Cleveland-Cliffs’ Foray Into Steel: Zero Impact?

After dropping to more than a decade low of $3, Cleveland-Cliffs stock (NYSE: CLF) has recovered about 80% in the last 4 months, while the S&P 500 has increased about 46% during the same period. CLF has been able to outperform the broader market with the US government announcing a string of measures along with stimulus packages announced in other economies to keep businesses afloat, which led to a rise in iron ore and pellet prices. But are the investors too exuberant or is the price rise justified? We believe that the rise was warranted and at the current price of around $5.50, CLF’s stock seems to be fairly valued. But will the recent acquisition of AK Steel boost the price? Likely not. Though revenue is expected to rise 150% in 2020 due to the acquisition, margin is expected to nearly halve. Additionally, with the share count also increasing significantly, it could nullify the effect of higher net income whereby earnings per share and P/E multiple could in fact remain almost stable, leading to no major change in stock price from its current level. So despite the stock being more than 20% below its level at the end of 2017, it seems to be fairly valued. Our dashboard What Factors Drove 21% Change In Cleveland-Cliffs Stock Between 2017 And Now? provides the key numbers behind our thinking.

Some of the stock price rise between 2017 and 2019 is justified by the 6.6% increase growth seen in Cleveland-Cliffs’ revenues due to increased production and higher iron ore prices. This was offset by a 24% decline in profitability as net income margins dropped from 19.5% in 2017 to 14.7% in 2019. Margins shot up in 2018 due to significant tax benefits, income from discontinued APAC operations, and a sharp rise in revenues, but in 2019 they went below the 2017 level due to a drop in revenue (mainly due to sale of APAC operations and not any change in fundamentals) and increase in tax expense. On a per share basis, earnings dropped 17% from $1.28 in 2017 to $1.06 in 2019.

Though earnings dropped, CLF’s P/E multiple increased from 5x in 2017 to 8x in 2019 mainly due to higher revenues, the company’s expansion plans, and rising iron ore prices. The multiple dropped in early 2020 to 4x in April after the outbreak of coronavirus but has since then recovered and currently stands at a little over 5x, as iron ore prices have rebounded post the stimulus announcements. We believe that the company’s P/E multiple is unlikely to see any major movement anytime soon, thus keeping its stock price almost stable in the near term.

Rationale Behind CLF’s Stock Price

The global spread of coronavirus led to lockdown in various cities across the globe, which 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, led to a drop in global iron ore prices in early 2020. Additionally, the lockdown has affected the supply chain for companies like CLF, leading to a decline in production and shipments.

This was evident in the recently announced Q2 2020 results where pellet production dropped 61% while shipments dropped 24% y-o-y. Though total revenue increased due to the acquisition of AK Steel, the company’s traditional pellet business was hit significantly due to the pandemic. The company also reported a loss of $0.31/share as against profit of $0.57/share in the year ago period.

However, the gradual lifting of lockdowns is also giving investors confidence that developed markets may have put the worst of the pandemic behind them. Following the Fed stimulus — which helped set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view, with investors now mainly focusing their attention on 2021 results. The lifting of lockdowns and easing of global supply bottlenecks is likely to help CLF, which is projected to lead to higher shipments post the crisis. Though steel prices could rise as the crisis abates, elevated iron ore prices are expected to eat into the margins of the company’s steel business (iron ore is a raw material for steel). Thus, the expected rise in revenues due to the addition of the steel business is likely to be offset by shrinking margins on account of acquisition costs and higher cost of production.

We do not project any material movement in the P/E multiple as the markets do not seem to be enthused by the acquisition of AK Steel. 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. 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 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.

Thus, the market seems to have rightly priced in all these factors in CLF’s current stock price. Cleveland-Cliffs valuation by Trefis works out to $5 per share, similar to its current market price. Additionally, for further insight in to the steel industry, find out how the steel war is heating up between giants US Steel and Arcelor Mittal and for further insight in to the iron ore space, here’s how Vale compares with Cleveland-Cliffs.

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