Why Oil and Steel Don't Mix


By Alan Hughes The story is a staple of the tabloid newspapers. Doctors spend hours in the operating room trying to separate Siamese twins, grafting here, reconstructing there, in a desperate effort to make sure each child has the best possible chance of leading a healthy life after the surgery. The worried parents pace the waiting room, hoping everything will work out.

That's something like the current situation for USX Corp., the parent company of U.S. Steel Group (X) and Marathon Group (MRO), which are represented by separate tracking stocks. An ugly environment for the steel industry is squeezing both US Steel and Marathon, an oil and natural-gas exploration and production company. Many unhappy Marathon shareholders are clamoring for the two companies to be separated. They may get their wish soon enough, with a possible announcement early this quarter. But how can a split be structured to satisfy shareholders of both divisions?

HEAVY DEBT. One option rumored to be under consideration would involve Marathon paying US Steel a $400 million to $800 million dividend to compensate for a likely reduction in US Steel's credit rating. US Steel could use the cash to help pay down some of its heavy debt load, which totaled $2.2 billion at the end of 2000, vs. $902 million a year earlier. Debt jumped because the company acquired European steel producers and the tin-mill business of LTV Steel. But it's unclear whether that would satisfy US Steel shareholders, who are likely to see their shares plummet should the split-off occur.

The steel company is clearly dragging the oil company down. Marathon shares are trading 15% to 20% lower than those of its peers, according to Fadel Gheit, an energy analyst at Fahnestock & Co. Last year, the much smaller US Steel lost $21 million, or 33? per diluted share, on revenues of $6.1 billion.

On the other hand, Marathon earned $432 million, or $1.39 per diluted share, on revenues of $33.8 billion. And the divergence between the two units' performances is expected to continue. According to Standard & Poor's estimates, US steel is expected to lose $2.50 per share for 2001 while Marathon is expected to nearly triple its earnings, to $3.65 per share.

On the steel side, the problems are numerous. Competition is so fierce that the price of standard commodity sheet steel is near 20-year lows. In the U.S., some 12 million tons of new commodity sheet-steel capacity has been built over the past decade by minimills. They can afford to expand because they have a much lower cost structure than traditional integrated mills, such as US Steel. Plus, mills outside the U.S. continue to focus on cost-reduction initiatives more successfully than their U.S. rivals. "The traditional [U.S.] mills have been losing ground fairly consistently over the past decade," notes Mark Parr, an analyst at McDonald Investments Inc.

POWER SURGE. Combine that with higher costs for raw materials, weaker end demand, and the strong dollar, and it's little wonder that US Steel stock has withered to small-cap status. One of the mightiest U.S. companies as recently as the 1970s, its market capitalization is now only about $1 billion. It's having so much trouble that new U.S. Trade Representative Robert Zoellick says the Bush Administration might limit the levels of steel imported into the U.S. But such a move would only be a short-term solution, insiders say, and it wouldn't reduce excess capacity in the global steel industry, which is the main problem.

Marathon Group's situation is almost the mirror image of the steel company's. Clarence P. Cazalot, former president of international production and chairman of Texaco Ltd., was brought in as president in March, 2000. With Cazalot at the helm, Marathon has been focusing on the U.S., which was a good strategy, considering demand and prices for oil and gas are at all-time highs. Last year, natural-gas prices quadrupled, heating-oil prices doubled, and crude-oil prices rose more than 50%.

There's no longer any tax benefit for the tracking stocks

Last December, Marathon completed an exchange agreement in which it swapped its 37.5% interest in Sakhalin Energy Investment Co., an exploration and production company located off the eastern coast of Russia, for, among other assets, cash as well as a stake in producing properties in the Gulf of Mexico.

Yet Marathon shares have essentially been dead money. They're trading at roughly 8 times 2001 earnings, while the peer group median trades at 9 to 10 times. The oil company's stock began the year at $28.38 a share and closed on Apr. 16 at $29.78. US Steel, which saw its shares fall 13%, to $15.59, during the same period, appears to be the reason.

Why the tracking stocks in the first place? In 1982, USX Corp., which at the time had principal operating units involved in energy and steel, acquired Marathon Oil Co. USX shareholders voted to change the company's structure to create the tracking shares in 1991. The change allowed USX to continue to reduce its tax bill by applying US Steel's tax-loss carryforwards against the profits of Marathon.

It was a good plan at the time. But there's no longer any tax-loss carryforward benefit, so Marathon shareholders ask: Why keep the Siamese-twin structure? They see a lot of consolidation in the oil industry and figure Marathon likely would be bought at a premium price if it didn't have US Steel riding on its back.

Bruce Lanni, a senior oil analyst at AG Edwards & Sons, is very much in favor of the split-off and believes it would benefit Marathon. "Having a company that's just a tracking stock doesn't represent the true entity, and you don't have all the shareholder rights that you'd want," he says. "I think it would be a very strong positive for the stock."

TAKEOVER TARGET? USX, however, is taking it slow. Because of the accounting measures used on the corporate balance sheets, numerous tax issues have to be addressed before any action is taken. A split-off would affect shareholders of both tracking stocks, so it has to be structured in a manner attractive to both sets of stockholders to receive approval.

Whatever happens, US Steel likely will feel the pinch. As part of USX's consolidated balance sheet, the steel unit has been able to maintain an investment-grade credit rating. With the two units separated, that rating would likely be lost. Marathon, however, free of the drag of the steel business, would likely begin to trade in line with its industry. "I feel pretty comfortable saying you'd see Marathon stock move up in a positive fashion with the announcement of the split-off, depending on how it's structured," Lanni says.

Many analysts believe Marathon would quickly become an attractive takeover target, given that its industry is in the midst of aggressive consolidation. If so, the value of those shares would skyrocket. "I think it would be a great fit with a company like Conoco, who could benefit from Marathon's strength domestically," says Gheit.

It seems Marathon and its shareholders have little to lose should the companies split up. The picture isn't quite as rosy for its Siamese twin, however. Hughes covers financial markets for BusinessWeek Online in New York


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