Cleveland-Cliffs: Simply Ludicrous (NYSE:CLF) | Seeking Alpha

One of the hottest topics among our membership has been the action in Cleveland-Cliffs Inc.’s (NYSE:CLF) stock. We have traded it successfully several times in the last few months, padding short-term gains. We believe in the company and management long-term.

Steel is of, course, rather cyclical, and some investors never touch it because long-term the stocks seem to offer lower returns than the broader market given how tethered the sector is to steel and iron ore pricing, as well as economic demand. In turn, the stocks ebb and flow. It sets it up to be bought and sold by firms like ours, riding the waves higher, and selling or shorting the way down. It is simply reality.

But honestly, the action right now is a bit ludicrous. Let us put this in perspective here. You can probably stop reading after this sentence. The stock has been eviscerated because “there are fears” of a Fed-induced “hard landing” and a “possible recession.” Think about this. Steel pricing has fallen badly because of what could occur, not necessarily what will occur. Sure, the Fed is working to lower inflation. We expected commodities to retract some. But this is a whole new Cleveland-Cliffs. This company has transformed itself, and we think that it does indeed have great long-term potential, beyond being a stock we trade for gain. Given the outlook for the company longer-term, this action is simply ludicrous.

Valuation and steel pricing

The company just reported earnings, and they were strong. In reality earnings estimates may have been slightly too high, but shares are valued at just 3.5x FWD EPS compared to consensus, and just 4X even if we take a more conservative view on earnings. After it reported, there were a few big positives in the release. Management still has a strong “full-year 2022 average selling price expectation of $1,410 per net ton.” Some of this is due to the fact that “the current 2022 futures curve, implies an average hot-rolled coil steel index price of $850 per net ton for the remainder of the year.” This is lower than just 4-5 months ago, but, the company expects to generate massive levels of free cash flow in 2022. And yet, the stock is stuck.

Strong revenue generation

There is no way to look at performance and think the company is faltering. The action is all about fears of the future and lower revenues and margins because steel prices may cool even further, and/or demand could weaken. The stock has been cut in half. What are their earnings worth? That is the question the Street is trying to figure out while balancing the question of much earnings will go down in the future if steel pricing worsens and/or demand softens further. That really is the story here folks. And yet, the numbers remain strong as Q2 2022 consolidated revenues were $6.34 billion, rising 26% from last year. This was a beat of $226 million vs. estimates. Not too shabby.

The company’s adjusted EBITDA of $1.1 billion in Q2 of 2022 was down sequentially, and lower from last year’s $1.4 billion but is $2.6 billion through H1 2022 vs $1.9 billion through H1 2021. This was three times higher than last year. It also brought the last 12 months of EBITDA to $6.2 billion. That is an all-time record for any 12-month period in Cliff’s history. Pricing has fluctuated, with prices slightly lower, but spreads on hot and cold rolled steel improving. Overall, the company earned $1.31 per share, missing by $0.05.

If earnings fall, it is still a bargain

As we mentioned the valuation is really silly, but the market is expecting some multiple expansion when contract prices reset in the fall, as steel prices are lower. The company is trading at a forward price to earnings of 3.5, even lower if you buy shares on a dip. We really like them under $15 even if earnings power is coming down. However, what if the company sees dramatic cost increases and estimates are far too high. We do not believe over $6 in EPS is out of reach this year but if the company “only” earns $4.00. Well, at our buy points you are still paying less than 4x FWD EPS at a $15 target entry. Winning. It is kind of ludicrous, really.

We are also looking at a price to cash flow of less than 3x. The EV/sales is a ludicrous 0.54 and the price to book is now less than 1.0 on a forward basis. It is almost like they cannot give the company away at these prices.

The debt

Now, aside from recession, or steel prices cratering, there remains risk. We have discussed heavily with our members the debt and we were clear that the debt would be getting paid down, transforming the company. The balance sheet is improving here folks. They were able to achieve the company’s largest quarterly debt reduction such this process began, paying down hundreds of million in debt. There is still a lot of debt, but now down to about $4.6 billion worth. The company also repurchased 7.5 million shares in the quarter, reducing the float, and had $2.3 billion of liquidity. They are in good shape and just $35 million of cash on hand. This was addressed further on the conference call:

Michael Glick

…as we think about the balance sheet, how should we think about your net or maybe even absolute debt target in this environment?

Lourenco Goncalves (CEO of the company)

Look, I think we got to what we have to get. We are consistently below one time EBITDA. And we will continue to manage down this debt with cash flow. It’s our — clearly, our main priority to continue to knock down debt…our conversion to free cash flow was also outstanding. And we put the vast majority of the cash generated to pay down debt. We started buy stock until the silly season started, and then we stopped buying stock and then we focus only on that…we’re going to be very focused on paying down debt as always.

We love what we are seeing here. The fact is that this was the largest free cash flow induced debt reduction in the company’s history. The company managed to drive $633 million in free cash flow on the $1.1 billion of adjusted EBITDA and this level of cash flow was more than double what they generated in Q1. And we will say that the share repurchases are nice to boost shareholder value and increased EPS potential, but prioritizing debt reduction is paramount. They have done and amazing job here.

Final thoughts

There is value here, especially as the stock moves lower and the company chips away at debt. The stock has moved lower because of the fear that growth will cease. Steel prices have come down on fear of recession. All of this ludicrous action is driven by what could happen. Not what will happen. The Fed wanted lower commodity prices and the market responded. Demand may soften, but the auto industry will be huge for them. But, due to supply chain issues, nearly ten million vehicles which should have been produced were not. The company expects this will help demand through 2023.

Take home

We think you let the market move lower, then add to this quality name. While it is great for trading, management is setting it up for investment returns. $15 is a strong entry point, all things considered.