Cleveland-Cliffs: Simply Ridiculous (NYSE: CLF) | Looking for Alpha

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One of the hottest topics among our members has been the action at Cleveland-Cliffs Inc. (New York Stock Exchange: CLF) Inventory. We have successfully traded it several times over the past few months, inflating short-term gains. We believe in business and long-term management.

Steel is, of course, quite cyclical, and some investors never touch it, because over the long term, stocks seem to underperform the market as a whole, given how much the sector is linked to steel and iron ore prices, as well as economic demand. In turn, stocks fluctuate. He sets it up to be bought and sold by companies like ours, riding the waves higher, and selling or shorting the way down. It is simply reality.

But honestly, the action right now is kinda ridiculous. Let’s put that into perspective here. You can probably stop reading after this sentence. The stock was gutted as “there are fears” of a Fed-induced “hard landing” and “possible recession“. Think about it. The price of steel has fallen a lot because of what could happen, not necessarily what will happen. Of course, the Fed is trying to reduce inflation. We expected commodities to pull back. But it’s a whole new Cleveland-Cliffs. This company has transformed, and we believe it indeed has great long-term potential, beyond being a stock that we trade for profit. Given the company’s longer-term outlook, this action is simply ridiculous.

Valuation and price of steel

The company just released earnings, and they were solid. In reality, earnings estimates may have been slightly too high, but stocks are only valued at 3.5x FWD EPS relative to consensus, and just 4X even if we take a more conservative view on earnings. After pointing out, there were some big positives in the release. Management still has a strong “average selling price expectation for the year 2022 of $1,410 per net ton.” This is in part because “the current 2022 futures curve implies an average hot-rolled coil steel index price of $850 per net ton for the remainder of the year.” That’s less than just 4-5 months ago, but the company expects to generate massive levels of free cash flow in 2022. And yet, the stock is stuck.

Strong revenue generation

There’s no way to look at performance and think the company is faltering. The action addresses fears for the future and declining revenues and margins as steel prices could fall further and/or demand could weaken. The stock has been halved. What are their winnings worth? This is the question the street is trying to figure out while balancing the question of lower earnings going forward if steel prices deteriorate and/or demand slows further. That’s really the story here folks. And yet, the numbers remain strong, with second-quarter 2022 consolidated revenue of $6.34 billion, up 26% from a year ago. That was a $226 million beat from estimates. Not too bad.

The company’s adjusted EBITDA of $1.1 billion in the second quarter of 2022 was down sequentially and lower than last year’s $1.4 billion, but is up $2.6 billion. in the first half of 2022 versus $1.9 billion through the first half of 2021. That was three times higher than last year. It also brought trailing 12-month EBITDA to $6.2 billion. That’s an all-time high for any 12-month period in Cliff’s history. Prices have fluctuated, with slightly lower prices, but spreads on hot and cold rolled steel are improving. Overall, the company earned $1.31 per share, missing $0.05.

If revenue drops, it’s still a good deal

As mentioned, the valuation is really stupid, but the market expects some multiple expansion when contract prices reset in the fall, as steel prices are lower. The company is trading at a futures price for a profit of 3.5, or even lower if you buy shares falling. We really like them under $15 even though the earning power is decreasing. However, what if the company sees dramatic cost increases and the estimates are way too high? We don’t think more than $6 EPS is out of reach this year, but if the company earns “only” $4.00. Well, at our buy points, you’re still paying less than 4x FWD EPS at a $15 target entry. Winner. It’s a bit ridiculous, really.

We also envisage a price/cash flow ratio of less than 3x. The EV/sales is a ridiculous 0.54 and the price to book is now below 1.0 on a forward basis. It’s almost like they can’t afford the business at those prices.

Debt

Now, apart from recession or falling steel prices, there remains a risk. We discussed the debt extensively with our members and were clear that the debt would be repaid, transforming the business. The track record is improving here folks. They were able to achieve the largest quarterly debt reduction in the company, this process began, paying off hundreds of millions of dollars in debt. There’s still a lot of debt, but it’s now down to about $4.6 billion. The company also repurchased 7.5 million shares during the quarter, reducing the free float, and had $2.3 billion in cash. They are in good shape and only have $35 million in cash. This was discussed further on the conference call:

Michael Glick

…as we think about the balance sheet, how should we think about your net or maybe even absolute debt target in this environment?

Lourenco Gonçalves (CEO of the company)

Listen, I think we got to what we need to get. We are consistently below one times EBITDA. And we will continue to manage that debt with cash flow. It’s our – clearly, our top priority to continue to reduce debt…our conversion to free cash flow has also been outstanding. And we are devoting the vast majority of the cash generated to debt repayment. We started buying stocks until the silly season started and then we stopped buying stocks and just focused on that… we’re going to be very focused on paying down debt as always .

We like what we see here. The fact is, it was the largest free cash flow induced debt reduction in the company’s history. The company managed to generate $633 million in free cash flow out of $1.1 billion in adjusted EBITDA and that level of free cash flow was more than double what they generated in the first quarter. And we will say that stock buybacks are fine for increasing shareholder value and increasing EPS potential, but prioritizing debt reduction is paramount. They have done an amazing job here.

Final Thoughts

There’s value here, especially as the stock drops and the company reduces debt. The stock fell due to fears that growth might cease. Steel prices fell on fears of recession. All of these ridiculous actions are driven by what could happen. Not what will happen. The Fed wanted lower commodity prices and the market reacted. Demand may slow, but the auto industry will be huge for them. But, due to supply chain issues, almost ten million vehicles that should have been produced were not. The company expects this to support demand through 2023.

Bring back home

We think you let the market go down and then add to that quality name. Although it is ideal for trading, the management sets it up for returns on investment. $15 is a solid entry point, all things considered.

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