The Remarkable Transformation: Cleveland-Cliffs
Summary
- Cleveland-Cliffs is transforming itself into a key player in the US steel industry.
- That transformation depends on a strategy that has components of both vertical and horizontal integration.
- The vertical integration applies to the company's ability to control the resources and mechanisms for its own steelmaking capabilities.
- The horizontal integration is expressed in Cleveland-Cliffs functioning as an important supplier to other players in the US steelmaking landscape.
- These changes are largely the result of the leadership of CEO Lourenco Goncalves, who stands in the first rank of today's CEOs.
Introduction
Cleveland-Cliffs (NYSE:CLF) is a company in the throes of a remarkable transformation in focus, size and momentum. The same can be said of its stock, whose recent volatility is a reflection of this kinetic reality.
The power of the CLF story lies as well in its uniqueness, which is captured in the bullet points above and by the leadership of CEO Lourenco Goncalves. The company's transformation from an ore producer into a forward-looking leader in the US steel industry is tied directly to Goncalves’ strategic vision, consistent execution and underpinning characteristics of skill and confidence.
Mr. Goncalves believes in the mission and has demonstrated his ability to lead a team in execution. This is a real difference-maker for Cleveland-Cliffs.
A snapshot view of the company may cause an investor to hesitate, given that it is a turnaround story. The change in scale and the ambitious self-redefinition may cause the share price to fluctuate in the short term.
My view of CLF’s future is a rosy one: think a cold Great Lakes sunrise rising up out of slate-grey and up into a brightly-hued clarity.
Revisiting the Business Case
Several weeks ago, I wrote a piece about CLF published on Seeking Alpha. I stated that “Cleveland-Cliffs' business model has several key components, including consolidation, efficiency and growth. There is extensive interplay between the three.”
Here was a company in the midst of a transformation, and that transformation triggered growth through acquisitions and expansion. Beyond that, the emphasis for CEO Goncalves beyond expansion was efficiencies, including greater exploitation of existing resources to achieve superior production and greater revenues, profits and shareholder value.
CLF’s transformation, however, is more than the byproduct of acquisition and efficiencies. It depends upon vertical and horizontal integration. CLF now controls its own steelmaking chain from raw ore to finished CLF-made steel, and has set itself up as a high-quality supplier of production materials for use by other steelmakers.
This strategic transformation, resting in very coherent vertical and horizontal integration models, is in turn actualised by technical components and capabilities that I describe in the next section.
New Product Technology Facilitates Transformation
The transformation is not occurring by itself. CLF's emphasis on quality products that fit the needs of its own production and its clients (other steelmakers, automotive companies, etc.) is making a critical and positive difference.
As CLF Seeking Alpha advocate Rick Jensen has pointed out, CLF’s profit drivers are changing from old models of ‘coil and plate’ to a complex of HBI, UHSS/AHSS and custom recipes.
What are these products?
HBI is a compacted form of direct reduction processes that produce Direct Reduced Iron (DRI). Direct reduction reduces iron ore to iron, taking iron lumps or pellets and treating them with a reducing gas or elemental carbon.
“HBI” stands for hot-briquetted iron, a variation or subset of DRI.
Whichever reduction method is employed, the result is the burning of oxygen in the ore. The ore becomes metallic iron, which is then turned into steel using EAF (electric arc furnaces) or by another means.
Some of the advantages of using DRI/HBI to produce iron include its constitution as 90-94% total iron, raising its value as feedstock for electric furnaces and its ability to use pellets or natural lump ore (CLF produces these pellets). CLF can take its ore and turn it into iron that it uses to manufacture steel or sell to other steelmakers. HBI is thus a critical process for CLF and an enormous profit lever.
The CLF Toledo HBI plant is new and operational:
CLF emphasises the power this provides in its latest 10-Q filing in the wake of the first quarter earnings report:
“We are the first and the only supplier of HBI in the Great Lakes region. Construction of our Toledo, Ohio, direct reduction plant was completed in the fourth quarter of 2020. From this modern plant, we offer a high-quality scrap and pig iron alternative to the several EAFs in the region. Previously, ore-based metallics that compete with our HBI had to be imported from locations like Russia, Ukraine and Brazil...our HBI offers a sophisticated alternative with less impurities, allowing other steelmakers to increase the quality of their respective end-steel products and reduce reliance on imported metallics."
The iron ore-to-iron-to-steel production path is also evidence of the vertical integration described earlier. In the press release accompanying the February 25 earnings report, CLF describes the role of HBI in its internal integration:
“We are vertically integrated from the mining of iron ore and coal; to production of metallics and coke; through iron making, steelmaking, rolling and finishing; and to downstream tubular components, stamping and tooling. We have the unique advantage as a steel producer of being fully or partially self-sufficient with our production of raw materials for steel manufacturing, which includes iron ore pellets, HBI and coking coal…we believe such vertical integration represents a sustainable business model that is…the surest way to secure a long-term competitive advantage.”
CLF explains how the acquisitions of AK Steel and ArcelorMittal greatly strengthen its ability to supply ore and its byproducts to itself and customers:
“As a result of the Acquisitions, production from our iron ore mines is now predominantly consumed by our newly acquired steelmaking operations. On a full-year basis, we would expect between 22 million and 24 million long tons of our iron ore pellets to be consumed by our steelmaking operations. During 2020, 2019 and 2018, we sold 12 million, 19 million and 21 million long tons of iron ore product, respectively, to third parties from our share of production from our iron ore mines.”
CLF mines the ore, turns it into iron, uses the iron in its own steelmaking and sells it to other steel companies. Vertical and horizontal integration is a powerful combination.
New Technology Applied: The Automobile Market
CLF’s primary end market is the automakers, as indicated:
Market Share:
Automotive 45%
Infrastructure/manufacturing 15%
Distributors/Converters 13%
Steel Producers 27%
Total 100
Lourenco Goncalves has emphasized the importance of auto manufacturers to the company before, as in this CNBC interview from late 2020:
"Cleveland-Cliffs has a massive exposure to automotive…in Q3 [2020), we have been through a very profitable quarter, and very strong in terms of recovery of demand - particularly in automotive."
In the SEC 10-Q filing after the February earnings report, Goncalves mentions how the recent acquisitions strengthen the ability to produce high-quality steel products for the automobile industry: (ArcelorMittal’s product line is an example.)
“With the Acquisitions completed, we now have enhanced our offering to a full suite of flat steel products encompassing all steps of the steel manufacturing process. We have increased our industry-leading market share in the automotive sector, where our portfolio of high-end products will deliver a broad range of differentiated solutions for this highly sought after customer base."
Automobile customer preferences again play into CLF’s technological strengths and processes, as witnessed in its UHSS (Ultra High Strength Steel) and AHSS capabilities.
“There are two main factors driving the development of Ultra-high-strength steels (UHSS),” says Frederic Painchault, head of automotive marketing with steelmaker ArcelorMittal. “The first is CO2 emissions regulation, which leads to a strong demand for weight reduction. Advanced high-strength steels (AHSS) are one solution to vehicle lightweighting. The second is legislative requirements in the area of safety. AHSS help auto manufacturers to achieve safety standards and to meet CO2 legislative demands.”
The power and utility of AHSS products are explained in this excerpt:
“The metallurgy and processing of advanced high strength steel (AHSS) grades are somewhat novel compared to conventional steels. Their remarkable mechanical properties are the result of their unique processing and structure…AHSS is most advantageous when used for safety components of automobiles and their structural parts where high strength with reasonable ductility is important. AHSS has become the material of choice for passenger safety cage components like sill reinforcements, A-pillars, B-pillars, side impact beams, waistline reinforcements, bumpers, and roof bows. Advanced high strength steel has also been introduced in all other vital areas of the automotive industry, like seats. Many new cars are already composed of 30% – 40% AHSS…to reduce the weight of bumper systems, door side impact beams, seat structures, etc.
This ability to create UHSS/AHSS-based products and market them to vehicle manufacturers is critical given that customer segments' emphasis on producing safer, lightweight and regulation-complying products.
Custom Recipes for Steelmaking Clients
HBI, as mentioned, is made from DRI pellets. CLF is one of the few companies that will develop HBI by custom order, structuring the pellet composition to fit the method used to produce the iron/steel make-up that the customer seeks. An example is the "Mustang Pellet", which was designed specifically for blast furnaces. Extra limestone is added to the pellet so that it converts from a liquid to a solid state more quickly. The customized pellet production results in the highest-quality carbon HBI.
With a high 3% carbon content, Cliffs' HBI is a differentiated premium product and can replace imported pig iron. The hardness in the steel produced from such pellets is also an indicator of greater material strength. Contrast this to the ingredients of A36 grade steel, a low-grade recipe that has a mix of elements and just .25% to .29% carbon.
This produces a quality domestic product to replace US steelmakers’ dependence on imported pig iron, and helps show why Cleveland-Cliffs is evolving as a very attractive supplier to US steel companies. They are very likely to increasingly buy from a high-quality domestic supplier over external sources.
(Lourenco Goncalves constantly refers to quality as a key emphasis. This quality facilitates the application of high margins.)
Note: A hat tip goes out to frequent SA CLF commenter Rick Jensen for his generous help with explaining technical processes presented in this section.
CLF: Opportunities
Cleveland-Cliffs in my view is sitting on a gold mine, or more precisely an ore-iron-steel ‘mine.’ It is undergoing major change that is intentional - the result of a strategy in the midst of successful execution guided by its dynamic CEO.
The strategy is designed to both achieve vertical and horizontal integration. The vertical integration is expressed in a chain that starts with the mine and continues with ore processing and CLF’s own steel manufacturing. The supplier role with other steel manufacturers expands the company's profit opportunities significantly. CLF has positioned itself as a replacement for the foreign-sourced pig iron that many US steelmakers have depended upon.
Under Lourenco Goncalves’ leadership, the company has identified the problems and seen the opportunities, then created a dual strategy (vertical-horizontal[supplier]), that it is executing successfully.
Risks
No stock is without risk. I have outlined my sense of such risks in my earlier piece on the company. The company does have significant debt - but without debt companies also do not grow - and CLF is growing rapidly.
There is also the fact that the price of commodities such as iron and steel rise and fall. Should external events cause a correction in the price of steel or iron, CLF and its share price will be affected.
There is also the scenario in which Mr. Goncalves departs his role. I discussed this in the previous piece at length.
In terms of competition, my research on this and my previous CLF piece suggest that the company is in a powerful 'pole' position. In other words, there appears to be no single US-premised steelmaker that has executed a similar strategy to that of CLF.
The risks exist, but I believe that they are far outweighed by Cleveland-Cliff's opportunities.
Quick Financial Review
CLF finances appear sound, and the recent earnings report was positive. Details are available in the 10-Q.
Here is a quick graphical look at 2020 revenues as portrayed by a CLF-produced chart:
During the year CLF revenues were approximately $5.4 billion, an increase of approximately $3.4 billion, or 169% compared to 2019. The increase was due to the addition of $4.0 billion in revenues as a result of the Acquisitions, partially offset by a decrease in revenue from iron products of $655 million resulting from lower sales volumes of 6.9 million long tons compared to 2019.
The press release includes further details about fourth-quarter results:
Fourth-quarter 2020 consolidated revenues were $2.3 billion, compared to prior-year fourth-quarter revenues of $534 million. The Company recorded net income of $74 million, or $0.14 per diluted share. This included $44 million of charges, or $0.10 per diluted share, from acquisition-related costs and amortization of inventory step-up. This compares to net income of $63 million, or $0.23 per diluted share, recorded in the fourth quarter of 2019, which included $7 million, or $0.03 per share, of acquisition-related costs.
Fourth-quarter 2020 Adjusted EBITDA1 was $286 million, compared to $111 million in the fourth quarter of 2019.
For steelmaking, fourth-quarter revenues were $2.1 billion, and included approximately $859 million, or 41%, of sales to the automotive market; $503 million, or 24%, of sales to steel producers (external pellet sales, slabs and freight); $374 million or 18%, of sales to the distributors and converters market; and $363 million, or 17%, of sales to the infrastructure and manufacturing market. Cost of goods sold was $1.9 billion included depreciation, depletion, and amortization of $105 million plus amortization of inventory step-up charges ($22 million).
Summary
I view CLF as an exceptional opportunity. The price dipped for reasons I would describe as ‘market irrational’ after the recent earnings report. CLF has also suffered in the correction that was still ongoing as of this writing.
Here is a CLF-supplied chart about stock price performance versus relevant industry indices:
I am bullish-to-very-bullish on Cleveland-Cliffs. I have increased my own stake in the company so that shares comprise about 6% portfolio share.
I believe that this is a great name to own, and that the present is an excellent time to open a position or add to an existing one.
Good luck.
This article was written by
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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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