Company history and business
Cleveland-Cliffs Inc. (CLF, Financial), founded in 1847, is the largest and oldest independent iron ore mining company in the U.S., supplying iron ore pellets to the domestic steel industry. The company aims to have the only hot-briquetted iron plant in the Great Lakes region by 2020. It is divided into two segments: mining and pelletizing, and metallics.
The mining and pelletizing segment consists of large interests in four running iron ore mines and one closed mine. The metallics segment consists of the hot-briquetted iron production plant, which should be up and running by 2020. This segment is eating a lot of cash.
The company has some customer concentration risk, with the vast majority of its sales going to two clients: ArcelorMittal (MT, Financial) and AK Steel (AKS, Financial). This setup is not as risky as it sounds, though, as the two customers are in long-term “take or pay” contracts. The contracts act somewhat like a hedge, but they are likely more beneficial to both parties than a financially engineered hedge.
Cliffs designs custom feedstock so that its clients can optimize their operations. Customization also makes it less likely that its customers will try to buy on the open market. Probably the most important benefit of custom feedstock is that it allows companies to run their plants in a more environmentally friendly manner, which is becoming increasingly prioritized.
Financial strength
Cliffs has about $430 million in cash, $2 billion in debt and $740 million in Ebitda. Currently, Capex is heightened, but in a year’s time management expects to generate $800 million in free cash flow. With the current numbers and especially management guidance, the company looks financially solid.
It is crucial to remember that this is a commodity business. Worse, Cleveland-Cliffs is a price-taker with a high break-even cost. Currently, prices are very strong, and management expects them to stay that way. But that surely is no given. If iron ore prices fall dramatically, the picture will look drastically different. Long-term contracts provide something of a cushion, but the company is not a great one to own through a deep iron ore bear market, were one to erupt quickly. But the debt at 2x Ebitda is down from around 8x in 2015, so the financial situation is definitely much improved. Also, the outlook for iron ore is bright in the short term.
What ultimately alleviated most of my concerns about the company was its favorable debt maturity schedule. Most of the debt comes due only in 2024 and beyond.
Management
Back in 2014, Cleveland-Cliffs was near bankruptcy. An activist shareholder, Casablance Capital, came on board and installed new management. It brought in CEO Lourenco Goncalves who had a track record of successful turnarounds within the industry. Goncalves initially went through the standard turnaround playbook of cutting costs and deleveraging in an attempt to save the company. He’s been successful at that. But, in addition, he has a longer-term vision of a more sustainable industry. He believes that, globally, the steel industry will move from blast furnaces to electric arc furnaces.
Goncalves owns 3.2 million shares, a substantial amount of which he acquired on the open market. Goncalves and other insiders have been buying relatively recently as well. Goncalves acts and talks like an owner-operator, using clear language and not mincing words with analysts or when talking about competitors.
Valuation
The company trades at 6x free cash flow or 5x forward free cash flow based on management guidance for after the HBI investment is done. It trades at about 6.5x EV-Ebitda.
To put this into context, BHP Billiton trades around 7x EV/Ebitda. But it is not as levered at only about 1x Ebitda. In addition, it is positioned much more advantageously on the cost curve of the seaborne market.
Rio Tinto (RIO, Financial) trades around 6.6x EV-Ebitda, and it has virtually no net debt. It is also has a more advantageous position on the cost curve.
Fortescue (FSUMF) trades around 7.5x EV-Ebitda. It has debt of about 1.5x Ebitda. It is producing a lower-quality product that positions it less well for the future.
This entire industry is undervalued and of the above examples, I am invested in Rio Tinto (RIO, Financial) and was previously in BHP Billiton (BHP, Financial). After the disaster in January at Brumadinho dam, owned by Vale SA (VALE), I switched from BHP to Rio.
Although Cleveland-Cliffs is not necessarily a growth company, it is involved in one large growth project: the new HBI plant. This is affecting current capex levels and will free up substantial free cash flow going forward. Here’s what Golcanves said on the most recent earnings call:
"And wrapping up my remarks, with less but less than a year left until the major capital spend on HBI is done, we are just on the brink of our much anticipated overwhelming cash flow generating position. It may be difficult for some to see right now given we are still in peak capital spending mode on HBI, but in less than 12 months, we'll be looking at a business that is set up to throw off enormous amounts of free cash.
I’d like to say, with our HBI plant completed and in full production free cash on an annualized basis will be EBITDA minus $220 million. Other than $100 million of sustaining capital, and $120 million of debt service, all the rest of the EBITDA is free cash. Since we will continue to use our NOLs and I'd have to disperse any cash to pay taxes for the foreseeable future, and we are not even adding to this free cash number, the cash coming from our future AMT refunds which are real as you all know.
At price levels comparable to what we've seen this year and with HBI layered in, we would expect to generate about an annualized $1 billion in EBITDA meaning that we would have around $800 million in free cash flow to return to shareholders primarily via stock buybacks and increased dividends."
A scenario like this would mean the S&P 500 index would likely be hard-pressed to keep up with the stock. One billion in Ebitda or $800 million in free cash flow on a $3 billion market cap or $4.7 billion enterprise value is hard to find. Even among cyclical offerings. Not to mention, the CEO and largest shareholder has indicated that he's interested in returning all that cash flow to shareholders via buybacks and dividends.
Risks
China's market slowdown is the obvious elephant in the room. China's growth has eased to a pace of about 6% GDP growth per year, which is low compared to the '90s. The data from U.S. companies invested in China isn’t great either. Then there is the trade tension that may exacerbate the cooling in China further. However, so far the Chinese response to the has included stimulating infrastructure spending, which is a boon for commodity producers. As a result, iron ore demand from China has been relatively strong.
The company's leverage profile has improved immensely, but the balance sheet is certainly not void of risk. If iron ore tailspins into a bear market, this could come into focus. The concern is mitigated by strong current prices, far-out maturity dates and long-term contracts with its customers.
Customer concentration risk is a slight concern. At the end of the day, Cleveland-Cliffs is digging up iron ore and if these preferred customers don’t take it, someone else will. The price may not be as good, but it is not like iron ore is a product you can’t move even if you wanted to. If you want it badly enough, you can always move it.
Outlook
Management has guided for $1 billion in Ebitda or $800 million in free cash flow in the not-too-distant future. The company is buying back shares, and insiders are buying too.
Iron ore is priced over $120 and due to the lag in Cleveland-Cliffs' contracts, the company's revenue is poised to step up based on today’s prevailing prices. Long-term many analysts are bearish on the price of iron ore, but an increasing number of them are buying into the higher-for-longer idea.
I was bullish on iron ore prices earlier in the year (based on supply, which was dramatically constrained), but going forward I’m not as sure what to think. I’m wary of both a slowdown in China and the rest of the world, but so far demand has held up well. The company is sufficiently undervalued that it could probably manage an iron ore bear market (which I don’t foresee), do reasonably well under many different scenarios and perform extremely well under favorable circumstances.
Disclosure: Long Rio. May buy Cleveland-Cliffs in the next 48 hours.
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