- Cleveland-Cliffs is a stock that I have been covering publicly on Seeking Alpha since May 2016.
- Shares of CLF have increased 385.8% since my initial publication date, outpacing the SPDR S&P 500 ETF, which has gained 87.5% over this time frame.
- While Cleveland-Cliffs' common shares have done well on a percentage basis since their 2016 depths, they are still trailing the absolute performance of their mega-capitalization peers.
- Fortunately, supply/demand fundamentals for steel are incredibly favorable, and this is going to lead to a super cycle boom in income and free cash flows for Cleveland-Cliffs.
- With the benefit of hindsight, Lourenco Goncalves' transformation of Cleveland-Cliffs, including the acquisition of AK Steel and ArcelorMittal's U.S. operations near the bottom of the cycle, is going to be a defining masterpiece.
- This idea was discussed in more depth with members of my private investing community, The Contrarian. Get started today »
If everybody indexed, the only word you could use is chaos, catastrophe… The markets would fail. - John Bogle, May 2017
Try to buy assets at a discount rather than earnings. Earnings can change dramatically in a short time. Usually, assets change slowly. One has to know much more about a company if one buys earnings. - Walter Schloss
(Source: With Permission From James Duckworth Photography)
On May 12, 2016, I published an article on Cleveland-Cliffs (NYSE:CLF) with the title, "Cliffs Natural Resources: Too Cheap To Ignore." With the benefit of time, the title proved appropriate, as Cleveland-Cliffs' common shares rose 385.8% from the date of publication through Tuesday, March 2nd, 2021's close, far outpacing SPDR S&P 500 ETF's (SPY) return, which was a gain of 87.5% over this same time frame.
Now, the ride has not always been smooth as the longer-term chart of CLF shares shows below.
(Source: Author, StockCharts.com)
Looking at the chart above, CLF shares actually approached their late 2015 and early 2016 lows in the spring of 2020, as the heart of the COVID-19 market-induced panic enveloped the markets, sparking fear of a global depression.
This heightened level of fear quickly abated, creating a truly unique risk/reward opportunity in Cleveland-Cliffs' shares, as well as in many downtrodden commodity producers, and frankly in the broader equity market in general.
The strange thing today is that even with Cleveland-Cliffs' shares markedly higher than both their 2016 and 2020 lows, there's still a tremendous amount of appreciation potential in shares, particularly given the developments in North American and global steel prices, and the timely acquisitions of AK Steel and ArcelorMittal's (MT) U.S. operations.
These acquisitions were spearheaded by Lourenco Goncalves' vision, which has completed transformed Cleveland-Cliffs from an iron ore producer to the largest integrated steel producer in the United States. Ironically, both of these acquisitions were widely questioned at the time of their consummations, yet they have proved particularly prescient given that steel prices are now trading above even their 2008 highs.
Bigger picture, the steel producers, including Cleveland-Cliffs have a chance for their share prices to catch-up with the leading economically sensitive commodity equity bellwether's, including BHP Group (BHP), Rio Tinto (RIO), Companhia Vale do Rio Doce (VALE), Caterpillar (CAT), and Deere & Co. (DE), which are almost all trading above their 2011 high watermarks.
This implies significant upside opportunity in CLF shares from today's prices, and I will illustrate the scope of this opportunity in this article.
Steel Prices Dwarf Their 2016 Highs And Are Even Above Their 2011 and 2008 Highs
Steel prices in the United States have accelerated higher, as robust demand from housing to structural steel to appliances to automotive steel has dwarfed a relatively restrained, and constrained, supply chain.
Right now, steel prices in the U.S. are the outlier; however, they are leading other markets higher.
The strength in steel prices is pretty far reaching too, with steel prices above the $1000 per metric tonne price all the way out to August of 2021, according to recent data from CME.
Given the shortages in the supply chain, which are articulated nicely in this article, and the prevailing steel prices, current earnings estimates, which have been rising, are woefully understating the true earnings potential for Cleveland-Cliffs, U.S. Steel (X), Nucor (NUE), Steel Dynamics (STLD), and ArcelorMittal.
Earnings and Cash Flows Set For A Record Year
Earnings estimates have been rapidly rising for Cleveland-Cliffs over the past 90 days, as the following snapshot of analyst estimates shows.
Building on this narrative, on Tuesday, March 2, 2021, CLF shares were upgraded by GLJ Research Analyst Gordon Johnson and given a $22 price target, which is roughly 50% above Tuesday's closing price of $14.68.
With an enterprise value of roughly $13.7 billion at Tuesday's close, and a market capitalization of $7.3 billion, Cliffs would need roughly $2 billion of EBITDA, to seem relatively cheap on an EV/EBITDA basis from my metrics, and I think that is actually achievable in 2021.
With Q4 2020 results in the books, Goncalves, who is chairman, president, and CEO, was sounding optimistic in the press release about results and the outlook ahead.
We expect the continuation of the favorable market environment we are in now, and an increasingly positive impact of the well-known lagged pricing mechanisms common in our steel sales. With the contribution of steel sales from Cleveland-Cliffs Steel LLC for a full quarter, we expect first-quarter 2021 steel product shipments of approximately 4 million net tons, and a significant improvement in first-quarter 2021 Adjusted EBITDA from the fourth quarter of 2020. Additionally positive, our second-quarter 2021 profitability should be enhanced even further by the impact of our initial sales of HBI to outside clients.
Lourenco Goncalves via Cleveland-Cliffs' Q4 2020 and Full Year 2020 Earnings Results
With fourth quarter 2020 adjusted EBITDA coming in at $286 million, we could easily see EBITDA double in the first quarter of 2021, and there's growth potential from those levels, as contracts roll over at newer, higher prices.
When pressed for what EBITDA could be on the conference call discussing the Q4 2020 and full-year 2020 results, this exchange between Lucas Pipes of B. Riley Financial (RILY) and Goncalves, summarized in the conference call transcript on Seeking Alpha, highlighted the potential in EBITDA growth in 2021 (emphasis added is via bold is my own).
Lourenco and Keith, when I go through the historical results for CLF, AKS and ArcelorMittal USA and I add in synergies, I shake out at EBITDA, call it, in the kind of high $2 billion range for prior market peaks. But then steel pricing during these prior market peaks was much lower than it is today. So I wondered if there is a perspective on your earnings power in the current market environment that you would be able to share. Thank you very much.
OK. Look, we are not going to discuss modeling in investors call, but just to directionally guide you through how things work. Contract prices with automotive, they stay in place for a year. So whatever we negotiated during the pandemic when the automotive clients were not even operating stayed in place. What we negotiated in December when they were back, but still with a lot of scars on the time that they were not in operation, stay in place.
So the automotive portion will lag in terms of spot price performance that you see reported in the market every day. That is kind of one side that we can call bad news, not bad news. Otherwise, not every single company out there will be trying to desperately to grow their participation in automotive. It is a net, net positive. But as far as pricing, it lags what you are seeing in the marketplace.
But the good news is that with the acquisition of the assets from ArcelorMittal USA, we increased our tonnage in general and we also increased our tonnage to automotive, but we dramatically increased our tonnage to other clients. And to these other clients, even though steel not a real spot transaction, it is a lot closer and a lot faster to materialize the gain.
I said in my prepared remarks, we are now down to 40%, mid 38% participation in automotive. So that means that we have a lot more in the market to [HVAC] (NYSE:PH) and appliances and [steel hot band] (PH), and stuff like that.
So we are selling more in the market, and we are anticipating and accelerating the realization of this higher price. And of course, it is a lot in is good work in a price environment in which hot-rolled is above $1,200 per ton per natural and IODEX is 174 per long ton. It is a lot, lot usage. So we are good. We are good.
We are going to have an EBITDA this year that will be higher than the revenues of the previous year when we are Cleveland-Cliffs alone. Very few companies can say that I transformed my yearly revenue and my yearly EBITDA when actually the yearly EBITDA is a little high. So there you can say that, we can. And we will do that.
(Source: Seeking Alpha February 25th, 2021 Conference Call Transcript)
Translating the exchange, Lucas hinted at peak EBITDA potential in the high $2 billion range based on an agglomeration of the prior business units that now compromised the new Cleveland-Cliffs and using prior steel price bull markets. Going further, he implicitly suggested that EBITDA could be materially above $3 billion on an annual basis from where steel prices are today compared to historical levels. For his part, Goncalves said they are on track with EBITDA increasing strongly, yet because of the nature of their contracting, the growth in EBITDA will be achieved with a delay. Thus, at the time of the conference call, on February 25th, 2021, Goncalves was only promising they would do EBITDA above CLF's 2019 revenues, which were $1.99 billion.
Given the prior rise of Cleveland-Cliffs' shares into the earnings call, from the $7 range in early November of 2020, to over $16 per share in February 2021 prior to the fourth quarter and full-year 2020 results being released, the subsequent sell-off in Cleveland-Cliffs shares is not a surprise, as the market was expecting potentially a higher EBITDA guidance range in 2020. However, even at a $2 billion in EBITDA run rate, with a potential further rise, CLF's shares are trading at roughly 6.9 EV/EBITDA multiple on current implied 2021 EBITDA guidance, which is attractive versus the broader equity market.
Personally, I think EBITDA guidance will be raised as the year progresses because of the sustained strength in steel prices, and this will fuel the upside in CLF shares from today's price levels. $2.5 billion in annualized EBITDA and a 7 times EV/EBITDA multiple would bring CLF's fair value to roughly the $22 share price range, right in line with GLJ's price target. This represents roughly 50% upside from Tuesday's closing price of $14.68 per share, and there could be more upside if CLF's trades to a higher EV/EBITDA multiple (or if EBITDA rises further), more in line with the broader market, which could happen as debt is paid down rapidly from free cash flow generation.
Cleveland-Cliffs Has Significant Catch-Up Potential Compared To The Mega-Capitalization Commodity Equity Leaders
Bigger picture, I think there's more upside potential in CLF shares than the EV/EBITDA multiples suggest. How this is achieved remains to be seen, though I speculate it could occur from stock buybacks, higher than modeled EBITDA, and a higher base level of steel profitability than is believed right now, as we are still coming out of the bottom of the cyclical cycle in terms of duration, with the explosive move higher in steel prices potentially simply the opening salvo in a supply/demand imbalance.
Specific to Cleveland-Cliffs, despite a strong run in CLF shares from both their 2016 and 2020 lows, there remains a lot of catch-up potential in CLF's shares, especially relative to larger capitalization leading commodity equities. Part of this upside potential comes from the prescient timing of Cleveland-Cliffs buying industry assets for bargain prices near the bottom of the cycle. This has positioned Cleveland-Cliffs favorably to capture a bigger portion of the gains from a commodity super cycle, which many investment banks from JPMorgan (JPM), via Marko Kolanovic's recent call, to Goldman Sachs (GS), which I wrote about here in this article, are on board with right now.
The very large capitalization commodity equities, including BHP Group, Rio Tinto, Vale, Caterpillar, and Deere & Company, have been clearer in pricing in the upturn in commodities, as these equities are now generally above both their 2008 & 2011 levels, as the charts below show.
Looking at these charts of the largest capitalization commodity producers and directly related beneficiaries collectively reinforces that the commodity bear market really ended in late 2015/early 2016. This was not clear from 2017-2020, as many commodity prices and commodity equities struggled on both a relative and absolute basis, especially in the downtrodden energy sector, as the disinflationary environment that dominated 2011-2016 resurfaced from 2017-2020.
Large-cap growth stocks, and growth stocks in general, reasserted their market leadership mantle during this time frame, making almost all market participants think we were transported back to 2011-2015, yet the price action of the past 12 months, is firmly suggesting a historical capital rotation that is now in full bloom, and now the false start we saw in 2016. Once a larger section of the market wakes up to this reality, Cleveland-Cliffs' shares could challenge their 2011 highs too.
Looking at the chart above, there's a lot of distance between where we are today and where CLF's share price was in 2011, or even 2008, and keep in mind that steel prices are actually much higher right now than those two prior time frames, and Cleveland-Cliffs is a much larger company.
Also keep in mind that BHP Group, Rio Tinto, Vale, Caterpillar, and Deere, whom I was bullish on with this May 15, 2016, article titled, "Deere Investors, I've Found Your Inflationary Hedge," have almost all, with the exception of Vale, exceeded their 2008 and 2011 highs, suggesting further upside for the broader commodity equity complex.
Specific to the upside potential in shares, investors should reference that Deere shares have blown away my bullish scenario estimate from the aforementioned May 2016 article.
(Source: Author's Work From May 15, 2016 Deere & Company Seeking Alpha Article)
The lesson here is that you have to be careful modeling as an analyst, and both upside and downside scenarios can be more extreme that what you would model by taking near-term prior estimates and extrapolating forward.
Closing Thoughts: Lourenco Goncalves Has Painted A Masterpiece With His Latest Version Of Cleveland-Cliffs
Operating from an opportunistic vantage point has historically served Lourenco Goncalves well, and he has outdone himself with his strategic and tactical moves at Cleveland-Cliffs over the past five years, and more specifically over the past year. The opportunistic acquisition of AK Steel and ArcelorMittal's U.S. operations near the bottom of the cycle, has positioned the current version of Cleveland-Cliffs to report record net income, EBITDA, and free cash flows.
Buy-side and sell-side analysts are having trouble modeling what the profit and free cash flow potential is here, as this version of Cleveland-Cliffs has not existed previously, and from a macro standpoint, nobody is sure how long steel prices will stay at these lofty price levels.
This confusion is creating opportunity in Cleveland-Cliffs shares, as I see a path forward to EBITDA north of $3 billion. Adding to the narrative, free cash flows are going to surge higher, providing the opportunity for debt payback and the transfer of enterprise value from debt holders to equity holders, shareholder buybacks, dividend growth, and opportunistic business growth.
Risks include the fact that U.S. steel operators, even from an advantaged position, have historically had trouble competing on the global marketplace with state sponsored behemoth's and giants like Pohang Iron & Steel (PKX), also known as POSCO, so a change in the current supply/demand imbalance could lead to a flood of imports at some undetermined point in the future. Pushing back against this bearish scenario is the fact that the global steel market place is imbalanced too right now too, with demand exceeding supply, and we can see this in the dramatic increases in iron ore prices, metallurgical coal prices, and prices of zinc, which are all crucial inputs into steel production, and steel prices.
The untold story with the rise in commodity equities is that this is a supply side story and, more specifically, the capital cycle is playing out real time as many commodity industries were starved of capital the past decade as almost all stakeholders, including shareholders, were impaired in one form or another, especially on a relative basis as traditional financial assets soared, and real assets were left behind.
With the broader equity market ripe for at least a sharp correction and potentially something much greater amidst an ongoing historic capital rotation, which could be fueled by rising long-term interest rates rising because of supply side commodity inflationary pressures, investors should be looking for non-correlated sectors and non-correlated stocks. On this note, commodity stocks certainly fit the bill in this regard, as they are historically non-correlated.
In closing, I have been pounding the table on the extremely out-of-favor commodity equities for a long time now, and I still think we are in the early innings of what will be a longer-term price appreciation cycle. Cleveland-Cliffs is perfect example of a still out-of-favor commodity producer. My first public article on CLF was published was all way back in May of 2016, and investors had the same opportunity in CLF shares in the spring of 2020, so we are just getting started with the secular bull market in commodities, and commodity equities, at least from my perspective.
Understanding the bigger picture, then having an understanding of the bottoms-up fundamentals has been the key to outperformance, and this is a path that has not been easy with those participating confirming this reality. However, the road less taken is sometimes the better path, and I firmly believe that today, as traditional stocks, bonds, and real estate offer very poor starting valuations, and very poor projected future real returns, from today's price levels. More specifically, the out-of-favor assets and asset classes, including commodities and commodity equities, and out-of-favor specific securities are where the historic opportunity has been, and that's where it still stands, from my perspective.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
This article was written by
KCI Research, aka Travis, has been a financial professional for over 20 years. Formerly a director of research at a mid-sized RIA, and one of four strategic investment decision makers at one of the largest RIA's in the United States, Travis founded his own boutique investment firm in February of 2009. He specializes in against grain investing backed by real-world wisdom and experience by targeting out-of-favor, contrarian investment opportunities.Travis is the leader of the investment group The Contrarian where he shares premium research and uncovers investment gems hidden in plain sight. Travis shares an all weather portfolio for minimal volatility along with a concentrated best-ideas portfolio Learn More.
Analyst’s Disclosure: I am/we are long CLF, BHP, MT, RIO, STLD, VALE, X, AND SHORT SPY IN A LONG/SHORT PORTFOLIO. 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.
Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication and are subject to change without notice.
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