Steel/Meme type Pokemon, I choose you! Algoma Steel $ASTL and Cleveland Cliffs $CLF

A Fintwit Favorites Series

Algoma Steel (ASTL) is a Canada domiciled steel mill undergoing a transformation to electric arc furnace technology.  These new electric arc furnaces are expected to come online toward the end of 2024, but won’t be ramped up to full capacity until the end of 2025, and in the meanwhile the old coking blast furnaces will continue to keep output stable.  Electric arc furnaces are used to smelt recycled steel using electricity from the grid instead of using coking coal to create virgin steel from iron ore.  Currently about 60% of global steel production is recycled scrap, and the remaining 40% is new virgin steel.

The attraction on FinTwit over ASTL and for this new technology is twofold, first since the electricity can come from the grid, and the environmentalists are working tirelessly to make the grid operate on the wind and sun, there is the possibility of making “green” steel which could theoretically fetch a higher price.  The environmental movement generally and the “green” products specifically seem to be in something of a retreat since the rise in interest rates.  Inefficient boondoggles really do seem to be a zero interest rate policy (ZIRP) phenomenon.  But secondly, electricity is significantly cheaper than coking coal, so the profit margin might expand dramatically at least at first until the electric arc furnace space becomes crowded and pushes steel prices down.  Beyond profitability, the predictability of profit margins could improve drastically as steel scrap and finished steel prices are more closely related than finished steel and iron ore and coking coal prices. 

In the case of ASTL, the transition to electric arc furnaces is also an expansion, and as Canada’s only steel plate mill, they could capture up to an additional 40% of the steel plate market in Canada which is currently imported from the rest of the world.  By being “green” steel, the Canadian government, especially under Trudeau, might be heavy handed in placing import tariffs or prohibitions on dirty, high CO2 steel.  Of course the Canadian government could also change, but it appears that protectionism and reshoring is on the rise whether environmental or otherwise.

The attraction for me is that I am lacking exposure to industrials due to two factors, first industrials have idiosyncratic barriers to analysis, the products are mostly B2B, highly differentiated, and with unknown substitutability.  Is your flange really irreplaceable or will your largest customer with 35% of sales go to a competitor?  Secondly, valuations for industrials never really feel cheap as a sector.  Steel bypasses both of these problems in that the output is mostly a commodity although with a bit of differentiation, and the valuations are always cheap.  The main problem is that there is almost no hope of a sustainable multiple rerating.  

Algoma steel only went public in 2021, so there is not a large amount of price data:

But take a look at their midcap competitor also investing in arc furnace technology, Cleveland Cliffs (CLF).

You should notice right away that this is the type of company that has extreme cyclicality, which means that buy and hold is out of the question.  If you want to be in steel mills, you need to have your finger on the sell button waiting for that rare exit opportunity at 8x to 10x the typical baseline price.  Why is the market this irrational?  Why can’t investors see that the profits from steel come once a business cycle in extreme swings?  Who knows, but thank goodness it gives us a chance to ride the wave.

CLF gross profit:

The reason why I say there is little hope of a sustained multiple rerating is that professional fund managers have ESG mandates, and while it appears at first glance that steel could be “green,” and it is true that these windmills and solar panels use an incredible amount of steel, the current environmentalist movement is mother goddess cult, and to extract the earth’s minerals is to rape the mother goddess.  As long as the current batch of environmentalists dictate what is “green” and what is not, I believe there is little hope of a multiple rerating ever being achieved by mining or metals industries, no matter how important they are to the same environmentalists’ goals.  It is interesting that due to the artificial intelligence revolution’s power demand, the stance on nuclear has turned on a dime.  However, steel does not appear as critical to silicon valley who seem to really be the masters of the universe regarding public opinion.

With a multiple rerating off the table, ASTL would be purchased for future cash flows only, and of course the chance of a massive price spike once every ten to fifteen years or so.

Well, what would those future cash flows be?  ASTL shipped 2.3 million tons of steel in 2022 and 2.0 million tons of steel in 2023.  Those shipments resulted in gross profits of 1.5 billion and 389 million Canadian dollars respectively.  ASTL’s theoretical capacity today is 2.8 million tons of steel, and with the electric arc furnace, that number will be 3.7 million tons of steel.  So ASTL has a near term catalyst to increase production by about 25%, with lowered costs, and this can be purchased at a market capitalization of $740 million, or about two thirds of peak gross profit.

Cleveland Cliffs, which owns five iron mines for vertical integration and is also building electric arc furnaces, shipped 16.4 million tons of steel in 2023 and 14.8 million tons of steel in 2022, for a gross profit of $1.39 billion USD and $2.5 billion USD respectively.  Due to fiscal calendar mismatches, CLF’s 2021 peak gross profit of $4.5 billion should be a fair comparison to ASTL’s 2022 peak gross profit of $1.5 billion. Unlike ASTL, CLF is paying down debt and returning capital to shareholders, and has strong insider buying from the CFO and CEO, and can be purchased at a market capitalization of $7 billion, or about 1.5 times peak gross profit in 2021.  So by some measurements, twice as expensive as ASTL, or by others, about 1.3 times as expensive.

If you are a degenerate, ASTL has a lot more torque, being able to go from $389 million to $1.5 billion CAD gross profit with changes in steel prices is a lot of operational leverage.  Add onto that the potential benefits of being a Canadian steel plate monopoly, and some cost reduction and increased volume from the arc furnace coming online, and the stock price could really moon.

If you are a value investor, CLF’s debt paydown from $5.6 billion to $2.9 billion in three years, and their decrease in pension liabilities from $4.2 billion to $586 million in the same three years, while simultaneously shrinking the share count by 14% is damn impressive.  It’s not that CLF is without torque, with a prior market cap peak of $16 billion, a current market cap of $7 billion, a current price of $14.75 and heavy insider buying as high as $20, it could easily provide a 3x the next time the cycle is in favor.   CLF might need another 18 months to 2 years of stable conditions to pay down more debt before ramping up returning more capital to shareholders, in the range of $1 billion to $2 billion annually, and in the meantime it’s a lottery ticket on steel prices, and a whole heap of real assets in an inflationary world.  

One caveat regarding CLF, about a fourth of their steel production goes to the US automotive industry, and I do not have a positive outlook for this industry.  In a future article I will probably write about Havana Syndrome and Advance Auto Parts (AAP) and AutoNation (AN). But bearish US automobiles is not my most strongly held thesis.

If you are a believer in the global commodity supercycle, or the revenge of the old economy, ASTL or CLF could make a fine addition to your strategy.  Would you rather have more risk, uncertainty, a chance to be a monopolist and more torque, or would you rather have capitalists at the helm and a strong vertical integration with a track record or returning capital to shareholders?

I have been siding against the capitalists too many times in these recent articles, so for this instance I would prefer the midcap that could 3x with the insider buying over the small cap that could 5x without insider buying.  There’s enough opportunity without being reckless or greedy. But whatever you choose, this is a stock that you need to watch and keep your finger on the sell trigger, because price spikes are extreme and they come and go as quickly as any meme stonk.