What’s Behind The 40% Drop In Cleveland-Cliffs’ Stock?

by Trefis Team
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Cleveland-Cliffs Inc.
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Cleveland-Cliffs’ stock (NYSE: CLF) lost about 38% of its value in the last 3 years, with the stock price dropping from $8 at the end of 2016 to $5 as of 28th May 2020. But Cleveland-Cliffs’ revenue has remained flat at $2 billion in 2016 and 2019. Our interactive dashboard Why Is There A Mismatch In The Rate At Which Cleveland-Cliffs Inc.’s Revenues And Stock Price Have Changed? gives a detailed picture of how stock and revenue moved for the company over recent years.

Almost the entire drop in stock price took place in 2020 itself. But how did CLF’s stock suffer this beating with Cleveland-Cliffs’ revenue being almost flat and net income margins in fact increasing from 11.2% in 2016 to 14.7% in 2019? There is a reason, of course – it is the company’s future growth prospects, reflected in the P/E multiple. Turns out CLF’s P/E multiple has declined from 9x in 2016 to 5.1x currently. This is mainly due to the company’s net income margin expected to plunge from 14.7% in 2019 to 8% in 2020.

So, how come CLF’s profitability is expected to deteriorate suddenly? Our interactive dashboard on Cleveland-Cliffs Expenses provides the detailed picture.

One change – a major acquisition just before a crisis. In December 2019, Cleveland-Cliffs announced the acquisition of AK Steel. This $1.1 billion all-stock deal was concluded in March 2020, coinciding with the outbreak of the Covid-19 pandemic. The global spread of coronavirus has led to lockdown in various cities across the globe, which has affected industrial and economic activity. The iron ore demand from industry players affects global iron ore price levels, in turn impacting the company’s price realization for its products. Lower demand from construction players and shedding of capacity by major steel companies, mainly in China, has led to a drop in global iron ore prices recently.

Acquiring a steel company at such a time has anything but enthused the markets. Pandemic-induced lower steel demand from construction and automobile players, has led to a drop in global steel prices recently, which had already seen a drop due to the US-China trade war. Further, expectations of lower output are also reflected in the price drop, with US raw steel capacity utilization for the week ending 23rd May 2020 being 53.2%, significantly lower than the 82% utilization in the beginning of 2020. Thus, Cleveland-Cliffs is expected to be hit by a double whammy of slowdown in the iron ore as well as steel markets.

Though total revenue is expected to increase from $2 billion in 2019 to $5 billion in 2020 due to acquisition benefits, CLF’s margin is expected to drop sharply from 14.7% in 2019 to 8% in 2020, due to lower gross margins and acquisition-related costs.

The drop in P/E multiple is an indication that along with the timing, the market is not happy with the target company as well. AK Steel is one of the weakest steel companies in the US. After losing money for 8 years in a row, the company reported profits in 2017, 2018 and 2019. The steel industry did suffer a prolonged downturn during this period, but AK Steel was the most affected and the last to recover in the steel space. AK Steel is also a highly leveraged company, with a Debt-to EBITDA ratio of 5x in 2019, much higher than 1.7x for close rival Nucor. US Steel is the only major steel company to have a worse leverage ratio, though that is mainly due to a recent shift in strategy of the company, while AK Steel has remained highly leveraged for a couple of years.

Thus, the acquisition looks like a bailout for AK Steel with its bond holders being the biggest beneficiary. As for Cleveland-Cliffs, the only notable advantage seems to be the 25% of its products’ demand being secured, and the access to AK Steel’s Ashland facility (which is closed currently) which will help CLF explore pig iron manufacturing, along with pellet and hot-briquetted iron. But for now the negatives seem to far outweigh the positives from this deal, especially with major global iron ore and steel miners focusing on liquidity and survival.

If there are signs of abatement of the crisis by the end of Q2 2020, CLF’s P/E multiple could see a minor uptick to around the 6x-7x level. In the absence of any abatement by the end of Q2, the stock could plunge to below $5. Currently, based on Cleveland-Cliffs’ Valuation, Trefis has a fair price estimate of $5 per share for CLF’s stock, valuing the company at the P/E valuation multiple of 5x.

As CLF has now entered the steel space, here’s some insight into how its new close rival US Steel’s stock has been hammered despite revenue growth.

 

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