Description

Executive Summary:

• Cleveland-Cliffs has transformed itself through acquisitions into vertically-integrated industrial powerhouse that has consolidated the US steel industry
• Its dominant share position in end markets such as automotive steel allow it to have more durable full-cycle earnings
• Company is rapidly paying down debt through cash generation, and is on track to be debt-free by mid-2026
• There are multiple growth engines as the company focuses on being a leader in the “green industrial revolution”
• CEO Goncalves has proven to be an exceptional CEO
• Currently modelling a $45 price for the stock, a 179% IRR from current levels

Cleveland-Cliffs was founded in 1846. As recently as 2019, it was an iron ore producer operating primarily in the Great Lakes region serving US-based steel companies, and had no steel production to speak of. However, a string of transactions including the acquisitions of AK Steel (“AKS”) and ArcelorMittal US (“AM US”) in 2020, as well as Ferrous Process and Trading Company (“FPT”) in 2021, has transformed the company into a vertically-integrated industrial powerhouse. Cliffs, led by a savvy, visionary CEO Laurenco Goncalves, combines its upstream iron ore mining with downstream steel production and scrap processing.

Over the last twelve months, Cliffs has shipped nearly 16 million tons of steel, generated $22 billion of revenues, $1.7 billion of EBITDA and $1.1 billion of free cash flow. Notably, this period includes two quarters of weaker steel pricing and elevated costs thanks to the spike in energy prices in 2022. Over the last twelve quarters, Cliffs has generated an average of $1,437 of revenue and $223 of EBITDA per ton of steel shipped, for an average EBITDA margin of 15.5%.

Cliffs sells a variety of steel products, including hot-rolled, cold-rolled, coated, stainless and electrical, plate, and other products. Approximately 30% of sales (7 million tons) are US automotive-related sales; Cliffs has nearly half the market share for automotive steel. Other end markets include infrastructure and manufacturing, distributors and converters, and steel producers. Around 45% of Cliffs’ production is sold on fixed price contracts; the balance is sold on the spot market.

While steel is generally regarded as a commodity product, Cliffs differentiates itself in several ways. First, most steel production in the US is done via Electric Arc Furnaces (“EAFs”), Cleveland-Cliffs has leaned into blast furnace production, which accounts for approx. 30% of domestic steel production. The former uses steel scrap as its primary raw material and electricity for the heating process, while traditionally the latter uses iron ore as the primary feedstock, heated by coke. Blast furnace production with iron ore and coke creates a more “pure” steel product, which is more desirable for exposed auto panels. On the other hand, scrap tends to have deleterious elements such as copper, which is costly to extract and erodes quality. So, Cliffs’ blast furnace-produced steel is a more desirable product versus EAF produced steel, and commands a higher price tag. And the acquisitions of AKS and AM US leave only two integrated steel mill owners in the US: Cleveland-Cliffs and US Steel. This further insulates them from competition.

Second, Cliffs completed its Toledo Direct Reduction plant in 2020, which is a natural-gas-based plant that supplies hot-briquetted iron (“HBI”). It is the first and only HBI plant in the Great Lakes region. HBI can be used as feedstock for EAFs, basic oxygen furnaces (“BOF”), and blast furnaces. This is extremely important, because the use of HBI reduces the amount of coke needed in the blast furnace process, allowing Cliffs to substantially reduce its carbon emissions. On its latest earnings call, CEO Goncalves announced Cliffs would be adding a $40/ton surcharge for steel produced using HBI. Further, the introduction of HBI into the blast furnace process doesn’t just allow Cliffs to lower carbon emissions and charge higher prices; it also lowers costs. On the same call, Goncalves explained that, in the second quarter of 2023 the company shipped 4.2m tons of steel, the same level as the second quarter of 2021. However, this was achieved while operating only seven major blast furnaces following the idling of its Indiana Harbor No. 4 blast furnace in 2022. The use of HBI substantially reduces Cliffs’ coke needs in the blast furnace process, allowing for better utilization of its fixed assets and lowering unit costs.

There are future opportunities as well for Cliffs as leaders in carbon-reduction initiatives in US and global steelmaking processes. For example, the company has initial plans for a carbon-reduction facility that will capture carbon in the steelmaking process. With the passing of the Infrastructure bill in 2022, the US government is offering $85 per ton of carbon captured. Cliffs estimates that it can build a facility allowing it to capture 2.8 million tons of carbon per year, with roughly 50% contribution margins. So, that comes to about a $120 million contribution on a $500-$600 million buildout.

Further, here is CEO Goncalves again on the latest earnings call on the potential for a hydrogen in the steelmaking process:

“The next step in our evolution will be the use of hydrogen throughout our footprint including at our DRI facility and our blast furnaces, which we have already proven are hydrogen ready. Three months ago on May 8, at Middletown Works, we became the 1st company in the Western Hemisphere to successfully complete a full scale trial injecting hydrogen into all two years of a blast furnace for an extended period of time.

Using the existing pipeline and transportation infrastructure in place, hydrogen gas was injected into all two years of the blast furnaces, and used as a substitute for fossil fuel reduction. This ultimately replaced the release of CO2 with the release of H2O with water vapor, with no impact to product quality or operating efficiency.

We'll be next trialing the technology at our largest blast furnace Indiana Harbor #7. We believe hydrogen will be the true game changer for the decarbonization of steel, it’s simple chemistry after all, and we have already proven its effectiveness.

The main hurdle right now is economics. As of today, equivalent units of hydrogen gas are about 10 times more expensive than natural gas.

That’s why we are an active player on the initiatives to build hydrogen hubs in the Midwest is specifically near our Burns Harbor, Indiana Harbor is through complex in Northwest Indiana and also near our Toledo, Ohio direct reduction plant. As hydrogen becomes more and more economical, we'll be able to implement it throughout our entire footprint.”

The timing for this couldn’t be better, as auto production in the US has started to normalize back to the 16-17 million SAAR levels was at pre-COVID, before the chips shortage limited OEMs’ productive capacity. And demand-driven incentives from other federal government programs, including the aforementioned Infrastructure Act, Inflation Reduction Act and CHIPS Act, as well as a general political shift towards protecting industries critical to national security, have and will continue to place a floor for domestically produced steel.

With that in mind, over the next twelve quarters I’m assuming Cliffs ships around 4m tons of steel per quarter, with average revenues per ton of about $1,500 and EBITDA per ton of $200. That gets us to a run rate of about $800 million EBITDA per quarter. Assuming $700 million CAPEX per annum (as indicated in recent earnings call) means Cliffs will generate on average $625 million of cash flow before interest and taxes per quarter. Cliffs can spend half of that cash paying down debt, and still have plenty left over for interest, taxes, working capital and some shareholder returns. CEO Goncalves has been steadfast in his commitment to deleveraging Cliffs’ balance sheet, and the results speak for themselves: over the past two years, net debt has dropped from $5.3 billion to $3.9 billion. Not only that, but OPEB liabilities have gone from $3.8 billion to $750 million. And Cliffs has also managed to reduce its shares outstanding from $585 million to $508 million over the same period, a 13% reduction.

With $3.9 billion net debt, and paying down $312.5 million debt per quarter on average, Cliffs can achieve a net cash position by around mid-2026. And that assumes flat production, modest revenue growth, and slightly lower EBITDA per ton as the prior twelve quarters, to be conservative. And that is all before considering new business lines related to carbon capture or hydrogen production, which would be accretive to earnings. The $800 million/quarter ($3.2 billion/year) “average” EBITDA run rate is consistent with conversations I’ve had with CFO Goncalves about their estimate of full-cycle earnings power. And on the latest call, he indicated a shift towards more shareholder returns in their capital allocation strategy once net debt hits around $3 billion. Such a level is around 1.0x “average” EBITDA, which is where CEO Goncalves has indicated in the past is a “healthy” level of debt for a company. So, my $800 million of EBITDA/quarter over the next twelve quarters passes the sanity check.

Here is a current cap table for the company (note, some bond prices may be stale):

Below is a scenario analysis using the above assumptions and a 6.0x exit multiple on the $3.2 billion average EBITDA figure. I pencil in a $45 share price and 179% IRR from current levels. I don’t think these are particularly heroic assumptions; 6.0x for a vertically integrated industrial company with a dominant share in a market as essential as autos are for the US economy seems reasonable. And playing with various different assumptions for share repurchases vs. debt paydown can easily make this a three-bagger. And that is before considering Cleveland-Cliffs’ various growth opportunities.

Obviously, given the company's exposure to market spot prices, the actual results will be lumpier than those assumed above. However, on average they should be about right.

As far as risks go, the first thing that comes to mind is antitrust. While I think the current FTC administration would have made it tough for Cliffs to acquire AM US, AKS, and FPT, the chances of Cleveland-Cliffs being “broken up” anytime soon is very remote. The market also seems to believe, despite all evidence to the contrary, that a recession is just around the corner. Obviously a recession would be a headwind, but in my opinion Cliffs can better manage a recession than the market believes. The lack of competition in its specific end markets and its vertical integration enables the company to protect its margins. Plus, I expect auto production to continue “normalizing” back to a production level that more closely resembles pre-COVID. A pickup in production volumes helps dilute fixed costs, which will be a tailwind.

As Cliffs comes closer to an investment-grade rating, I think some institutional investors may push back on their current governance structure, given the company’s record of nepotism: the board approved the hiring of the CEO’s son as CFO. Not that Celso Goncalves isn’t qualified - I’ve met him several times and he is very competent. Over the last five years, Cleveland-Cliffs’ total shareholder returns have outpaced the S&P 500 and all other relevant benchmarks, so I think this will be a non-issue:

Source: Company filings

Further, I think CEO Goncalves is truly exceptional. He has a rare combination of being a visionary, effective operator, and smart capital allocator. Most are probably aware of the verbal abuse he’s given to sellside analysts in past earnings calls; he can certainly come across as brash and perhaps a little arrogant at times. That being said, while certainly eccentric, he is a tough, no-nonsense guy who delivers on his promises.

I’ll finish this write-up with a recent quote of his from the latest earnings call which gives a sense of the long-term vision Goncalves has for the company’s shareholders:

“I think like a shareholder. By the way, that's a thing that very few CEOs particularly in our space can brag about.

I have never sold a single share that was acquired in the open market or that was given to me as compensation. So, I think like a shareholder, I like dividends, I'm 65 years old man.

One day, that's far away in the future, I will retire and I'm going to live off dividends from Cleveland-Cliffs.”

Catalyst

Continued deleveraging, investment-grade rating, share repurchases