U.S. Steel Debt Ratings Lowered

S&P cites increased debt levels, substantial legacy liabilities, and continued weakness in the steel industry

On May 7, 2003, Standard & Poor's Ratings Services lowered its ratings on integrated steel producer U.S. Steel (X ) and removed them from CreditWatch. The company's corporate credit rating was lowered to 'BB-' from 'BB'. At the same time, Standard & Poor's assigned its 'BB-' rating to the company's proposed $350 million senior notes due 2010. Pittsburgh, Pa.-based U.S. Steel had about $1.8 billion in debt (lease adjusted) at Mar. 31, 2003.

The rating actions reflected U.S. Steel's heightened financial risk resulting from increases in its debt levels and substantial legacy liabilities (pension and retiree medical benefits) and continued weakness in the steel industry. Proceeds from the proposed notes together with borrowings under its bank facilities will be used to acquire substantially all of the assets of National Steel Corp. out of bankruptcy for $1.05 billion, including approximately $200 million of assumed liabilities.

The ratings on U.S. Steel reflect the company's aggressive financial leverage--including its underfunded postretirement benefit obligations--and challenging market conditions, which overshadow its fair liquidity and its improved market share and cost position. The company also benefits from a product mix that is more diverse than that of its competitors. USS is the largest integrated steel company in North America with an estimated 24.7 million tons of capacity, including National's 6.9 million tons and 5 million tons of capacity in the Slovak Republic through its Kosice (USSK) operation. USS reached a new agreement with the steelworkers union, which is expected to be ratified on May 20, 2003, that enables USS to significantly reduce its employee and retiree healthcare expenses through the introduction of variable cost-sharing mechanisms and provides for a workforce reduction of at least 20 percent at both the U. S. Steel and National facilities. In addition, the company expects annual acquisition synergies of at least $200 million within two years of completing the transaction, along with the elimination of legacy costs related to National's postretirement plans, which have not been assumed by U. S. Steel. Additional benefits to USS's market position include National's contribution of value-added products, primarily the automotive sector.

Still, Standard & Poor's is concerned about deteriorating conditions in the North American steel industry caused by the re-emergence of idled steel sheet capacity, softening demand, and the continued high levels of imports that have driven spot selling prices lower. Spot hot rolled sheet prices have fallen to about $270 per ton from $400 per ton in July, 2002, and prices for other steel products have been declining as well. Despite USS's increase in value-added production, it will still be exposed to the volatile spot market, where it will generate about 55% of its revenues.

Conversely, its USSK operations have been realizing higher capacity utilization rates and selling price increases because of more favorable conditions in its Central European markets. USSK's operating costs are much lower than those of the company's U.S.-based facilities mainly because of USSK's low labor costs, but its product mix is less value-added, consisting mostly of commodity hot-rolled sheet steel. Management has increased spending to reduce costs and increase its value-added production, which is contributing to its enhanced performance.

Initially, the National acquisition weakens the company's financial profile, as its total debt (adjusted for operating leases) increases to $2.6 billion from $1.8 billion. Moreover, USS's pension went from an overfunded status of $1.2 billion at year-end 2001 to an underfunded status of $400 million at year-end 2002 and its other postretirement benefits (OPEB) underfunded status declined to $2.6 billion from $1.8 billion, due to revisions to its discount rate and higher medical cost inflation. As a result, the company's pension and OPEB expenses are increasing and affecting the company's profitability levels. Higher natural gas costs are also pressuring the company's margins. These higher costs together with lower steel prices will likely more than offset expected savings from the acquisition in 2003. However, the company should realize increased profitability levels in 2004 as cost savings are expected to accumulate.

Liquidity: In order to preserve its liquidity following the National acquisition, USS will replace its $400 million senior secured revolving credit facility (inventory facility) with a new $600 million senior secured revolving credit facility due 2007, and is increasing its $400 million accounts receivable facility due 2006 to $500 million. Both facilities are subject to a borrowing base. Most financial covenants under the inventory facility will be eliminated, with only a fixed-charge covenant of 1.25x remaining if availability under the facility drops below $100 million. Ultimately, liquidity is expected to be about $1 billion after the close of the acquisition, including cash balances and about $40 million available on a $50 million revolving facility at USSK. The company also has a manageable debt amortization schedule (the bulk of its debt matures after 2007) and no near-term pension funding requirements.

Cash requirements in 2003 will be meaningful and might precipitate some borrowing by USS if market conditions remain challenged. USS estimates it will have cash payments of approximately $150 million in 2003 related to early retirement incentives and other benefits associated with the acquisition. Although capital expenditures are expected to increase in 2004, higher earnings should bolster free cash flows and be used for debt reduction.

Outlook: The outlook is negative. With a majority of its sales to the volatile spot market and currently unfavorable trends in the steel industry, Standard & Poor's is concerned the company's profitability and cash flows could be significantly affected. Should these conditions exceed expected benefits from the acquisition or management take additional steps that forestall improvement to the company's financial profile, ratings will be lowered.

From Standard & Poor's CreditWire