Cleveland-Cliffs: A Clear Runway To A Higher Share Price

Feb. 11, 2019 6:24 PM ETCleveland-Cliffs Inc. (CLF)VALE199 Comments

Summary

Cleveland-Cliffs released their Q4 2018 and full-year 2018 results on Friday, February 8th, 2019.
A reversal of a tax valuation allowance allowed CLF to post a headline beat for Q4.
Bigger picture, 2019 guidance was implicitly raised due to higher pellet pricing. Adding to the narrative, an expanded HBI facility should raise earnings power for 2020 and beyond.
EBITDA and operating cash flows for 2019 should come in above 2018's already elevated levels (the highest in the past four years).
The front-loaded expected increase in CLF's operating results (2019 & 2020) raises my price target from $20 to $30 with $35 per share easily achievable if CLF executes on their plan.
This idea was discussed in more depth with members of my private investing community, The Contrarian. Get started today »

Introduction

Cleveland-Cliffs (NYSE:CLF), a focus stock of The Contrarian since inception on December 7th, 2015, rallied strongly on Friday, February 8th, gaining 8.5% for the trading session, and rising 12.4% for the week, which was its seventh straight week of gains, following CLF's headline Q4 2018 earnings beat, and more importantly, CLF's implicitly raised guidance for both 2019 and 2020.

Bigger picture, CLF, partly through Vale's (VALE) tragic misfortune, which is going to raise iron ore and pellet prices globally, and partly through their own innovation, including the forthcoming HBI (hot-briquetted iron) Toledo, Ohio facility, favorable contract renegotiations (past and upcoming), and future mine openings (Empire in Michigan and Nashwauk in Minnesota), is positioned to expand revenues and overall margins, driving an increase in equity value per share.

At this juncture, CLF shares are worth roughly $19 through EV/EBITDA valuation analysis, and I can model higher share price targets using a discounted cash flow approach that I have used privately.

A Healthy 2018 And A Brighter Future Ahead In 2019 And 2020

Cleveland-Cliffs' Q4 2018 results ex-adjusted items actually came in moderately below (elevated) expectations. However, the silver lining was that both 2019 and 2020 guidance were implicitly raised.

First, outside the tax allowance release (a favorable $461 million adjustment to GAAP income), there were positives and negatives during the quarter as shown by my highlighted excerpt from the press release below.

(Source: Cleveland-Cliffs Q4 & Full Year 2018 Earnings Press Release)

Bigger picture, higher pellet margins in 2019, and an expanded HBI plant coming online in 2020, are going to raise CLF's net income, operating cash flows, and operating margins.

(Source: Cleveland-Cliffs Q4 & Full Year 2018 Earnings Press Release)

With adjusted EBITDA coming in at $766 million for 2018, a $1 billion adjusted EBITDA year in 2019 or 2020 is in reach, depending, of course, on prevailing iron ore and pellet prices.

Seven Weeks In A Row Higher

After a very difficult fourth quarter of 2018, CLF's share price has started to respond to the favorable backdrop, rising seven weeks in a row.

(Source: Author, StockCharts.com)

Looking at the price action from a longer time-frame view, CLF shares could conceivably make new post 2016 highs in the near term.

(Source: Author, StockCharts.com)

Longer term, CLF is not the same company it was five years ago, or a decade ago, lacking the metallurgical coal assets in the United States, which were sold by Lourenco Goncalves (maybe his only clear mistake in otherwise what has been an excellent tenure as the CEO of CLF) near cycle lows (a negative with met coal prices where they have been the past several years and where they are projected to be), and also lacking their Australian iron ore operations (generally a positive, though a negative at elevated global iron ore prices).

Still, with an improving domestic steel market (capacity utilization at 81% is at multi-year highs), and an entry into the higher margin HBI market, which will serve the dual purpose of absorbing existing pellet supply, which will provide an impetus for CLF to restart their idled Empire iron ore mine) while diversifying CLF's revenues, and higher iron ore prices and pellet prices for the foreseeable future, it is not hard to model a higher share price for CLF shares.

EV/EBITDA Valuation Suggests $19 Price Target

In a prior public Seeking Alpha article on Cleveland-Cliffs, published on May 31st, 2018, when CLF shares were trading at $8.31 (CLF shares closed at $8.31 on May 30th, 2018), I suggested a targeted share price range of $13.80 to $18.50 per share based on EV/EBITDA valuation analysis.

With adjusted EBITDA of $766 million for 2018, an increase of 67% compared to CLF's 2017 adjusted EBITDA of $460 million, cash of $823 million, long-term debt of $2,093 million, and 304,141,000 diluted shares outstanding at year-end 2018, CLF is current trading at an EV/EBITDA multiple of roughly 6.5.

This is below CLF's historical range of a 7-10x EV/EBITDA multiple. However, it is not the degree of undervaluation that some of the other undervalued commodity equities are trading at by a long-shot.

Favorable to CLF, however, is that they are in the sweet spot of an upturn in results, and with favorable pellet prices, and the HBI plant coming online later in 2020, adjusted EBITDA has a realistic chance of surpassing $1 billion per year, and then climbing further with Empire, Nashwauk, and potential future additional HBI plants adding to results in the intermediate-term future.

If that EBITDA target is hit, CLF's adjusted EV/EBITDA multiple would be under 5, creating plenty of room for share price appreciation. For example, a 7x EV/EBITDA multiple at a $1 billion EBITDA run rate (historically conservative) would imply CLF shares are worth $18.85 per share today, and a higher EV/EBITDA multiple, or higher EBITDA estimates can imply an even higher share price.

For members of The Contrarian, I have done more detailed financial modeling, including discounted cash flow, and future discounted values based on operating margin assumptions, profitability, etc.

Closing Thoughts

Cleveland-Cliffs is ahead of some of our other targeted downtrodden commodity equities in their turnaround, though CLF's balance sheet is just now starting to recognize this progress, with the almost $900 million improvement in tangible book value from December 31st, 2017, through December 31st, 2018.

Adding to the narrative, the rise from purgatory has been a two-steps-forward, one-step back journey, frustrating many shareholders, yet the progress at this juncture is undeniable.

Bigger picture, Cleveland-Cliffs owns top-notch assets on a relative basis located in the heart of the United States that have a moat. Specifically shipping iron ore to North America's steel mills from overseas is costly, pellet capacity is limited, and pellets are the feed-stock for the HBI plants CLF is building.

This dominant position, which has provided the cash flows for CLF's turnaround and had funded the balance sheet repair from the depths of late 2015, while simultaneously allowing CLF to internally fund their HBI plant construction, is going to lead to perpetually higher operating margins, compared to other North American steel companies, which are not really peers but provide a comparative template.

In summary, outspoken CEO Lourenco Goncalves has done an excellent job turning around Cleveland-Cliffs, and he is set to enjoy the fruits of his labor over the past five years.

Bigger picture, fundamentals still do matter, fundamentals were always the wrong scapegoat, and I still believe 2019 is going to be a banner year for value equities, as price discovery, after a decade of growth outperforming value, is poised to return with a vengeance. Specific to Cleveland-Cliffs, the positive fundamentals are just starting to shine through.

To close, even though it has been a very difficult almost decade-long stretch for value-oriented investors, with pockets of significant outperformance, including 2016, I think we are about to enter a golden age for active, value investors, who do the fundamental work, who can find the future free cash flow leading companies, and the most out-of-favor sectors, and the most out-of-favor equities will be at the forefront of this opportunity.

Thank you for taking the time to read this article,

WTK

This article was written by

KCI Research Ltd.

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Founder of "The Contrarian", a premium research service, featuring a committed, collegial group that has uncovered a number of hidden gems, hidden in plain sight. Immensely proud of what our members have accomplished. Actively investing since 1995, I have soared like an eagle, and been unmercifully humbled by the markets. Achieved positive returns in 2008, and turned an account with $60,310 on 1/1/2009 into an account with $3,177,937 on 11/30/2009. My best years have been 1995-2003, 2008-2012, 2016, 2020, & 2021. My worst years were 2013-2015 & 2017-2019. I believe inflation is coming, and we are at an inflection point in the markets.

Twenty plus year career as an investment analyst, investor, portfolio manager, consultant, and writer. Founder of Koldus Contrarian Investments, Ltd, which was incorporated in the spring of 2009. Dyed in the wool contrarian investor, who has learned, the hard way, that a good contrarian is only contrarian 20% of the time, but being right at key inflection points is the key to meaningful wealth creation in the markets. I believe we are near a meaningful inflection point, perhaps the biggest one yet, for the third time in the past 15 years.

Historically, I have had huge wins and impressive losses based on a concentrated, contrarian strategy. Trying to keep the good while filtering out the bad.

Seeking to run an all weather portfolio with minimal volatility and index overlays to capture my strategic and tactical recommendations along with a concentrated best ideas portfolio, which is my bread and butter, but the volatility only makes it suitable for a small piece of an investor's overall portfolio. The following are a couple of my favorite investment quotes.

"Life and investing are long ballgames." Julian Robertson

"A diamond is a chunk of coal that is made good under pressure."

Henry Kissinger

"Knowledge is limited. Imagination encircles the world." Albert Einstein

I’ve been on top of the world, and the world has been on top of me. I have learned to enjoy the perspective from each view, and use opportunities to persistently acquire knowledge, and enjoy the company of those around me, especially loved ones, family, and friends.

At heart, I am a market historian with an unrivaled passion for the capital markets. I have had a long history and specialization with concentrated positions and options trading. Made money in 2008 with a net long portfolio, deploying capital in some of the market's darkest hours into long positions including purchases of American Express, Atlas Energy, Crosstex, First Industrial Real Estate, General Growth Properties, Genworth, Macquarie Infrastructure, Ruth Chris Steakhouse, and Vornado near their lows. Shorting, hedging, and option strategies also helped me in 2007 and 2009, and these are skills that I have developed ever since I started trading heavily in 1996.I enjoy reading, accumulating knowledge, and putting this knowledge to work in the active capital markets, learning lessons along the way.To this day, I continue to learn, and some of these learning lessons have been excruciatingly difficult ones, especially over the past several years, as I made mistakes allocating capital, including a sizable portion of my own capital (I always invest alongside my clients), to commodity related stocks. While all commodity related stocks have struggled since April of 2011, coal companies, which attracted me due to their extremely cheap valuations, and out-of-favor status (I am a strong believer in behavioral finance alongside fundamentals and technicals) have been the worst investing mistake of my career. The focus on the commodity arena has been the biggest mistake of my investment career thus far, yet in its aftermath, I see tremendous opportunity, even larger in scope than the fortuitous 2008/2009 environment.The capital that I accumulated and the confidence gained in navigating the treacherous investment waters of 2008 gave me the confidence to launch my own investment firm in the spring of 2009, right before the ultimate lows in the stock market. At the time I was working as a senior analyst at one of the largest RIA's in the country, and I felt strongly that the market environment was the best time since 1974/1975 to start an investment firm.

Prior to starting my firm, I was a senior analyst for three different firms over approximately 10 years (Charles Schwab, Redwood, Oxford), moving up in responsibility and scope at each stop along my journey. Since I was a paperboy, I have always had an interest in the investment markets. I love researching and finding opportunities. I was a Chartered Financial Analyst, CFA from 2006-2018. Additionally, I have been a Chartered Alternative Investment Analyst, CAIA. After starting in the teaching program at Ball State University, I switched to a career in finance when I turned a small student loan into a substantial amount of capital. I graduated summa cum laude with a degree in finance from Ball State.

Full disclosure, I am not currently a registered investment advisor, though I did serve in this capacity from 2009-2014, while owning Koldus Contrarian Investments, Ltd. Additionally, I held various securities licenses from 2000-2014 without a single formal complaint filed. At the end of 2014, I voluntarily let my state registration expire, as I transitioned the business to a different structure after going through a brutal business environment, divestiture and difficult divorce and custody battle. Prior to this, I had passed, and held, various securities exams and licenses, including the Series 7, Series 63, and Series 65 exams, in addition to others, alongside the CFA and CAIA designations. Unfortunately, I did not file the proper paperwork to withdraw my state registration, and I did not disclose a personal arrangement, and subsequent civil case, between myself and a former close personal friend and client. This arrangement was initiated informally in 2011, after a substantial period of success, as we aimed to be business partners, and it ultimately resulted in a dispute. I was unaware that I was required to disclose these items, and my securities attorney, at the time, did not advise me to do so. Previously, I had managed a portfolio for this gentleman, and we had taken an investment of approximately $7 million in 2009, and grown it to over $25 million at the beginning of 2012. After a very difficult year of performance, an employee of the firm I owned, and friend, resigned in early 2013, and took the aforementioned client to a competing firm. As a result of not filing the proper paperwork, I agreed to a settlement, with a potential $2500 fine in the future, depending on if I choose to reapply to be a non-exempt advisor. Additionally, while going through the difficult divorce and business dispute and divestiture, I did not file the proper disclosure on two of the annual CFA renewals. As a result, the CFA Institute sought a 3-Year Suspension of my right to use the CFA designation, which I appealed, since the primary investigator in the case sought a 1-year suspension of my right to use the CFA designation for a majority of the investigation. A Hearing Panel heard the case, and went against the recommendation of the CFA's Institute's Professional Conduct Department. Long story short, be careful who you trust, especially when substantial money is involved, and always disclose everything properly, which is hard to do when you are going through difficult situations, as this is the last thing you are probably thinking of at the time. In closing, I have had more experience in the markets, business, and life than most, yet I am grateful & thankful for every day. Additionally, I have learned through success and failures that you have to move forward, and if you can do this, your life will form a rich tapestry of stories.

Analyst’s Disclosure: I am/we are long CLF, VALE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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