Cleveland-Cliffs: Reaping The Benefits Of Well-Timed Transformational Deals

Summary

• Cleveland-Cliffs has been the best performing steel producer in the U.S. even as integration of AK Steel and ArcelorMittal USA is still ongoing.
• The company is exceptionally well-positioned - both from a market and industry wide perspective.
• Following the acquisitions, the business is on a much stronger footing with solidified pre-existing competitive advantages.

Source: clevelandcliffs.com

I have been following and owning Cleveland-Cliffs (NYSE:CLF) for a bit more than two years now, but the past one year has been one of the busiest, most exciting and most volatile for the company.

Even though the stock has a relatively high risk and large fluctuations in price are quite normal, this past year was marked with two of the most transformative acquisitions in the company's history, a sharp increase in steel prices and last but not least increased market volatility due to the pandemic.

During this period of increased market and idiosyncratic business risks, however, CLF has been one of the best performing names in the steel industry.

Data by YCharts

For the past year, I covered CLF three times - during September and November of 2020 when I explained my long-term investment thesis behind the company and later on improved on this thought piece by adding some nuance on why quarterly fluctuations in fundamentals and share price do not bother me.

Source: Seeking Alpha

In my last analysis in January of this year, I also explained how short-term bullishness and analyst recommendations could drive the share price to unsustainable short-term highs.

Now once again, as CLF share price starts to appreciate, analysts are slowly starting to update their ratings to buy & strong buy, which could drive CLF share price to an unsustainable short-term high.

Source: Seeking Alpha

Having seen this price action before, when sudden inflow of favorable analyst recommendations, new investors and bullish sentiment drove the share price to unsustainable short-term highs, I turned Neutral back in January.

Source: Seeking Alpha

Following the recent correction and fiscal year 2020 results, however, I am turning cautiously positive on share price again while I am not adding to my positions yet.

Positioning from a market perspective

Cleveland-Cliffs' share price is the riskiest from its peer group, both from a market risk point of view, as measured by the beta of the stock, and from total risk perspective, measured by the standard deviation of daily returns.

Source: prepared by the author, using data from Yahoo Finance

This, and the high leverage, partly explain the outstanding performance of CLF over the past year, as higher risk translates into higher expected returns.

However, even if we control for market risk and take into account Cliffs' 1-year daily beta of around 1.6, or even its 5-year monthly beta of 2.3 as calculated here, the company's total return over the past year was far greater than what the market return would suggest.

Data by YCharts

Even if we take the total risk as measured by the standard deviation above, CLF and United Steel (X) significantly outperformed its peers while their standard deviations were around 1.5 times higher.

Interestingly the high beta stocks, such as CLF, have been on a tear recently, significantly outperforming the market during the last couple of months. If we use the Invesco S&P 500 High Beta ETF (SPHB) as a proxy for high beta stocks performance, we could easily see the identical price pattern between SPHB and CLF.

Data by YCharts

The Invesco S&P 500 High Beta ETF, however, is predominantly focused on Financial, Energy and Consumer Discretionary companies which combined make up around two-thirds of the ETF's holdings. Materials, on the other hand, make merely 4% of the ETF's holdings.

Source: invesco.com

Going back a few months, just to the moment before SPHB and CLF started to increase materially, we could see that the share of Basic Materials actually decreased from 5.7% in October 2020 to 3.9% in February this year.

Source: web.archive.org

The share of Energy, on the other hand, increased from 13% to 20% in a matter of just few months. While the rally in oil and natural gas prices does explain the sharp increase in Energy stocks, these commodities are actually a significant cost input for Cleveland-Cliffs.

Higher inflation expectations could also provide an explanation on why CLF performance matched that of the high beta Energy stocks and Financials.

Source: fred.stlouisfed.org

These higher inflation expectations and commodity prices did help Cliffs' traditional peers as well; however, CLF performance has also been far better than that of its traditional legacy competitors, such as Vale (VALE), Rio Tinto (RIO) and BHP Billiton (BHP).

Data by YCharts

While this could also be easily attributed to luck, it appears that CLF management's decision to go all-in on its vertical integration into steel manufacturing has been very well-timed and resulted in the company outperforming both its current and legacy competitors.

Cliffs' Business Perspective

Even after the recent rally in CLF share price the stock still trades near its 5-year lows, while it has solidified its pre-existing competitive advantages and is on track to also reduce earnings volatility through vertical integration.

Data by YCharts

On an enterprise basis, however, CLF trades at significantly elevated multiples due to its higher leverage. That is why deleveraging is once again high on the management's agenda and the recent rally in steel prices is just what was needed.

Source: lme.com

While many experts are once again forecasting that this rally in steel prices will be short-lived as the economy picks up and supply comes back online, the long-term trend of less imports of more polluting steel and metallics from overseas remains intact.

Source: fitchratings.com

Moreover, CLF management now exerts significant control over the supply of steel in North America and appears determined to prioritize value over volume.

And we are not in the pursuit of capacity utilization either. We prioritize value over volume. We prioritize delivering on time and we accommodate the demands of our clients, particularly automotive clients.

Lourenco Goncalves - President and Chief Executive Officer

Source: Cleveland-Cliffs Q4 2020 Earnings Transcript

Even if it turns out to be "a short-lived" rally in steel prices, it will benefit Cliffs' cash flow over the coming year.

Our steel supply contracts are roughly 45% annual fixed price with resets throughout the year and 55% HRC index-linked. That latter piece further breaks down to about 40% on pricing lag, split between monthly and quarterly, with the remaining 15% on a spot basis that currently have lead times up to three months for hot-rolled and four months for cold-rolled and coated products.

Lourenco Goncalves - President and Chief Executive Officer

Source: Cleveland-Cliffs Q4 2020 Earnings Transcript

While restructuring charges will likely persist over the coming quarters, CLF bottom line is likely to improve during 2021 as AM USA assets are fully consolidated.

Due to how contract prices work and usually applies lagging mechanisms and the fact that we only controlled the AM USA assets for the last 23-days towards the end of the year, our steel profitability in the fourth quarter of 2020 has not benefited or improved from these strong prices just yet. As a result, our EBITDA performance will dramatically improve in the first quarter of 2020.

Lourenco Goncalves - President and Chief Executive Officer

Source: Cleveland-Cliffs Q4 2020 Earnings Transcript

Moreover, CLF will also benefit in the following quarters from Hot Briquetted Iron (HBI) shipments as it begins to reap the benefits of years of investing into its plant in Toledo, Ohio. I cover Cliffs' competitive advantages in metallics and HBI in more detail here.

Source: argusmedia.com

The decision to expand into steel manufacturing appears to have been very well-timed from a valuation perspective as well as Cliffs announced the acquisition of AK Steel in December of 2019 which coincided with a long-term bottom in valuations. The second transformative deal for ArcelorMittal USA was announced just a couple of months later in September of 2020.

Data by YCharts

These two deals also gave CLF significant exposure and important competitive advantages in the high margin automotive steel segment.

Source: Cleveland-Cliffs 2020 10-K SEC Filing

As vehicle sales recovered in the second half of 2020, the sector now deals with semiconductor shortages which would have some short-term implications for production. Over the long run, however, there will be increasing pressures to move more automotive production back to the US.

Source: fred.stlouisfed.org

Demand from automotive remains strong, and auto OEMs continue to struggle to keep up with resilient consumer demand. So far, we have seen only minor short-term demand impact from a widely publicized cheap shortage, all of which, as we have been told by our automotive clients, will be made up for during the year.

Source: Cleveland-Cliffs Q4 2020 Earnings Transcript

On top of that consumer demand for autos remains robust, President Biden's $1.9T stimulus bill is being finalized and there is a growing need for increased infrastructure spending.

Even if these tailwinds remain short-lived, they would allow CLF to reduce its debt levels using excess free cash flow during 2021.

At the same time the debt maturity profile does not seem to pose a significant risk for the company as the vast majority of principal payments are due in 2025 onwards.

Source: Cleveland-Cliffs 2020 10-K SEC Filing

Conclusion

Holding onto Cleveland-Cliffs' shares has not been an easy task for anyone bothered with quarterly performance, speculations about commodity prices or the economy. Highly volatile shares of CLF are also often subject to wild speculations and short selling, which necessitates even more patience for anyone convinced in the long-term investment thesis.

Taking a step back, however, and focusing on the business itself, CLF appears on an even stronger footing now with the vertical integration of AK Steel and AM USA. The company has undeniable regional, technological and supply related competitive advantages that are almost impossible to replicate. While I expect short-term volatility to remain both on the upside and the downside as well, I am using short-term pullbacks to slowly increase my positions.

Analyst’s Disclosure: I am/we are long CLF. 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.

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 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.