Algoma Steel part 2: EAF project, plate mill modernization and steel prices
Algoma Steel part 2: EAF project, plate mill modernization and steel prices
My fondness for Algoma Steel keeps increasing
Here is my first Algoma article.
In the first article, I mostly ignored the EAF(electric arc furnace) transition and many other things, because my argument was that it’s cheap regardless. Reading that article makes me see how little I actually knew about Algoma at the time. I had held the stock about a month before I wrote it and I had not done much DD on it. I certainly do more DD on my stocks now than I did at the time.
Still, Algoma remains an amazing risk/reward opportunity and this is because of their EAF project coupled with their current valuation.
The valuation has not changed much since my previous article, the market cap is a bit higher, but I think this point should say a lot. Their market cap is 1b CAD and their EV is 960m. Their positive working capital(current assets-current liabilities) is 986m. TBH most of that is their unusually humongous inventories of 822m. They are looking to reduce it by 150m CAD. So there's another source of cash flow.
Because this is a steel company the past earnings are not a very good indicator, but let’s say we hold around current steel prices next year(900-1100$ HRC) the forward PE is gonna be around 2-3. And then we have the EAF project commissioning in late 2024 which will make everything better.
I have said in the past that the market would probably value this company higher if they were not doing the EAF. Because if they were not doing it, we would have large buybacks or dividends or both. Now we don’t have that because we need the money to build the EAF, Now we just have a small dividend for candy money, but regardless I think it’s the correct decision to do the EAF and this is giving a very nice window of opportunity for someone who can wait a year or two to buy the very cheaply stock from the impatient.
valuations of EAF producers vs Blast Furnace producers
It’s typical for Blast Furnace producers to have low valuations like Algoma has now(although Algoma is cheap even among them), but because Algoma will go from BF to an EAF producer let’s compare the valuations of companies that use EAF to those using mainly the Blast Furnace method.
Steel Dynamics is 100% EAF They have a similar amount of revenue to US steel(mainly BF).
US steel market cap 7,6b
Steel dynamics market cap 18,5b market cap
Nucor another EAF producer is trading at around 1 P/S like Steel Dynamics.
Then we have another mainly BF producer Cleveland Cliffs. Even though this one is very fancy because it’s “vertically integrated” It’s trading at 0,4 P/S. It has more revenue than Steel Dynamics, but it has only an 8,6b market cap. Algoma is also trading at a P/S of 0,39, but 0,34 EV/S while Cleveland is 0,56 EV/S.
Why am I going on about P/S? Because it shows that one operation of a similar scale is being valued higher than another for some reason. EAF operations are valued higher than the BF ones, because of the many benefits EAF has over BF.
One reason for the higher valuations is the consistent profitability of the EAF producers caused by their lower cost of production for example from 2013-2022 US steel(BF) had 6 years when they were net income negative and another large BF producer ArcelorMittal had 5 net income negative years during the same time period
The EAF producer Nucor had no net income negative years during this time period and steel dynamics had only 1 money losing year which was quite a modest loss.
Market likes the predictability of earnings and EAF provides better predictability and less vulnerability to cyclicaty hence a higher multiple.
Benefits of EAF for Algoma
Source: Algoma Steel Corporate presentation
So there is a long list of benefits in the picture, but the biggest single impact is the steelmaking capacity increase of +32% coupled with these other benefits.
This production increase is also happening while they will have lower fixed costs in general and the employee count will be reduced as EAF requires fewer employees to operate. Higher revenue. Lower costs.
https://nationalpost.com/news/canada/going-green-could-mean-big-job-losses-after-ottawa-pledges-420-million-to-aid-algomas-electric-retrofit
In the article linked above, you can read about the union not liking Algoma’s EAF transition because of the job losses.
Sustaining Capex is lower=higher FCF
In Algoma’s case according to one of their earnings calls their sustaining capex will be reduced by 20 to 30m USD(27-41 CAD) per year.
CO2 emission 70% lower. Great, but what is the financial impact?
They had 12.2m CAD of carbon taxes during the last during the last Q but 7,2m during the last year so I don’t know how it works, but 70% lower emissions I guess it should mean 70% lower carbon taxes so a couple of million$ impact there. If you know the exact monetary impact I would like for you to put it in the comments. Just in general if I didn’t know or mention something important you can put it in the comments.
Also, they are safer in general from the government. Less danger from new climate-related regulations and taxes when they are on the right side of the climate battle. Quite the opposite. The government will be supporting them like they already are with the financing of EAF.
The reduction of emissions will also improve their ESG metrics which means they can access a larger pool of capital as many funds have ESG requirements nowadays about what they can invest in. So this might lead to a higher valuation.
We do not have the exact details on this(at least I haven’t found them) but their SIF loan that gives them access to max 200m is partly forgivable based on emissions performance. So this could have a significant financial impact based on how much exactly could be forgiven.
Source: Algoma Steel Corporate presentation
First, they will use both EAF and Blast furnace and eventually, they will go 100% EAF, but I doubt I will be in this stock at that point when they are 100% EAF. Most of the benefits will be already realized in 2024-2025 time. This is also the time when the massive buybacks return and I assume an increase in dividends because the large capex will be spent.
This exchange from the latest earnings call was shedding light on the transition.
“Ahmad Shaath
Hi, guys.Just a really quick one for me on the EAF project. Did I read that right? The hybrid scenario is not on play anymore and you guys going to start commission on both EAFs, what your thoughts on the on the grid connectivity?
Michael Garcia (CEO)
No, I think hybrid is definitely still in play, but what we mentioned was that we wanted to emphasize that we will be able to match our current output with only running EAFs coal charge and the power that is available today and with the recent decisions by [Indiscernible] and the completion of the system impact study.So there's been a full kind of understanding of the impact of our power demand and the nature of it by the operator of the grid in Ontario. And they've issued some conclusions based on that.However, we still have the optionality to continue to run our blast furnaces and take advantage of hot metal from those blast furnaces at a reduced blast furnace rate to augment our production through the EAFs if we want to increase the total amount of steel produced and again, that'll go back to the economics and how that decision looks from an economic perspective.”
EAF project status
As of q3, they have spent “During the quarter, cumulative investment in the EAF project reached $456 million or 54% of our expected total project cost at the midpoint of our project budget” Quote from q3 call. This is cad btw. So They have around 379m left to spend. They can easily finance this from their cash reserves, liquidation of inventories, and credit available to them even if they only break even next year, which is not likely. They will most likely generate a significant amount of cash from operations.
They have already established a JV with Triple M Metal LP to source scrap from them. They have already “secured contracts for approximately 80% of the forecasted total project expenses, with approximately 95% of these contracts being fixed price agreements” Quote from q3 PR. Because of this, I don’t expect significant upward budget revisions in the future.
Another quote from q3 PR “EAF project, including achieving two important milestones in securing the necessary power supply for our EAFs. First, Ontario’s Independent Electricity System Operator provided further positive indication on connecting our EAFs to the grid. This means we will have access to the power required to operate the EAFs at our current run rate annual business plan range of 2.2 - 2.4 million shippable tons without relying on hot metal. Additionally, the Ontario Government issued an Order in Counsel to accelerate regional power infrastructure upgrades, which provides further comfort that the necessary infrastructure will be in place to meet the long-term power requirements of our EAF project, allowing for increased future EAF production capacity.”
As you can see they are derisking the project from many fronts. I’m not saying that nothing is going to go wrong. But they are reducing that likelihood with these actions. They are predicting commissioning in late 2024.
Any catalyst before EAF commissioning?
Source: Algoma Steel Corporate presentation
We are mostly in waiting mode before that, but there is one. The modernization of the plate mill should increase plate production by 10-15% during the following months and then expand further from there. Their current plate capacity is 350-400kt per year and they are looking to get that to 700kt per year eventually. So that is eventually going to add a couple hundred million of revenue annually.
Steel price thoughts
Other than the plate production increase the success of Algoma in 2024 will be mostly dependent on steel prices. And there are some things that are pointing towards a continued strong market. Like I said earlier if we maintain around current prices 2024 will be very lucrative for Algoma.
Source: FRED
There is kind of a construction boom going on in the US. A lot of this is due to all the fiscal spending that was approved in the US. There was a 1 trillion bipartisan infrastructure passed in 2021. There was the Chips Act that gives 39b of subsidies for chip manufacturing in the US.
Then there was the “Inflation Reduction Act” visualized below
Source: McKinsey&company
I just see more steel demand. Note that “clean energy” is the most steel-intensive kind of energy. I think many people kind of forgot about all of these bills after a while. We also had the UAW strike resolved recently. I would also expect continued strong spending from the O&G sector in the following years which is very steel-intensive.
This could be acquired
It’s interesting before the project is ready the market does not seem to give it any value. Imagine from an acquirer’s perspective. Everyone is transitioning into EAF. Formerly mentioned US Steel, ArcelorMittal, and Cleveland Cliffs are all building EAF capacity. Why not just buy Algoma instead of doing it themselves? Algoma has already spent 456m, locked in most costs, electricity, and scrap supply and you can probably make a bid at 1,5-2b for the whole company. You get over 200m of cash you get over 800m of inventories, and as for debt there are only 120m of low-interest government loans (partly forgivable based on EAF emissions performance) and you get the existing profitable operation which will be improving massively with the plate mill modernization and EAF. Once those are finished could probably make 1 billion a year of FCF in a strong steel price environment. This is an amazing acquisition target. And we just had Cleveland Cliffs bidding for US steel. I don’t know why someone has not already made a bid.
Summary
This is a sit-and-wait until 2024-2025 situation. If it re-rates before that. Then I might exit early. I see very little risk that could make this ultimately a losing investment. I guess a new great depression or something. Maybe some major disasters in their facilities. Unlikely scenarios. It’s already very cheap and it’s making a huge value-adding investment not appreciated by the market. We’ll see what the stock price does. If EAF will be roughly on time and on budget, I doubt I will be sitting here at the end of 2024 telling you how cheap Algoma is at 7.4$ when EAF is ready to go and all of these benefits start to reflect in the financials. I assume quite likely +50-100% by the end of 2024. And for me I’m greedy that is why I have some margin on this stock, although I would not recommend it. There are also warrants which is another option for the greedy people out there. Still, 50-100% in one year is a good return. The greatest investor Warren Buffett did 30% annually during his early years when he achieved his best performance.