Cleveland-Cliffs Stock: Stay Away To Avoid 25% Value Erosion

After rising more than 160% from its March lows of this year, at the current price of over $8 per share, we believe Cleveland-Cliffs stock (NYSE: CLF) is overvalued. The iron ore and pellet giant’s stock has rallied from $3 to over $8 off its recent bottom compared to the S&P 500 which increased almost 52% from its recent lows. The stock has outperformed 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. Though revenue is expected to shoot up almost 150% due to the acquisition of AK Steel and ArcelorMittal USA, it is unlikely to be reflected in the stock price. This is because earnings are expected to drop significantly due to lower margins and higher shares outstanding. Thus, despite the stock currently being almost at its December 2019 level, we could see a 25% drop from its current price. Our dashboard What Factors Drove 22% 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 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. 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 following the outbreak of coronavirus. It has since then recovered and currently stands at its 2019 level of close to 8x, as iron ore prices have rebounded post the stimulus announcements. We believe that though the company’s P/E multiple could remain around the current level in the near term, CLF is likely to report losses in 2020 and profit of around $0.60 per share in 2021, which would be lower than the EPS in the last three years. Low EPS is likely to lead to a drop in the stock price.

Where Is The Stock Headed?

The global spread of coronavirus led to lockdown in various cities across the globe, which affected industrial and economic activity. 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 results where pellet production dropped (y-o-y) 61% in Q2 2020 and 12% in Q3 2020, while shipments dropped 24% and 15%, respectively. Though total revenue increased due to the acquisition of AK Steel this year, the company’s traditional pellet business was hit significantly due to the pandemic. The company also reported a loss of $0.31/share and $0.02/share in Q2 2020 and Q3 2020, respectively, as against profits reported in the year ago period.

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. Iron ore prices have rebounded sharply from $80/ton in April 2020 to over $120/ton in October 2020. Though steel prices are also rising (though at a slower rate) 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.

Also, CLF’s P/E multiple is unlikely to see a major jump in the near term despite sharp revenue growth estimates, mainly due to the acquisition of one of the weakest steel companies. 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. The only notable advantage seems to be the 25% of CLF’s pellet 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 outweigh the positives from this deal, especially with major global iron ore and steel miners focusing on liquidity and survival. With EPS expected to remain low even in 2021, Cleveland-Cliffs’ stock can drop by 25% to about $6 even if its P/E multiple remains elevated.

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.

What if you’re looking for a more balanced portfolio instead? Here’s a high quality portfolio to beat the market, with over 100% return since 2016, versus 55% for the S&P 500. Comprised of companies with strong revenue growth, healthy profits, lots of cash, and low risk, it has outperformed the broader market year after year, consistently.

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