Cleveland-Cliffs: The Ducks Are Being Lined Up Pretty Nicely

About: Cleveland-Cliffs Inc. (CLF)
by: Peter Arendas

Cleveland Cliffs expects to generate EBITDA around $800 million this year and over $1 billion next year.

Two new processing facilities will help to produce premium iron ore pellets.

A share repurchase program is underway, with $129 million remaining to spend.

The debt load is well manageable at the current iron ore prices; moreover, after the recent refinancing, no debt will mature before 2024.

Various metrics indicate that Cleveland-Cliffs is notably undervalued compared to its peers.

Cleveland-Cliffs (CLF) is a U.S. iron ore producer. The company was established back in 1847 and it was able to overcome various economic downturns and severe recessions. And although it had to face various issues also over the recent years, there are several reasons to believe that its share price is primed for another bull run in the near future.


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Cleveland Cliffs Today

Cleveland-Cliffs operates four iron ore mines in Minnesota (United Taconite, Hibbing Taconite, Northshore mine) and Michigan (Tilden mine). Also the Empire mine is situated in Michigan, but it is on care and maintenance now. Moreover, a Hot-Briquetted Iron (HBI) facility is under construction in Toledo, Ohio.

Source: Cleveland-Cliffs

The United Taconite mine is 100%-owned by Cleveland-Cliffs. Its production capacity is 5.4 million gross tons of iron ore pellets per year.

The Hibbing Taconite mine is 23%-owned by Cleveland Cliffs. The remainder of the mining operation is owned by ArcelorMittal (MT) (62.3%) and United States Steel (X) (14.7%). Its annual production capacity is 8 million gross tons of iron ore pellets per year. It means that capacity of 1.85 million gross tons is attributable to Cleveland-Cliffs.

The Northshore mine is 100%-owned by Cleveland Cliffs. Its annual capacity is 6 million tons of iron ore pellets and concentrate. A facility capable to produce 3.5 million long tons of DR-grade pellets will be completed soon (a ribbon cutting ceremony is scheduled for August 7). The DR-grade pellets are used for the production of DRI (DRI - Direct Reduced Iron - 90% iron content). They will be used primarily to feed Cleveland-Cliffs' Hot-Briquetted Iron Plant in Toledo. The excess production will be sold to foreign customers. Production of steel from DRI requires less energy. As a result, DRI is usually used for the production of steel in modern electric arc furnaces, not in traditional blast furnaces.

The Tilden mine is 100%-owned by Cleveland Cliffs. It has an annual capacity of 8 million gross tons of iron ore pellets.

The construction of the Toledo HBI plant is underway. It should be completed by the middle of 2020 and the CAPEX is projected at $830 million. HBI is a compacted form of DRI. Its main advantage is the ease of shipping, handling and feeding in the furnaces. The plant will have an annual production capacity of 1.9 million tonnes HBI.

The company is expected to produce 20 million tonnes of iron ore and pellets this year. According to Lourenco Goncalves, the CEO of Cleveland-Cliffs:

We expect to generate in excess of $800 million dollars in adjusted EBITDA in 2019. We plan to continue to put the cash generated to good use by paying down debt and returning cash to our shareholders, both through dividends and by taking advantage of our low equity valuation with the use of share buybacks.

The company paid dividends of $0.05 in Q1 and the Q2 dividend was set at $0.06. Much more interesting than dividends (the dividend yield is around 2.5% right now) is the share repurchase program. On November 26, the company announced its intention to repurchase its common shares worth up to $200 million. By the end of March, the company repurchased 17 million shares worth $171 million. As a result, the repurchase program was boosted by a further $100 million. The share count was reduced approximately by 6%. At the current share price, the repurchase program has the potential to reduce it by further 4.5%. However, it doesn't have to be the end. As of the end of Q1, Cleveland-Cliffs held cash and cash equivalents of $430 million and significant cash flows are indicated in the foreseeable future. If the company remains undervalued (the current P/E stands at 2.76 and forward P/E at 5.31, which is well below the sector median of 15.99 and 14.41, respectively), there is a good probability that the repurchase program will experience further expansions.

Cleveland-Cliffs Tomorrow

The introduction of premium products in the form of DRI (during Q3 2019) and HBI (by late Q2/ early Q3 2020) should mean a notable boost to Cleveland-Cliffs' cash flows. The DRI commands a significant premium to the common blast furnace pellets and iron ore itself. Back in 2018, when iron ore traded in the $60-70/tonne range, the DRI premium was around $65/tonne. At the same time, the HBI price was around $300/tonne.


The outlook for the iron ore market, especially for the premium products, seems to be positive. According to the Metallics Association, the DR-grade pellets demand should climb to 49.4 million tonnes in 2020, which is more than 21% above the 2018 level. On the other hand, Vale's (VALE) DR-grade pellets production may decline by 2.5 million tonnes, following the Brumadinho dam collapse. Vale cut not only its iron pellets production but also its iron ore production. As a result, the iron ore price (chart above) has grown above $100/tonne and it is at its highest level since H1 2014. Barring any economic downturn, the iron ore prices should remain strong in the foreseeable future.

The new facilities will provide Cleveland-Cliffs also some more flexibility. The company will be able to produce iron ore, DRI and also HBI. According to Lourenco Goncalves, the CEO of Cleveland-Cliffs:

What we are seeing in the world right now is the biggest pellet shortage that you could not have imagined what would happen. We prepared for the future, but the future became the present because of Vale.

We are a year away from starting to supply HBI to the market. In July we will start producing 3.5 million lt/year of DR-grade pellets out of Northshore."

So for us to produce we had to stop blast furnace [pellet] production and then move to DR. And now we have optionality. That's one thing that is great to have in this business. If a blast furnace starts reducing orders, I can immediately start selling DR-grade pellets. Right away, with no interruption.

The CEO also believes that the premium products will provide some form of a buffer for the case of a steel market downturn:

The last mills that will shut down in the US will be the electric arc furnaces. They have the balance sheet and the ability to withstand a lot more than the integrated mills in terms of their financial strength.

As the new products hit the market and the capital expenditures decline, Cleveland-Cliffs should become highly free-cash-flow positive. It will provide a significant room for acquisition of new projects, expansion of the current operations, expansion of the share repurchase program or significant growth of dividends, as well as a rapid debt reduction. All of the outcomes give a reason to believe that the share price should start to grow sooner than later.

The Risks

Of course, there are also several risks worth mentioning. The market capitalization of the company is only $2.8 billion right now. However, the company carries a significant debt load. The total debt equaled $2.09 billion and net debt equaled $1.66 billion as of the end of Q1. However, given the expected 2019 EBITDA of $800 million and even higher expectations from 2020, Cleveland-Cliffs should be able to reduce its debt notably. But complications may arise, if the global economy starts to weaken, pulling the iron ore demand down. In this case, Cleveland-Cliffs' cash flows will decline, which will lead to a worsening of the debt ratios. In this case, also the dividend payments and the share repurchase program would be endangered.

The good news is that Cleveland-Cliffs was able to refinance a major portion of its debt last month. It issued senior unsecured guaranteed notes worth $750 million, with maturity in 2027. The proceeds were used to redeem all of the 2021 notes and the 2025 notes worth $600 million. As a result, there are no debt maturities before 2024. It provides a lot of flexibility. Even if the iron ore market starts to collapse right now, Cleveland-Cliffs should have enough time to endure the headwinds and wait for the good times to return.


Cleveland-Cliffs is an interesting iron market play. The company is trying to penetrate the premium iron pellet markets which should provide a further boost to its EBITDA that should reach $800 million this year and more than $1 billion next year. The dividend yield is approximately 2.5% right now, moreover, a share repurchase program is underway. The most negative feature of Cleveland-Cliffs is its debt load. However, after the recent refinancing, there are no debt maturities before 2024. Moreover, at the current iron ore and pellet prices, the cash flow should be high enough to handle the debt easily.

Various metrics indicate that Cleveland-Cliffs is significantly undervalued compared to its peers. Its P/E ratio is only 2.76, which is much less than the sector median of 15.99. The forward P/E stands at 5.31, which is significantly below the sector median of 14.41. Also, other indicators such as price-to-cash-flow (5.22 vs. 8.73) or equity value-to-EBITDA (5.83 vs. 7.96) indicate that shares of Cleveland Cliffs have meaningful upside potential.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CLF over the next 72 hours. 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.