NISTF - United States Steel Surges As Nippon Swoops In And Seals The Deal

2023-12-18 18:06:36 ET

Summary

• United States Steel Corporation shares spiked by 26% after news of its acquisition by Nippon Steel Corporation in an all-cash deal.
• The deal, valued at $14.1 billion on an equity value basis, opens the door to further growth for Nippon Steel.
• The transaction is expensive, but potentially accretive to cash flows, and there may be opportunities for synergies between the two companies.

December 18th ended up being a fantastic day for shareholders of United States Steel Corporation ( X ). Shares of the company spiked, and as of this writing, they are up about 26%. This increase was driven by news that the company had agreed to be acquired by a larger competitor, Nippon Steel Corporation ( NISTF , NPSCY), in an all-cash deal. Those following the goings-on associated with United States Steel have been expecting a transaction to be announced any time now. But the size of the deal far surpassed what most had in mind, myself included. In addition to this, the buyer in question also is a major surprise.

This is obviously a positive development as far as owners of United States Steel shares should be concerned. As for Nippon Steel, the answer to the question of whether the deal makes sense is still somewhat up in the air. The transaction is certainly pricey. However, it does open the door to further growth for the company. And while the transaction is expensive on a relative basis, it's not exactly expensive on an absolute one.

One big question would be what kind of synergies, if any, can be captured from the deal. The management teams of both businesses have been mostly silent on that issue. But there does seem to be a bit of potential as far as synergies go.

A big move at last

Just the other day, on December 14th, I published an article involving rumors that had been circulating about a buyout of United States Steel. In that article, I rated the company a "strong buy" because, in addition to shares being cheap, I felt that the probability of a transaction occurring was incredibly high.

However, since the highest price that had been discussed in the rumor mill had been $45 per share, I felt that $45 was probably the high end that we would be likely to see. In the back of my mind, I did kick around the possibility of $50 per share, but I believed that such a scenario was quite improbable. In that article, I also made the argument that the two companies that were most likely to buy United States Steel were ArcelorMittal ( MT ) and Steel Dynamics ( STLD ), both for different reasons.

While I ended up being correct about the buyout, both my price and the suitor that ended up winning the deal were areas that I was sorely wrong on. The actual buyer was a company that many did not believe to even be in contention for the crown. And that is Nippon Steel. Furthermore, the price was far higher than what I think anybody anticipated, with Nippon Steel and United States Steel alternately settling on $55 per share in an all-cash bid. This translates to a price of about $14.1 billion on an equity value basis, and $14.9 billion on an enterprise value basis.

The primary purpose of this article is really to explain whether or not this transaction makes sense for Nippon Steel. However, it would be helpful to briefly dispense with whether or not it makes sense for shareholders of United States Steel. Using current forecasts, one offered up by management and the other by my own estimates, United States Steel should generate around $1.88 billion of adjusted operating cash flow and $2.06 billion of EBITDA this year. This is down from $3.58 billion and $4.15 billion, respectively, generated in 2022.

In the chart above, you can see how the buyout price values the company using these metrics for 2023 and 2022. Naturally, shares do look much more expensive on a forward basis because of the decline in profitability. For a discussion of a change in profitability for United States Steel, I would refer you to my original article from August, when Cleveland-Cliffs ( CLF ) offered to buy the firm for $32.53 per share.

In the next table above, you can see the multiples, using a trailing 12 month basis, for the five firms that I believed were possible buyout candidates for United States Steel based on the rumors that had been circulating. On a price to operating cash flow basis, they were trading at multiples of between 3.1 and 14.2. Four of the five companies ended up being cheaper than what United States Steel is being bought out at. Using the EV to EBITDA approach, we end up with a much narrower range of between 3.6 and 7.3. In this case, once again, four of the five companies are cheaper than our prospect. In my view, this alone goes a long way toward assuring investors of United States Steel that they are getting a solid price for the business.

Moving on to Nippon Steel, the answer is much less certain. In the chart above, you can see how its shares are priced using data from the 2023 fiscal year and the 2024 fiscal year that management has reported data for the first half of. Clearly, shares of the business are far cheaper by comparison. If this were an all-stock deal or a stock-heavy deal, I would be quite pessimistic. But the fact that it's all-cash in nature, which will include debt and a tax shield associated with whatever interest is paid, makes me much more open to looking at this and viewing it in a favorable light.

We don't yet know the terms of the debt, but if we assume a 6% interest rate, and a 21% tax rate, then the company should still bring in at least $1.2 billion of operating cash flow from United States Steel per annum. That pushes the price to operating cash flow multiple up to 12.3 while keeping the EV to EBITDA multiple unchanged. But at the end of the day, the transaction still ends up being highly accretive to the cash flows generated by the acquirer.

From a purely financial perspective, only time will tell exactly how this deal will work out for Nippon Steel. Unfortunately, the management teams of both firms have not been the most open about the transaction. For instance, Nippon Steel did go on to say that there will be synergies from the transaction. And these will largely be associated with bringing together the advanced production technologies that both firms have and operational know-how. But no estimates have been provided as to how large these synergies could become.

I do think that there is some opportunity for synergies to be captured, as the table above illustrates. This shows, on a trailing 12 month basis, the net profit margin, adjusted operating cash flow margin, EBITDA margin, return on assets, and return on equity, of each of the two companies involved in the deal. Given the price paid for United States Steel, I would have liked to have seen higher margins achieved by Nippon Steel. But even capturing a 1% improvement in profitability margins should bring in around $182.5 million of additional profits to the company from the acquired assets on an annual basis.

Outside of the financial picture, an argument can be made that this is a good purchase for Nippon Steel. Management has been working hard on growing the company, with the strategic goal of eventually increasing global crude steel production capacity to over 100 million tons per annum, with everything outside of its domestic capacity expected to grow to over 60 million tons per annum. From 2014 to the end of the 2022 fiscal year in March of this year, management managed to increase global production capacity from 58 million tons to 66 million tons. This came at a time when domestic production dropped from 52 million tons to 47 million tons, but as overseas production managed to increase from 6 million tons to 19 million tons. In aggregate, just shy of 7 million tons of production capacity per annum that is created by the company is done so in the U.S. market, with much of that centered around steel sheets. This is all in addition to 4 million units of crankshafts that the company produces under a subsidiary called International Crankshaft.

Also, for those concerned about whether or not management has the ability to integrate such a large business, it's important to note that Nippon Steel has long been in the business of acquiring assets. It has made purchases of other firms from time to time, including deals in 2006, 2011, 2014, 2018, 2019, and 2022.

Once this deal is completed, it should result in Nippon Steel’s production capacity climbing from 66 million tons per annum to 86 million tons. It will especially solidify the company's position in the U.S., which is a market where the firm sees strong demand for the kind of high-grade steel that United States Steel is so accustomed to producing. Examples of this high-grade steel include automotive sheets and electrical steel sheets. When it comes to research and development efforts, it will be interesting to see what the management team at Nippon Steel ultimately does.

I say this because, even through the present day, all of its research and development operations have been located in Japan. But management has expressed interest in establishing research and development facilities in other markets. And right now, United States Steel has facilities in Pennsylvania, Michigan, and Texas. It also has a facility located in Slovakia. Of course, this could also be an area of cost cutting if management is serious about boosting margins.

Takeaway

As things stand, I think it would be very interesting to see what happens with Nippon Steel in the future. From a purely operational perspective, this transaction makes a lot of sense for it and its shareholders. From a financial perspective, that remains to be seen, and it would be determined by a number of factors, including how efficient the management team at Nippon Steel is about cutting costs, the terms of the debt that it needs to take on in order to make the transaction occur, market conditions, and so much more.

I definitely wouldn't say that it's a bad deal at this time. Though it certainly is a pricey one. Despite this, I do have a enough optimism in the company, because of its long term track record and because of how cheap shares are, to rate it a soft "buy."

As for United States Steel, I am incredibly happy with my own decision to purchase units of the business some time ago. As of this writing, the stock is at $49.27. This implies an additional 11.6% of upside between now and when the deal closes. That is expected to be in the second or third quarter of next year. Some of this disparity is driven by the time value of money. But a lot of it is likely due to uncertainty about whether the deal will be approved from a regulatory perspective and ultimately consummated or not.

The management teams at both firms believe that there will not be any major regulatory issues at play. Obviously, this is something we will have to watch. But even if the deal were to fall through, I think there is a decent chance that another buyer could step in and pick up United States Steel at a price that is high enough to result in little to no downside from where the stock currently is trading for.

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