Cleveland-Cliffs: Get Ready (NYSE:CLF) | Seeking Alpha

Well it is a new month in the market, and it looks like we are back to selling off. The pain in retirement accounts, taxable portfolios, and in many people’s savings is increasing. At the same time, the quality of most of the middle class’s everyday life is starting to decline. One stock that we frequently trade is Cleveland-Cliffs Inc.’s (NYSE:CLF). We have traded CLF a dozen times in the last year, largely successfully, by being tactical and employing strategic options approaches around a core position. As we head into mid-October, we are coming into a critical time for markets. New inflation data is due out. Q3 earnings are set to be reported. The Fed is going to raise rates based on both of these sets of data points, as well as consumer confidence data, but their charge is price stability. That is their goal, even if it crushes stocks, causes unemployment to spike, and businesses to feel pressure. They want inflation down. But we believe the strain has started. We are seeing commodity prices coming down. But we have not seen much disinflation in the economic reports, but those are Simple as that. We believe that the Fed’s actions are starting to weigh, and that we will see signs of this on Q3 earnings. Look, we think CLF is cheap, but it can get cheaper if performance really slows, or the outlook is horrible. As the stock gets to the low teens, we have a long bias again, but Q3 earnings are coming up in two weeks. That said, steel and iron ore prices, as well as demand data, will drive a lot of the action in the stock both short and medium-term, but the earnings report will be a huge catalyst. More specifically, the outlook could really get things moving. Overall, we believe in the company and management long-term. In this column we discuss what we are looking for when Q3 is reported. Get ready.

The macroeconomic backdrop is problematic, though demand appears robust

One thing is for certain, CLF is pretty correlated to steel and iron ore pricing. The prices of these commodities are tied often to GDP, but watching steel pricing offers a great gauge for what the stock is expected to do. While the company locks in prices for contract, the concern is future contracts could see lower value if pricing continues to stay depressed. All of this is occurring as a result of the Federal Reserve’s quest for price stability. The economic damage comes second; curbing inflation comes first.

Obviously, recession is the main concern. This has investors selling week after week. The overall economy is just starting to feel the pressure. After prices of everything have escalated month after month, the consumer is pressed. Borrowing rates are not much higher. People’s retirements accounts are starting to get crushed. Compared to a year ago, steel pricing has fallen badly. A lot of this has to do with the fear of a bad recession.

The Fed’s actions will slow economic activity. Make no mistake, we expect commodities to pull back, as prices normalize from the actions taken to slow the economy. But frankly, commodity prices have been falling all year. The stock has reacted by largely selling off all year, with brief, rapid spikes. We tend to like the stock here, a lot, but the Q3 results and outlook are going to determine the direction of the stock. So let us talk about the value as well as what to look for in the Q3 report.

Current valuation is attractive, but performance is dipping due to steel pricing

Steel pricing has come down, though demand remains strong. When Cliffs reported earnings for Q2, they were strong. The company missed versus earnings estimates but shares are valued still at just 4x forward earnings per share. The thing is that performance is already falling, due to the normalization of steel prices this year. One thing we will be watching for is any updates to the overall selling prices for the full year 2022. Back in Q2 we learned in the earnings release that there was an “average selling price expectation of $1,410 per net ton” for the entire year 2022. This will be an important update in Q3, because there are expectations of big free cash flow in 2022. There are concerns the expectations will be drastically reduced, this is why the stock has suffered.

We expect revenues to fall

Revenues were strong in Q2 2022 hitting $6.34 billion, rising 26% from last year, and exceeded estimates by $226 million. However, with prices having come down, despite strong contract pricing, we think revenues fall in the mid-single-digits, and are looking for Q3 revenues of $5.6-$5.75 billion. This would be a decline of about 5% from a year ago. And with a reduced top line, we expect some pressure on earnings as well.

Keep an eye on the moves in EBITDA, as well as the bottom line trend

So back in Q2, the company’s EBITDA and EPS were strong, mostly following the higher revenues. So in Q2, Cliffs’ adjusted EBITDA was $1.1 billion from last year’s $1.4 billion. Adjusted EBITDA was $2.6 billion through H1 2022 vs $1.9 billion through H1 2021. This adjusted EBITDA though H1 was three times higher than last year. We expect EBITDA to dip under $1 billion on lower revenues, though operational expense is a wild card. Of course, at the end of the day, we care about the bottom line. The company brought in $1.31 per share in Q2, but we see declines in Q3 on the back of lower pricing, and moderated volumes. Depending on how operational expenses and debt servicing expense land, we see EPS falling dramatically from a year ago. We are looking for a range of $0.45-$0.60. This would be a fall of about 70% from a year ago.

Watch Cleveland-Cliffs’ cash flow

Now, this was to be another amazing year for cash flow. The company just had its best rolling 12-month cash flow after Q2. But we see this falling dramatically. Right now we the value is strong as the price to cash flow is far less than 3x because cash flow is so strong. The problem is that with the reduced top line, EBITDA, earnings, etc., and the costs the company is incurring, we think free cash flow dips to around $300 million in the quarter. Another wild card will be how the company addresses its debt.

Debt is high, so watch for the amount of reduction in Q3

The balance sheet is improving and the company is paying down hundreds of million in debt. There is still a lot of debt, but the company reduced dent to about $4.6 billion while buying back 7.5 million shares in the quarter. In Q2, saw $633 million in free cash flow, and this was used to reduce debt. With less cash flow expected, we will be watching to see how much debt is paid down. With buybacks, there has been a lot of capital returned to shareholders in some form or another and we expect this to continue. There is still $2.3 billion of liquidity on the balance sheet as well. Keep an eye on the trends.

Final thoughts on Q3

There is a lot to watch for when the company reports in two weeks. We like the valuation of the stock in the low teens. There is good value here, especially as the stock moves lower and the company improves its balance sheet. However, if the outlook for average selling prices is drastically reduced, or the company hints that demand is falling off a cliff (no pun intended) there will be ongoing pressure. Watch for cash flow, and the amount of debt reduced.