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Stelco Holdings: Abnormal Returns

Listed on the Toronto stock exchange, Stelco Holdings is one of the best-capitalized steel producer in the world, with zero-long term debt — absent pension obligations — and all liabilities covered by current assets. It is also the cheapest steel producer in North America, for it currently trades at 3.5x operating earnings and 5.5x cash earnings.

Based in Ontario, in business since 1910, Stelco’s history is one of repeated booms, busts and comebacks. In 2004, the company declared bankruptcy after years of sustained losses. In 2006, it emerged from court protection under the ownership of a private equity consortium, but was sold to U.S. Steel for $1.1bn the next year. Rebranded as U.S. Steel Canada, it did not survive the difficult period that followed and applied again for court protection in 2014.

In late 2016, Bedrock Industries — a newly formed vehicle by Mr. Alan Kestenbaum and his co-investors of Lindsay Goldberg — acquired the steelmaker for roughly $500mil at face value, or $800 million once taken into consideration various pension and environment commitments over the next two decades. In 2017, Bedrock conducted an IPO at $17 a share, which gave Stelco a market value of about $1.7bn.

In 2018, secondary offerings were completed at $22 per share, lowering Bedrock’s ownership from 85% to 64% of equity capital. The firm subsequently sold another 4% stake on the open market at prices between $23 to $25. In November, Fairfax Financial Holding purchased a 14% stake at a price of $20.5 per share. The same month, Mr. Kestenbaum argued that the company was “drastically undervalued” by financial markets. Why, then, would he — or his co-investors — proceed to offload a sizable part of Bedrock’s stake at such valuation?

A metals entrepreneur often tagged by the press as a turnaround artist, Mr. Kestenbaum merged his first venture Globe Specialty Metals with Grupo FerroAtlantica in a $3.1bn deal, upon which he was appointed executive chairman of the combined group rebranded as FerroGlobe. Alas, things did not turn well there. In 2018, pricing pressures, lower volumes and trade tariffs have sent the stock from $15 to less than $2.

Cyclical, commoditized, highly competitive, capital-intensive and subject to unfair trade practices, the steel industry and the endless hardships it endures need no introduction. If even large-scale, well-diversified players such as U.S. Steel or ArcelorMittal fail to generate decent returns for their shareholders over the full cycle, why should Stelco perform better?

Of course management have their own views to offer. The company is said to own the “newest and one of the most technologically advanced integrated steelmaking facilities in North America“, strategically located near raw materials suppliers and customers, with access to multiple modes of transportation — including naval ones — within the Great Lakes region.

In that respect, management assert that Stelco’s production costs count among the lowest in North America, while margins are expected to expand thanks to higher asset utilization. None of these claims can be verified yet.

As about the consequences of potentially long-lasting U.S. tariffs on Canadian steel, there is, according to Mr. Kestenbaum, nothing to worry about because Stelco will “just shift its business towards the domestic market”. Domestic demand, in effect, could be boosted by declining sales of steel produced in the U.S. as Canada implements tariffs against its southern neighbor.

Given that more steel is shipped to Canada from the U.S than the other way around – sales that should now be deterred by tariffs – Stelco could be poised to benefit from this new paradigm. This is perhaps what caught Prem Watsa’s eye, or whoever runs Fairfax’s portfolio of listed equity investments.

Regardless, beyond the upbeat tone and fairy tales, 2018 was in every respect an outstanding year — if not an outright anomaly — in large part because steel prices jumped to record highs in North America as a direct consequence of tariffs implementation. Stelco, for instance, delivered a 16% net margin — adjusted for some one-time pension remeasurement — and some return on equity north of 70%. In what world does a steel producer consistently achieve such performance, especially without employing leverage?

It should be noted that Mr. Kestenbaum and Mr. Cheney extract high management fees — $7 million in 2018 — despite admitting that they “will not spend their full business time on Stelco matters, and could spend part of their business time pursuing other Bedrock business that competes directly or indirectly with Stelco.”

In a like manner, though certainly much enjoyed by the 74% owner at the time — Bedrock — the $150mil special dividend distributed last summer strikes as inappropriate and self-serving, when a clear path towards growth would have been to take advantage of the good momentum to build reserves and prepare for opportunities.

Stelco isn’t the first dubious equity bet in Fairfax’s portfolio. See for instance BlackBerry, The Bad & The Ugly.

(No position.)

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