Cabot Turnaround Letter Issue: May 29, 2024

Make Mad Merger Arb Money on this Manufacturer

About 10 years ago, when I moved from being strictly a commodity supply, demand, and price forecaster into the weird, wild world of equity analysis, I wasn’t quite sure what to expect. On the one hand, the job was essentially the same – to determine either near-term or long-term directionality, depending on the focus. But on the other hand, now I had to take risk into account.

Because what was at stake was no longer just a series of numbers on a piece of paper – a series that, mind you, I could adjust in a month if reality does not comply with my modeling. Instead, my parent company was making recommendations to readers based on my analysis, which added a fiduciary duty that does not sit particularly well with the “agnostic” approach taken by most market analysts. Fortunately for me, I was just starting to write a commodity-focused newsletter with acclaimed natural resources investor Rick Rule, then of Sprott Global. And in our first real conversation as colleagues, he fed me a version of his oft-repeated line, “The natural resources space is inherently cyclical. And in these markets, either you are a contrarian or you will be a victim.”

Wise words always, but especially so with commodities, and inherently visible on charts like the one below that I showed you last week to illustrate the effect COVID had on markets:

On the left side, we see an absolutely enormous move of up to 200%, 300%, even almost 800% for some commodities, followed by equally enormous moves on the right side of 50%, 75%, even 85% back DOWN in the other direction. If you are unfortunate enough to hold a related stock through the entirety of the business cycle, that is what we call “round tripping,” a practice generally best avoided if possible.

Though I can’t say Rick’s quip about being a contrarian is particularly original – personally, I prefer Warren Buffett’s “be fearful when others are greedy, and be greedy when others are fearful” – it is particularly prescient with regard to its application. After all, at its core, being a contrarian is the soul of the Cabot Turnaround Letter. And to that end, a pronounced focus on new executive leadership, activist campaigns, bankruptcies, spinoffs, and deals have been the primary feeding grounds for ideas throughout its existence.

But as a former artist (well, of the musical variety anyway) I always like to try and add some color to the palette, so to speak. Last month, I did so by introducing cyclicality to our typical set of turnaround criteria. This month, I think it might be an especially opportune time to talk about merger arbitrage.

Je Suis un Arbitrageur

As Joel Greenblatt explained in his fantastic book So You Want to Be a Stock Market Genius – often referred to in my circles as the “Bible of special situations” – “Risk (or merger) arbitrage is the business of buying stock in a company that is subject to an announced merger or takeover. Contrary to popular belief (fostered by the exploits of the most infamous arbitrageur Ivan Boesky, and numerous other trading scandals), risk arbitrage generally involves the purchase of a stock after a merger announcement is already made.”

Think about it like this…Company A buys Company B for $50 a share. Prior to the news release, Company B was at $25 per share, and afterwards, rose to $48. To paraphrase Greenblatt again (seriously, read that book), the risk arbitrageur is just a fancy name for the guy who buys the shares at $48 and tries to pick up the last $2 per share.

Now, you might be correctly asking yourself, “What could go wrong?”

And the answer to that is…well, a lot.

Greenblatt recounts the story of the Harcourt Brace Jovanovich/Florida Cypress Gardens merger that was undermined – literally – by a sinkhole. And the Combined Insurance/Ryan Insurance Group deal that culminated in 80-year old W. Clement Stone almost refusing to relinquish his CEO throne to a much younger Pat Ryan, full-on Succession-style.

So, it’s fair to say that sizing up a merger arb opportunity requires more than just garden variety equity analysis. In his famous letter to Berkshire Hathaway shareholders in 1988, Warren Buffett laid out four questions to answer regarding arbitrage situations:

1. How likely is it that the promised event will indeed occur?
2. How long will your money be tied up?
3. What chance is there that something still better will transpire – a competing takeover bid, for example?
4. What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

In most cases, I must admit these are exceedingly difficult ideas to assess. But occasionally something falls into my lap where I not only have some expertise and perspective, but also a defensible view of how #4 – which is by far the most difficult to determine – plays out.

And the pending acquisition of American industrial stalwart US Steel (X) by Japanese industrial stalwart Nippon Steel (5401.JP) – both former clients harkening back to my days at Wood Mackenzie – is just one such situation.

Purchase RECOMMENDATION

United States Steel Corporation (X)

600 Grant Street
Pittsburgh, PA 15219
https://www.ussteel.com/

Symbol: X
Market Cap: $8.07 billion
Category: Mid Cap
Business: Industrials
Revenues (2024e): $16.64 Billion
Earnings (2024e): $721 Million
5/24/24 Price: $35.91
52-Week Range: $20.40-50.20
Dividend Yield: 0.56%
Price target: $55

Background: Some Ancient History

The steel industry in the United States has always been entrepreneurial in nature and replete with personalities. Even by the mid-1700s, the iron furnaces that had cropped up on the east coast – located as to take advantage of forests to make charcoal to reduce local bog iron – placed our fledgling nation as the world’s third largest iron producer after Sweden and Russia. By 1840, iron production had moved from the coasts closer to sources of coal, the coke made from which had replaced charcoal as the reductant of choice due to its higher crushing strength (and therefore scalability).

The Lackawanna Valley in Pennsylvania – rich in anthracite coal and iron deposits – was one of the first areas to adopt and scale the new production method. The Scranton Brothers founded the Lackawanna Steel Company in Slocum’s Hollow (now Scranton, obviously), establishing a local iron forge that used the newer and more productive “hot air blast” technique developed in Scotland rather than the traditional Cementation process.

By the mid-1800s, the Bessemer process had emerged as the most scalable technology. After learning about the process on a trip to Europe, famous industrialist Andrew Carnegie sought to capitalize on it. In 1875, he established the Edgar Thomson Steel Works – named after Pennsylvania Railroad President J. Edgar Thomson – along the Monongahela River east of Pittsburgh in Braddock, Pennsylvania. That plant, which is still active today, forms one of the core holdings of United States Steel Corporation (X). And its upcoming transformation is one of the company’s key investment theses.

Background: Some Recent History

Although production and productivity have been the secret to success for the bulk of the industry’s history, another theme has recently emerged as a driving force in industry valuations – so-called “green steel”. The goal there is to further transition away from carbon-intensive forms of steel production – such as the traditional “blast furnace” (BF) operations described above – and move more toward zero-carbon manufacturing methodologies such as electric arc furnaces (EAF), which recycle scrap steel into new material.

In recent years, valuations for modern, “greener” steel companies have significantly outweighed those of their traditional counterparts, though that has evolved a bit since COVID as steel prices soared and companies bought back shares.

But because of that dynamic, US Steel made an enormous bet on transitioning its own operations, acquiring 50% of the EAF mega-project Big River Steel in 2019 for $700M, then bought the remaining 50% for $774M less than two years later. When completed in 2024, the second EAF facility will bring total production capacity to over 6 million tons per year and award US Steel the flexibility to slow down or shut blast furnace capacity elsewhere.

Eyeing that growth and potential, the country’s largest flat-rolled steel producer and supplier of iron ore Cleveland-Cliffs (CLF) – led by magnanimous Brazilian Lourenco Goncalves – made an offer to purchase US Steel for $35 per share (a 54% premium at the time) in a 50/50 split of cash and CLF shares in early August of last year. That set off a bidding war that saw incrementally better offers from Esmark ($35/share all in cash), CLF again ($38.64 in shares and cash), ArcelorMittal and Stelco (in the $40-42 range), and CLF yet again ($47.31 in shares and cash) before finally settling on an all-cash offer from Nippon Steel at $55.

Not one to be outdone, Cliffs’ colorful leader Goncalves – who once famously berated an analyst (and my college classmate!) on an earnings call – has actively tried to scuttle the deal, currying favor from politicians and the steelworkers’ union, and putting out press releases with titles like “You Have No Path to Close”. And for what it’s worth, both Presidential candidates and the broader market have agreed, with share prices falling from ~$50 all the way back to the Friday 5/24/24 closing price of $35.91.

Analysis: Outlining the Opportunity

The outrage is, in a word, dumb. Japan is an ally to the United States and therefore poses no genuine national security risk. The operational concerns voiced by the union are equally without merit. In fact, Nippon would be more likely to increase domestic steel production to optimize global shipping logistics and thereby reduce Scope 3 carbon emissions. In turn, that would keep the US Steel blast furnaces and coke ovens open longer than planned under current company leadership and ensure those union jobs remain.

Moreover, the alternative – a CLF acquisition – would never pass antitrust scrutiny as it would give a single company control of 100% of blast furnace production in the United States.

Therefore, I suspect there are two likely outcomes. Either the deal goes through and shareholders, who have already overwhelmingly approved the merger, get paid a 53% premium to the 5/24/24 price, or nothing happens, and US Steel continues its path toward a greener future that comes with both production growth and a much higher multiple.

So, with that in mind, the time has come to be contrarians and take the other side of the bet. As such, let’s revisit Warren Buffett’s merger arb criteria to evaluate the risk:

1. How likely is it that the promised event will indeed occur?
   
   1. Let’s be honest – it’s probably a coin flip.
2. How long will your money be tied up?
   
   1. If approved, I suspect it would be during Congress’ lame duck session after the election.
      
   2. If it fails, then until the company’s Big River Steel 2 project ramps up to full production, by 2025.
3. What chance is there that something still better will transpire – a competing takeover bid, for example?
   
   1. Quite good, as there has already been a bidding war.
4. What will happen if the event does not take place because of antitrust action, financing glitches, etc.?
   
   1. US Steel retains ownership, nothing changes, and Big River Steel 2 comes online, adding another 3 million tons of production and increasing earnings by ~30-40%.

To be frank, I don’t see many win-win opportunities like this come across my desk. But as with everything, success lies in the execution, so let’s look at how best to get in and get out.

Entry and Exit Strategies:

The company’s share price has corrected back close to CLF’s initial offer price of $35 per share. This level has some support, given it approximately matches the prior cycle high at the outset of the Russia-Ukraine War. Moreover, from a technical standpoint it has nearly hit its bottom Bollinger Band, and its Relative Strength Index is in hugely oversold territory at 40, approaching prior cycle lows around 34. As such, it looks like an excellent contrarian value at current prices.

However, as I explained last week, to ensure the best possible average purchase price, I usually prefer to divide any intended position into equally sized, evenly spaced good-til-cancelled (GTC) limit orders all the way back down to the most recent lows. In this case, I don’t think we’re going to see the $20 level again, so I would probably size up a quarter to half-sized position over the next few months, and set limit orders for the remainder at $32.50, $30.00, and $27.50, which roughly corresponds to the 50% retracement of the stock’s post-COVID run.

Prices for the underlying commodity (hot-rolled coil, pictured below) are incredibly cyclical, with seasonal price movements hitting a peak in March or April and a trough around October. Given that the merger has become a political football, I think this allows us to be patient with an initial entry, simply buying a few basis points on down days over a few months.

If the deal is approved, we will exit the holding upon completion of the deal. Alternatively, we will exit when we get twin tailwinds from both the commodity cycle and the company’s expansion, which should be priced in within 12 months.

We recommend the purchase of United States Steel Corporation (X) shares with a $55 price target.

Ratings Changes

Finally, we are moving shares of Western Digital (WD) from BUY to HOLD. The turnaround is moving close to Bruce’s original price target of $78 per share, and we think it is prudent to wait and watch from here. Technology stocks I suspect will have a solid summer as they tend to benefit from inflationary environments where consumer spending is increasing. Shares of the company have beaten the broader market by almost 2x over the investment period, with WDC generating a 94% total return since our October 2020 recommendation versus a 51% total return for the S&P 500. We will continue to monitor prices over the coming weeks and alert you in the event they hit our price targets.

However, if you would prefer to lock in some profits today instead of holding the entire position, that is perfectly reasonable. Depending on your comfort level, that can be accomplished either by selling a percentage of shares (25-50%) or applying a trailing stop of 10-20%.

You can find more details by visiting our website at cabotwealth.com.

The chief analyst of the Cabot Turnaround Letter does not yet personally hold shares of every company on the Current Recommendations List, but that will change over time subject to the following guidelines. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may currently hold and may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap¹ ($1 billion - $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:

1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes spin-off value of BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.

The next Cabot Turnaround Letter will be published on June 26, 2024.

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