“Take all our money, our great deeds, mines and coke ovens, but leave our organization, and in four years I will rebuild myself.” – Andrew Carnegie
Cleveland-Cliffs Inc. (NYSE: CLF) was formerly an iron ore drilling company supplying iron ore pellets to steel producers. It nearly went bankrupt in 2014 when chief executive Lourenco Goncalves was named lifeguard.
Seven years later, Cleveland-Cliffs is a completely different company, vertically integrated into the steel processing industry and full of dynamism. The first quarter of 2021 is the first quarter after vertical integration. Like any interested analyst, I look forward to quarterly earnings reports and a first look at the financial results of the incredible turnaround, taking into account a number of issues such as
What happened in the Cleveland Cliffs over the past seven years is likely to go down in history as a classic example of transformation to be taught in American business school classrooms.
Gonçalves took over in August 2014 “a company struggling to survive with a disorganized portfolio full of underperforming assets built according to a horribly wrong strategy” (see here). He led a number of strategic steps for the company, starting with a financial boom, followed by metal materials (i.e. scrap metal) and entering the steel business:
After a successful transformation, the 174-year-old Cleveland-Cliffs has become a unique vertically integrated player, operating from mining (iron ore mining and pelletizing) to refining (steel production) (Figure 1).
In the early days of the industry, Carnegie turned his eponymous enterprise into America’s dominant steelmaker until he sold it to US Steel (X) in 1902. Since low cost is the holy grail of cyclical industry participants, Carnegie has adopted two main strategies to achieve low cost of production:
However, superior geographic location, vertical integration and even capacity expansion can be replicated by competitors. To keep the company competitive, Carnegie constantly introduced the latest technological innovations, constantly reinvested profits in factories, and frequently replaced slightly outdated equipment.
This capitalization allows it to both lower labor costs and rely on less skilled labor. He formalized what became known as the “hard drive” process of continuous improvement to achieve productivity gains that would increase production while lowering the price of steel (see here).
The vertical integration pursued by Gonsalves is taken from a play by Andrew Carnegie, although the Cleveland Cliff is a case of forward integration (i.e. adding a downstream business to an upstream business) rather than the case of reverse integration described above.
With the acquisition of AK Steel and ArcelorMittal USA in 2020, Cleveland-Cliffs is adding a full range of products to its existing iron ore and pelletizing business, including HBI; flat products in carbon steel, stainless steel, electrical, medium and heavy steel. long products, carbon steel and stainless steel pipes, hot and cold forging and dies. It has established itself as a leader in the very popular automotive market, where it dominates the volume and range of flat steel products.
Since mid-2020, the steel industry has entered an extremely favorable pricing environment. Domestic hot rolled coil (or HRC) prices in the US Midwest have tripled since August 2020, reaching a record high above $1,350/t as of mid-April 2020 (Figure 2).
Figure 2. Spot prices for 62% iron ore (right) and domestic HRC prices in the US Midwest (left) when Cleveland-Cliffs CEO Lourenko Gonçalves took over, as amended and source.
Cliffs will benefit from high steel prices. The acquisition of ArcelorMittal USA allows the company to stay on top of hot-rolled spot prices while annual fixed-price vehicle contracts, primarily from AK Steel, could be negotiated upwards in 2022 (one year below spot prices).
Cleveland-Cliffs has repeatedly assured that it will pursue a “philosophy of value over volume” and will not maximize market share to increase capacity utilization, with the exception of the automotive industry, which is partly helping to maintain the current pricing environment. However, how peers with traditionally ingrained cyclical thinking will respond to Goncalves’ cues is open to question.
Prices for iron ore and raw materials were also favorable. In August 2014, when Gonçalves became CEO of Cleveland-Cliffs, 62% Fe iron ore was worth about $96/ton, and by mid-April 2021, 62% Fe iron ore was worth about $173/ton (Figure 1). one). As long as iron ore prices remain stable, Cleveland Cliffs will face a sharp increase in the price of iron ore pellets that it sells to third party steelmakers while receiving a low cost of buying iron ore pellets from itself.
As for scrap raw materials for electric arc furnaces (ie electric arc furnaces), the price momentum is likely to continue for the next five years or so due to strong demand in China. China will double the capacity of its electric arc furnaces over the next five years from its current level of 100 metric tons, driving up scrap metal prices – bad news for US electric steel mills. This makes Cleveland-Cliffs’ decision to build a HBI plant in Toledo, Ohio an extremely smart strategic move. The self-sufficient supply of the metal is expected to help boost Cleveland-Cliffs’ profits in the coming years.
Cleveland-Cliffs expects its external sales of iron ore pellets to be 3-4 million long tons per annum after securing internal supplies from its own blast furnace and direct reduction plants. I expect pellet sales to remain at this level in line with the value over volume principle.
HBI sales at the Toledo plant began in March 2021 and will continue to grow in the second quarter of 2021, adding a new revenue stream for Cleveland-Cliffs.
Cleveland-Cliffs management was targeting adjusted EBITDA of $500 million in the first quarter, $1.2 billion in the second quarter and $3.5 billion in 2021, well above analyst consensus. These targets represent a significant increase from the $286 million recorded in the fourth quarter of 2020 (Figure 3).
Figure 3. Cleveland-Cliffs quarterly revenue and adjusted EBITDA, actual and forecast. Source: Laurentian Research, Natural Resources Center, based on financial data published by Cleveland-Cliffs.
The forecast includes a $150M synergy to be realized in 2021 as part of a total $310M synergy from asset optimization, economies of scale and overhead optimization.
Cleveland-Cliffs will not have to pay taxes in cash until $492 million of net deferred tax assets are depleted. Management does not expect significant capital expenditures or acquisitions. I expect the company to generate significant free cash flow in 2021. Management intends to use free cash flow to reduce debt by at least $1 billion.
The 2021 Q1 earnings conference call is scheduled for April 22, 2021 at 10:00 AM ET (click here). During the conference call, investors should pay attention to the following:
US steelmakers face stiff competition from foreign producers who may receive government subsidies or maintain an artificially low exchange rate against the US dollar and/or lower labor, raw materials, energy and environmental costs. The US government, especially the Trump administration, launched targeted trade investigations and imposed Section 232 tariffs on flat steel imports. If Section 232 tariffs are reduced or eliminated, foreign steel imports will once again drive down domestic steel prices and hurt Cleveland Cliffs’ promising financial recovery. President Biden has not yet made significant changes to the trade policy of the previous administration, but investors should be aware of this general uncertainty.
The acquisition of AK Steel and ArcelorMittal USA brought great benefits to Cleveland-Cliffs. However, the resulting vertical integration also carries risks. First, Cleveland-Cliffs will be affected not only by the iron ore mining cycle, but also by market volatility in the automotive industry, which could lead to a cyclical strengthening of the company’s management. Secondly, the acquisitions have accentuated the importance of R&D. Secondly, the acquisitions have accentuated the importance of R&D. Second, these acquisitions highlighted the importance of research and development. Second, acquisitions highlight the importance of R&D. The third generation NEXMET 1000 and NEXMET 1200 AHSS products, which are light, strong and moldable, are currently being developed for automotive customers, with an uncertain rate of introduction to the market.
Cleveland-Cliffs management says it will prioritize value creation (in terms of return on invested capital or ROIC) over volume expansion (see here). It remains to be seen if management can effectively implement this rigorous supply management approach in a notoriously cyclical industry.
For a 174-year-old company with more retirees in its pension and medical plans, Cleveland-Cliffs faces higher total operating costs than some of its peers. Trade union relations are another acute issue. On April 12, 2021, Cleveland-Cliffs entered into a 53-month provisional agreement with United Steelworkers for a new labor contract at the Mansfield plant, pending approval from local union members.
Looking at the $3.5 billion Adjusted EBITDA guidance, Cleveland-Cliffs trades at a forward EV/EBITDA ratio of 4.55x. Since Cleveland-Cliffs is a very different business after acquiring AK Steel and ArcelorMittal USA, its historical median EV/EBITDA of 7.03x may mean nothing anymore.
Industry peers US Steel has historical median EV/EBITDA of 6.60x, Nucor 9.47x, Steel Dynamics (STLD) 8.67x and ArcelorMittal 7.40x. Even though Cleveland-Cliffs shares are up about 500% since bottoming in March 2020 (Figure 4), Cleveland-Cliffs still looks undervalued compared to the industry average multiple.
During the Covid-19 crisis, Cleveland-Cliffs suspended its $0.06 per share quarterly dividend in April 2020 and has not yet resumed paying dividends.
Under the leadership of CEO Lourenko Goncalves, Cleveland-Cliffs has undergone an incredible transformation.
In my opinion, Cleveland-Cliffs is on the eve of an explosion in earnings and free cash flow, which I think we’ll see for the first time on our next quarterly earnings report.
Cleveland-Cliffs is a cyclic investment game. Given his underpricing, earnings outlook and favorable commodity price environment, as well as the major bearish factors behind Biden’s infrastructure plans, I think it’s still good for long-term investors to take positions. It is always possible to buy a dip and add to existing positions if the 2021 Q1 income statement has the phrase “buy the rumor, sell the news.”
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Disclosure: I/we are a long-term CLF. I wrote this article myself and it expresses my own opinion. I have not received any compensation (other than Seeking Alpha). I have no business relationship with any of the companies listed in this article.