-end state product).

Source: Tradingview

Like oil refiners, U.S. Steel’s profitability relies on the spread between its input costs, which are driven by inflation, and its realized sales prices, which are driven by demand.

Financials

Source: Stock Analysis

Steel production ground to a halt during Covid before immediately rebounding.

Today, U.S. Steel sales are at their highest levels, but not because of volume. It’s all price-driven.

In 2019, the company shipped 95.5 million net tons, while in 2023, it yielded 82.3 million for the same period.

However, demand will remain strong as infrastructure projects dot the U.S. landscape. This should keep gross margins healthy and help them improve from their current levels.

Interestingly, the company holds very little debt, making any potential sale fairly clean.

Valuation

Source: Stock Analysis

On a valuation basis, U.S. Steel looks ridiculously cheap, whether you’re talking about price-to-earnings or price-to-cash flow. 

And the forward-looking price-to-cash flow is only 4.9x – still inexpensive.

All its peers trade at fairly low price-to-cash valuations, though all except Olympic Steel (ZEUS) trade at higher price-to-cash flow multiples.

Growth

Source: Seeking Alpha

All the steel companies saw sales pull back in 2022-2023. And most expect that to continue through the year.

And across the board, all have seen margins compress from their highs.

This is normal at this point in the economic cycle.

Profitability

Source: Seeking Alpha

Regarding margins, U.S. Steel isn’t at the top, but it’s not at the bottom either.

It is odd to see CLF with such poor margins since they’re one of the top bidders for U.S. Steel.

Our Opinion 7/10

We believe the downside for U.S. Steel is limited, and there should be a deal in the near future with anywhere from 5%-10% upside.

That said, we wouldn’t be buyers of CLF ahead of that deal.

If anything, we like U.S. Steel if you can get shares around $30.

But keep in mind that if the deal falls through, the stock will likely drop back down to $22-$24.

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