Algoma Steel: Macros Aside, Cannot Be Ignored At This Level (NASDAQ:ASTL)

BUSINESS

Algoma Steel (NASDAQ:ASTL) is a fully integrated steel producer of hot and cold rolled steel products including coiled sheet and plate. It has a current raw steel production capacity of 2.8Mt with incremental 0.9Mt from an idle blast furnace. Auto and manufacturing industry combined account for 65-70% of sales. 63% of revenues comes from the US and 65% of cost is in USD.

Sheet Steel (85% volume): Wide variety of widths, gauges, and grades available either unprocessed or with value-added processing such as temper rolling, cold rolled in both full-hard and annealed, hot-rolled pickled and oiled products, floor plate and cut-to-length products. Main end users are auto, structural product manufacturers and the light manufacturing and transportation industries. Value-added applications represent c. 45% of total steel volume.

Plate Steel (350-400Kt – 15% volume): Carbon-manganese, high-strength, low-alloy grades that are produced is as rolled, hot-rolled and heat-treated. Main end users are the fabrication industry, which uses plate products in the construction or manufacture of railcars, buildings, bridges, off-highway equipment, storage tanks, ships, armoured products for military, pipelines, and wind turbines.

The largest input cost in the steel-making prices is iron ore, which ASTL purchases under supply contracts with Cliffs and US Steel. ASTL’s iron ore needs are at 3.5Mt. The Cliffs iron ore contract was first negotiated in 2002 and been amended and extended on a number of occasions. Current contract (May-13) provides for the supply of iron ore though 2024. In 2020, ASTL secured Ana additional LT iron ore agreement with US Steel which also is due in 2024. ASTL will renegotiate contracts post 2024, since the addition of the EAF furnace reduces iron ore requirements.

ASTL is located close to key steel consuming regions of the US (Midwest and Northwest Canada, South Ontario) with 70% of customers located within a 500-mile radius. Access to well-established rail links and multiple forms of transportation supports competitive rates and protects the business from the competition. Post restricting, ASTL re-established ownership control of the Port of Algoma to receive critical inbound raw materials and facilitate outbound shipment of finished goods. Port faculty enables access to low-cost water transportation across the Great Lakes.

The new EAF project will add 0.7Mt finished steel capacity aligning steelmaking capacity to rolling capacity. The new furnace will eliminate coal as an input, reduce reliance on volatile iron ore merit, add operational flexibility, lower fixed costs, and reduce capex requirements. ASTL generates half of scrap requirements internally and the balance is purchased from third parties, primarily from regional sources where the Company has a pricing advantage.

MARKET

North American steel pricing is largely dependent on global supply and demand, the level of steel imports into North America, economic conditions, global steelmaking overcapacity and raw material costs. Global steel production was c. 1951Mt in 2021 with China representing 53%.

ASTL competes against numerous foreign and domestic steel producers based on the delivered price of finished products. EAF producers typically require lower capex for construction and maintenance of facilities, and usually have lower total employment cost. These advantages though, could be eliminated when scrap prices are high.

Freight cost often makes it uneconomic for distant steel producers to compete but a combination of lower labour, raw material and energy cost could make distant producers competitive. Government subsidies (e.g. China) could also increase competition from distant players.

ASTL is the only integrated steel producer in North America to operate a DSPC hot strip mill coupling integrated continuous casting with hot rolling directly into coil. The DSPC line is among the newest, continuous thin slab casters in North America. Management believes that this process provides cost advantages over traditional integrated hot rolling manufacturing process. Current annualised production capacity of the DSPC is 2.3MT.

ASTL is also the only discrete plate producer in Canada with current capacity of 350-400Kt and a potential to increase capacity to 600Kt upon completion of plate modernisation program to de-bottleneck and further automate production.

Blast Furnace No.6, with current capacity of 900Kt of liquid iron, provides ASTL flexibility to manage any future re-lines for Blast Furnace No.7 as well as respond to shortages in prime scrap availability once the EAF transformation is complete. Blast Furnace No.6 can be re-started in 6 months for an estimated cost of C$60m according to management.

The Company plays a critical role to the local economy since it represents 40% of Salt Set. Marie’s GDP directly or indirectly employs 70% of Algoma’s population. Moreover, the modernisation of the plate manufacturing process is expected to significantly reduce Canada’s reliance on pace imports and positively impact the Country’s trade balance in plate products. That position allows the company to receive support from federal and provincial government such as low-interest loans and grants. Part of the strategic relationship, allowed the company to restructure its pension obligations, capping contributions (cash funding inanition to the current service funding) at C$31m per year. In Mar-21, ASTL achieved a solvency funded status, which substantially reduced pension contributions.

Overall, ASTL’s strategic position lowers incoming raw material transportation costs as well as lower marine outbound costs of finished products. Grate Lake proves access to lower cost modes of transportation since 70% of customers are located within a 500-mile radius.

CAPITAL ALLOCATION

EAF Project: In Nov-21, ASTL’s board authorised Algoma to construct two new EAFs to replace its existing blast furnace steelmaking operations. EAF facility will be built adjacent to the current steel shop and will utilise existing downstream equipment and facilities. The project will cost $704m of which $163m has been spent already (Sep-22). According to the budget the remaining amount will be allocated 8%, 60% and 32% in FY22, FY23 and FY24 accordingly. Construction is expected to be finished by 2024. The deal will be partially financed by a C$420m Federal Government loan. The C$220 will be provided by Canada’s Infrastructure Bank (CIB) on commercial terms (Low-interest) and remaining C$200m by Canada’s Strategic Innovation fund (SIF) with annual repayments that commence once the final project is complete and Algoma has access to grid power supporting full production.

Tender Offer: In Jun-22, BoD approved a tender offer using a modified Dutch Action to purchase its common shares and aggregate value of the share repurchase of $400m. Shareholders who chose to participate could individually select the price within a range of not less than $8.75 and not more than $10.25 per share. The offer was completed and 41m share at a weighted average of C$9.11 ($7.33) per share were purchased for cancelation (28% of outstanding shares). Share buyback, mitigated the dilution effect from the outstanding options a reduced the diluted number to 103.8m. The Company funded the purchase from its cash balance.

RISKS & CONCERNS

China: Substantial increase of global steel capacity, particularly in China, could over supply the market and put pressure on steel prices. Moreover, a significant slowdown in domestic Chinese growth could result in surplus steel being exported to world markets. Historically, steel manufactures in Canada and the US, have been affected by dumbing from foreign production at marginal cost driven by political and economic policies. China is the wild card here. The country is on the verge of a real estate crash that could send shockwaves across the globe. Definitely a situation to be monitored closely.

Cyclicality: It’s a cyclical industry after all. It’s not the first time I see such low multiples in the steel industry hence I am not particularly excited about that. Steel companies obviously over-earned during a very favourable period powered by significant tailwinds such as high energy prices, supply chain challenges and supply constraints.

Energy Cost: ASTL has an advantage in power sourcing through an on-site low-cost power generation facility which is power by blast furnace and coke over gases. The co-generation facility provides on average 49% of power needs at favourable prices reducing reliance on the Ontario power grid. The Company covers all remaining power needs with natural gas from independent suppliers at market pricing and occasionally uses hedges. No hedges in place as at FY-end which is kind of a risky approach…

Contractual Obligations: Purchase obligations represent 72% of the total contractual obligations and comprised of contracts to purchase raw materials. The Company enters into such contracts on an ongoing basis to secure factorable prices and supply consistency. 58% of these contracts mature in less than one year with 24% and 17% in year 2 and year 3, respectively.

Shareholders: Post restructuring, debt funds such as Contrarian, Bain Capital and loan star remain invested in the company. Worth noting that these are not shareholder friendly funds and should be monitored closely. However we also see some value investors holding shares.

CEO Change: M.McQuare, the former CEO, retired and was replaced by M.Garcia. M.Garcia was appointed as a CEO in Jun-22. His career spans senior executive roles in numerous well-regarded companies such as Alcoa, Gerdau Ameristeel, Evraz and Domtar. R.Marwah (CFO) joined OpCO in 2008 as FPA analyst and became CFO in 2014.

INVESTMENT THESIS

It is always tricky to value cyclicals while the EAF transition adds further complexity in our valuation exercise. We should feel relatively comfortable that in a normal year, ASTL should ship c. 2.0-2.2Mt (Utilisation @ 80%). I am not concerned about next year or so but on average that should be the sales driver. The first challenge is to determine the EBITDA pet ton that the business can generate on an normalise basis. In the last 4 quarters, ASTL went from C$827m per ton (3Q22) down to C$191m per ton (2Q23). It should be obvious that the business was over-earning due to high steel prices.

Algoma is the only integrated steel producer with 2.3Mt Direct Strip Production Complex (DSPC), which is the newest the slab caster with direct hot rolling capability, in North America. That position provided a C$30-40 per ton cost advantage, according to the management.

Based on various reports and comps analysis, I’m getting that a C$100-110m EBITDA per ton should be on the conservative side. Taking into consideration the cost benefits from the DSPC, Algoma should be able to generate C$120-130m EBITDA per ton going forward. Hence, let’s call it C$230-250m normalised EBITDA. We don’t calculate EBITDA based on margin but worth noting that the global steel industry has a 10-year average EBITDA% of 8-10%. Very interested to hear your views since it is probably the most important part of the thesis.

Interest is not significant at this stage, but we should expect an increase given the EAF project financing. Debt cost should be low given the state involvement hence let’s call it 3-4% (previous government loans @ 2.5%) on C$500-600m in total. That gives C$15-25m interest cost in 2-3 years. Tax rate at 24% should do the job. Current interest cost looks significant but is mainly due to some PIK interest and two post restructuring TL facilities at L+8.5% and L+5% respectively (Fully repaid).

ASTL should have lower maintenance capex requirements going forward, given that EAF is less capital intensive, but let’s put it at C$100m to be conservative. Last but not least, ASTL has c. C$15-20m pension cash expense. That makes as C$100-120m in normalised FCF. Conservative assumptions though could understate case flow potential but I would be happy to be positively surprised. Worth remembering that steel companies could burn cash in a downturn.

“underlying order book, supported by a significant portion of contract sales, will keep demand for our products consistent with our expectations, including sales to the automotive, construction, oil and gas and other steel-intensive industries”

“the published forward curve for hot-rolled coil currently shows prices rising modestly from now through next summer, albeit at levels well below what we have realised the last few quarters” – 2Q23 Earnings Call

Restructuring, unfavourable market, minimal sell-side coverage and transition has defiantly created some interesting dynamics, translated into share price pressure. I think the trap here is to look at it as a net cash company given the significant investment program ahead. At this level ($6.1 per share), ASTL should offer at least 50-60% upside to a patient investor, which is not insignificant, but that comes with some risks. Low production cost, strategic location and the importance to the local economy mitigate some of these risks.

“When we consider the operational impacts in the quarter, namely the plate mill, conveyor outage and DSPC labor issues, we estimate there is a $130 million drag on EBITDA” – 2Q23 Earnings Call