naphtalina/iStock via Getty Images
naphtalina/iStock via Getty Images
A few weeks ago we had a trade idea on Cleveland-Cliffs (NYSE:CLF ) after it had pulled back some 33%, with ridiculous price action and encouraged scaling in on the way down. Of course, the stock blew past the low end of expectations, where when it hit the $15's we came back in for another trade. Trading is difficult at times. Sometimes it hurts even. In the market we are in right now, the volatility is strong. There has been an epic repricing of assets in the last few months. Now, we are seeing commodities start to fall, perhaps a sign that inflation has truly peaked. This however brought CLF stock down hard. With the market rebound the last few sessions there has been opportunity to recoup some losses, but even getting to the $20 range seems difficult. Mind you, this is all occurring with a stock at 2.5x FWD EPS. Steel prices have moderated some, and inflation may be curbed. The million dollar question is whether a recession is around the corner, and that is why steel names have been crushed. We know. It hurts to watch your investment evaporate before your eyes. But all hope is not lost. While there have been some macro changes, we believe the company needs to ensure it eliminates debt. That will be a game changer for investors here.
The macro picture remains the large story here. First, the market has been horrible up until last week when we started this bear market rally bounce. There is still fear of a recession, and the fear of recession is almost driving us into said recession. Kind of interesting the psychological side of things. Just weeks ago, inflation was rampant. Hint, it still is. But the market is getting ahead of the world (as it almost always does), and is suggesting inflation seriously has peaked now, and the 'rate' of inflation 'rising' is set to come down. But inflation is still increasing. With inflation and a still-hot economy as a whole, pricing will remain elevated, but commodities are normalizing. We are seeing steel prices come down. Steel prices were volatile on Chinese lockdowns over COVID, which lessened demand but also Chinese steel production was hampered. Now that production is back online there is a bump in supply, but demand in China is still hurting. That is an impact. But, overall steel industry data remains positive. Sure, the situation is not as ideal as it was at the New Year, but things do look rather positive all things considered. We still hold that the stock overshot to the downside. We still see the stock in the teens as a good buy. We may have been somewhat early on the timing of the last trade but that is the game.
We should also circle back again to Ukraine. The ongoing conflict has had a mixed impact. The conflict has disrupted pig iron supply badly. Millions of tons of pig iron supply have been impacted because of the chaos. Once again, we think it is key to point out that in the U.S. there are only seven producers of flat-rolled steel, but Cleveland-Cliffs has a competitive advantage. It is the only one among the seven that does not rely on imported pig iron. This means less cost increases for Cliffs relative to the competition.
As a reminder Cleveland-Cliffs' reported earnings were strong. The macro picture has changed a bit in that time, but shares are still 2.5x FWD EPS. Let's say earnings retract 25% this year vs what was expected. That would be terrible right? Well, we would still be absurdly cheap at not even 3.5X FWD EPS. The macro situation has changed but not as drastically as this dramatic fall in share prices suggest. In the earnings release the company raised "full-year 2022 average selling price expectation by $220 to $1,445 per net ton." That is strong. If selling prices 'only' go up say $100 due to price changes, it's still a big win. The bottom line here is that you can't look at performance and think the company is suffering. Maybe shares got ahead of themselves but frankly, they were more fairly valued. Looking at performance in Q1 2022 the revenues were $6.0 billion, compared to Q1 2021 revenues of $4.0 billion. This was a beat of $570 million vs. estimates, and a 50% increase year-over-year. Tremendous. The company's adjusted EBITDA of $1.5 billion in Q1 of 2022. This was three times higher than last year.
The company could see a gamechanger for investors if it is able to reduce, and really to eliminate debt, with the massive influx of cash it has seen. There are also chances for opportunistic buybacks, but the company will enjoy a much better valuation if it is able to drastically reduce debt. Even with debt, we are also looking at a stock with price to cash flow of less than 2.5x and the stock trades at book value. Eliminate debt, and it is a whole new game. Right now, there is around $5 billion worth of debt. But management plans to prioritize cash flow to reduce debt. We are of the opinion that it should go all in while steel is this expensive (even if it is normalizing). On the conference call management stated:
In a few quarters, our debt should be so low that it will no longer even be a discussion point and I look forward to talking about other ways of returning capital to our shareholders at that time.
While share repurchases do improve shareholder value and can prop up share prices due to higher EPS on a reduced float, debt reduction is paramount. If steel prices remain around where they are, with no debt, shares could easily double from current levels. With no debt, even a large retracement in pricing, so long as demand is reasonable, should still result in gains. There is a lot to like, even if the price action in the stock hurts right now. We should also point out that Cleveland-Cliffs has fixed price contracts, which provide much more stability for revenues and earnings. So while steel prices matter, the short-term fluctuations do not. Thus, we believe that what we are expecting for 2022 revenues and earnings should come in reasonably close. So, here we are at under 2.5X FWD EPS. Very cheap. Because it is so cheap, we would not be surprised if the company started some of the opportunistic buybacks at these levels.
This is a tough market, but even with all of the dark clouds out there, this is a company that is winning. It just happens to be a commodity stock that is linked to recession and economic booms. The macro situation has weakened but those locked in contracts help. The company is buying back shares, but most importantly, is going to drastically reduce debt. This is a big gamechanger for valuation.
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Disclosure: I/we have a beneficial long position in the shares of CLF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.