Cleveland Cliffs Bolsters Shareholder Value (NYSE:CLF)

Cleveland-Cliffs (NYSE:CLF) provided an outstanding FY23 with superior guidance for eFY24. Despite guiding flat production in eFY24, I believe the firm will experience strong tailwinds as they continue eliminating costs and enhance their hydrogen-reduced steelmaking process. I maintain my previous recommendation for CLF with a BUY recommendation with a price target of $27.65/share.

Update on US Steel (X) Merger

The deal isn’t done until it’s done. What I mean by this is that Nippon (OTCPK:NISTF) and US Steel still await antitrust approval before the deal is finalized. CEO Lourenco Goncalves and CFO Celso Goncalves are adamant that the deal will likely falter as the foreign buyer attempts to acquire the 3^rd largest domestic producer by volumes at 15.5mm tons next to Nucor at 23mm tons and Cleveland Cliffs at 16.4mm tons. What I believe that Mr. Goncalves was alluding to was that the Japanese steel market, specifically Nippon, has historically dumped steel onto the market and that by inviting a foreign entity into the domestic system, US Steel could potentially dump steel onto the market under Nippon, circumventing tariffs in the US. If this is the case, I believe that this could potentially lead to hazardous business practices that may lead to major disadvantages for domestic steel producers and either lead to a poor business climate or potentially bankruptcies and forced consolidation. Though these are my views from the outside in, this anticompetitive behavior cannot be discounted no matter how unlikely. I believe that if this were to happen, it will be similar to any other market crash in which it won’t be known until after the fact, in which it will be too late to act.

This is my speculation and should be taken with a grain of salt, but I believe that if the US Steel and Nippon deal were to falter under US antitrust, I believe that the offer Cleveland Cliffs brings to the table will be modestly reduced as a result.

“That transaction is no longer available, it’s no longer a backstop for their failure. If they can’t close — I don’t know where they are at this point — that offer is gone, that offer no longer exists.”

Lourenco Goncalves, CEO

Listening to the q4’23 earnings call, management’s tone towards the deal makes it clear that not only do they believe that their offer was the strongest and that the US Steel & Cleveland Cliffs merger should go through, they firmly believe that this merger is firmly backed by the USW union and that the union can have significant sway in determining the outcome of the merger. Since the earnings release, JP Morgan has suspended coverage ratings on both Cleveland Cliffs and US Steel, potentially suggesting that a merger between the two firms is still on the table and potentially more likely to occur.

Operations

Steel shipments for Cleveland Cliffs reached a new high watermark at 16.4mm tons in FY23. Accordingly, Cleveland Cliffs hadn’t experienced any slowdown in automotive sales as a result of the UAW strike at the end of q3’23/beginning of q4’23 and experienced an upswing in service center steel sales as service centers sought to replenish inventories. As we’re aware from q3’23, service centers slowed their steel purchasing as a result of the strike in anticipation of inventory builds. As a result, steel prices improved and therefore steel inventories were replenished at the higher price.

Management has been laser-focused on improving margins and experienced total cost savings of $80/ton of steel at an annual run rate of $1.3b. Management anticipates being able to squeeze out an additional $30/net ton in cost savings throughout 2024 as a result of negotiating coal and alloy supply agreements, lower natural gas hedges, and volumes-based economies of scale. These cost savings will translate to roughly $500mm in additional EBITDA.

Capex is expected to remain flat in the range of $675-725mm for FY24, slightly up from FY23. I do anticipate that Cleveland Cliffs will experience some margin expansion through their cost-cutting measures and experience some additional strength in free cash flow as a result. Though I anticipate revenue to be slightly lower when compared to FY23, I do expect that the firm should be able to generate stronger cash flow as cost-cutting measures take effect. The firm has made some minor improvements to working capital balances with their cash conversion reducing to 72 days from 83 days, the result of lower days payables and inventory. With few headwinds going into 2024, I believe that the firm should be able to generate significant free cash flow, of which ~50% will be allocated to paying down debt and the remainder towards share repurchasing. Overall, I believe that this should make for a bullish indicator for shareholders as management has successfully managed down the debt load in previous quarters.

I do believe that Cleveland Cliffs will experience significant pricing opportunities as Cliffs H2 as they seek to decarbonize the steelmaking process. Hydrogen hubs are slowly popping up and may further have a stronger presence in the latter half of the decade. With the DOE $7b funding for development, I believe availability of hydrogen is on the road to becoming a more prominent source of electricity, and in Cleveland Cliffs’ case, an oxygen reductant. Management discerned that Cliffs H has been adopted by all automotive clients and has allowed for the firm to hold their steel prices for the industry at a steady rate for eFY24. Management alluded to an even higher surcharge for Cliffs H2 when available for distribution. Mr. Goncalves mentioned on their q4’23 earnings call that the $10mm has been deployed to build the hydrogen pipeline to connect to the hydrogen hub that’s being constructed in Indiana with funding from the DOE. Accordingly, the pipeline is in place with their second blast furnace initiating trials with promising results.

Debt

Cleveland Cliffs has recently shifted their focus from recapitalizing by using the majority of excess free cash flow to focusing on share buybacks. The firm has also covered all outstanding debt under their ABL credit facility as of December 31, 2023, and closed out the year with $2.9b in net debt, down significantly from $3.4b in q3’23 and $4b in FY22 and has $4.5b in liquidity.

Assuming Cleveland Cliffs utilizes the entirety of their 50% free cash flow allocation for debt reduction, I anticipate net debt for eFY24 to be $1.9b for a net debt/EBITDA ratio of 0.95x, assuming the firm doesn’t take on any additional debt. Cleveland Cliffs has no maturities through 2026, providing management with some flexibility to pay down the more expensive notes on their books.

Valuation & Shareholder Value

CLF trades at 7.10x EV/EBITDA at an enterprise value of $13b. Working through management’s capital allocation plan for 2024 at ~50/50 for debt reduction and share buybacks, I anticipate significant improvements to the share price going forward. Assuming all free cash flow is allocated, I believe Cleveland Cliffs can repurchase 49mm shares in eFY24 and reduce net debt to $1.9b, creating significant tailwinds to the company’s valuation.

Cleveland Cliffs repurchased $152mm in shares outstanding during FY23, reducing the total share count by 10.4mm shares. Management discussed that they will be reallocating free cash flow beginning in q1’24 from 85% to reduce debt down to 50/50 for debt reduction and share repurchases. The initial reaction by shareholders appeared positive with the stock price post-earnings; however, share prices have since remained relatively flat as management had guided flat production growth for eFY24.

Working through share repurchases and debt reduction as seen below, we can conclude a price target of $24/share when assuming the same trading multiple of 7.10x EV/EBITDA.

I believe this share price is very attainable and given their outlook for the hydrogen surcharge, I believe Cleveland Cliffs will experience substantial growth as the firm’s steel remains differentiated from the commoditized products that result from competing mills. I provide CLF a BUY recommendation with a price target of $27.65/share.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.