Source: industr.com

Cleveland-Cliffs (CLF) has had a significant run over the past few months as the automotive sector in the U.S. rebounded and the company announced another important strategic acquisition – this time of ArcelorMittal USA.

Since I last wrote about it in September, the stock has appreciated by around 27%, but that is not why CLF appears as an attractive investment opportunity. As the title of my last article suggests, my investment thesis in the company is a long-term one.

Although CLF performance over the past 2 years has been disappointing, the company has been outperforming the other names in the steel industry over the past 5-year period, which covers most of the current CEO’s tenure. Also it’s worth mentioning that only recently did CLF become a direct competitor of the names quoted below with the acquisition of AK Steel and most recently that of ArcelorMittal USA.

ChartData by YCharts

Apart from Cleveland-Cliffs’ sustainable and almost impossible to replicate competitive advantages (which I cover here and here), there are two very important reasons why the company could prove to be an outstanding long-term investment.

The first reason is linked to long-term trends in the steel industry which is why a very long-term approach needs to be taken. For investors mostly interested in quarterly results and whether or not they meet or beat analyst expectations, this discussion will probably not be of interest.

The second reason is the current management’s approach to strategic investments and acquisitions, which is aimed to take a full advantage of these long-term trends.

The long-term trend in the steel industry

If we take a very long-term view of the steel industry, we could see years of steady price appreciation in the industry for the most part of the past century, followed by very disappointing performance over the past 20-years or so.

Source: prepared by the author, using data from Fama and French

The key reason behind this poor performance has been the rise of cheap (and less environmentally friendly) Chinese steel production, which skyrocketed since the beginning of this century.

Image result for steel production by country

Source: agmetalminer.com

Thus, china has become the world’s largest steel producer by a very wide margin to other countries, its CO2 emissions went through the roof and naturally sparked a trade war with the world’s largest economy.

The reduction in the great disbalance between U.S. steel consumption and production has also been prompted by a number of other factors, such as national security concerns, environmental issues and last but not least a shift in globalization trends.

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That is why the dynamics of U.S. steel imports have been changing at a very rapid pace over the recent years. Back in 2017, countries like Russia, Turkey and China had noticeable share of the country’s steel imports.

Source: legacy.trade.gov

In only a matter of two years, the importance of these countries in the U.S. steel imports has almost disappeared, thus benefiting countries like Canada, Brazil and Mexico.

Source: legacy.trade.gov

Similar trends have also been a dominant force in metallics segments, such as Pig Iron. Less than a year ago, when I wrote about the very important considerations behind Cliffs’ acquisition of AK Steel, Russia represented more than half of U.S. Pig iron imports.

Source: ustradenumbers.com

As of September this year, the amount of Pig iron has collapsed when compared to the same month a year ago.

Source: ustradenumbers.com

More importantly, Ukraine has now become the largest importer which suggests a collapse in Pig iron imports from Russia. As it happens, Cleveland-Cliffs has undeniable competitive advantages in the field of metallics such as Pig Iron and HBI which the company created internally and solidified through its recent acquisitions.

Investing at the bottom of the cycle

One very important distinguishing factor of CLF is the management’s long-term oriented approach. Although this is rarely rewarding for short-term oriented investors or traders, it is one of my key reasons for investing in the company.

As a result of this management’s approach, CLF has invested heavily in internal projects, such as the massive Toledo HBI plant that is due to be completed this quarter, and two large scale transformative deals for AK Steel and ArcelorMittal USA. This has made CLF from a small pellet producer in the U.S. to the largest North American flat-rolled steel producer.

Source: Cleveland-Cliffs to Acquire ArcelorMittal USA Presentation

While many are concerned whether or not CLF will meet or beat the quarterly estimates or whether some financial metric has deteriorated over the recent months, CLF management is making enormous investments at the bottom of the cycle.

ChartData by YCharts

The AK Steel acquisition for example, although a very risky move to some, was done at a time when valuation multiples in the sector were near all-time lows.

Source: prepared by the author, using data from morningstar.com

The deal for ArcelorMittal assets in the U.S. was no exception and was also done near all-time lows.

ChartData by YCharts

Thus, CLF has acquired and vertically integrated a large number of assets with its existing pelletizing and metallics operations, not when excitement in the sector is at peak levels but quite the opposite.

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CLF will also become an undisputed leader in the high margin automotive grade steel, with 63% of AK Steel sales attributed to the segment and 27% of ArcelorMittal USA revenues coming from this market.

Source: Cleveland-Cliffs ArcelorMittal USA acquisition investor presentation

AK Steel has been recognized by both General Motors (GM) and Ford (F) as supplier of the year in recent years (see here, here and here). This outstanding performance in the very high margin automotive steel segment will be further improved by:

  • larger scale of vertically integrated operations of Cleveland-Cliffs’ legacy operations, AK Steel and ArcelorMittal USA assets;

Source: Cleveland-Cliffs ArcelorMittal USA acquisition investor presentation

  • regional competitive advantages of the combined entity clustered operations in the North-East of the country;

Source: Cleveland-Cliffs ArcelorMittal USA acquisition investor presentation

  • superior technology for high-grate automotive steel;

Following the two deals, CLF will also benefit from AK Steel high innovation steel products and become the sole licensee of ArcelorMittal’s patent for its USIBOR® part processing technology.

Under this agreement with AK Steel, ArcelorMittal grants right for AK Steel to allow its customers to stamp and use its ULTRALUME® PHS product in the United States, Canada and Mexico. AK Steel will be the sole licensee, along with subsidiaries of ArcelorMittal, permitted to produce aluminized boron press hardenable steel in the United States, Canada or Mexico able to be processed as per licensed ArcelorMittal’s patent about its USIBOR® part processing technology.

Source: automotive.arcelormittal.com

You have to be comfortable with some risks

Fully capitalizing on the above described long-term trends, investing heavily at the bottom of the cycle and becoming the largest North American flat-rolled steel producer in a matter of months require a very aggressive approach.

Naturally, such an aggressive strategy comes along with heightened operational risks and elevated leverage. The increased risk, however, is supported by a very large long-term opportunity for high topline growth and significant return on capital, backed by sustainable and very hard to replicate competitive advantages.

Looking at debt, the seasonal impact of CLF legacy operations caused significant quarterly variation in the company’s interest coverage. This effect will be alleviated through the last two major steel acquisitions.

Source: author’s calculations based on data from CLF Quarterly Reports

The massive downturn in operating profitability during the recent pandemic is also quickly reversing and thus the interest payment risk will likely subside over the following year.

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The high risk approach I talked about above is also evident from the company’s extremely low cash balance as of the end of last quarter.

Source: author’s calculations based on data from CLF Quarterly Reports

However, this has been caused by the company’s continued high level of capital expenditures, aimed at finalizing its HBI Toledo plant later this year.

Source: author’s calculations based on data from CLF Quarterly Reports

Having said that, investors should be looking closely at CLF’s liquidity position and overall debt levels as these present one of the biggest risks for the company at present. Nevertheless, as CLF’s management is successfully renegotiating its long-term debt maturities and finalizing its internal projects and large scale acquisitions, the company’s leverage should become less of an issue over time.

Conclusion

Cleveland-Cliffs’ long-term investment thesis remains as solid as it has ever been, while management continues to execute on its strategy. The recent two acquisitions and continued high rate of capital spend will make the company’s competitive advantages almost impossible to replicate by any other U.S. steel manufacturer. At the same time, management’s long-term oriented strategy fits perfectly with long-term trends in the steel industry, which has been heavily disrupted over the past 20 years. In the meantime, as long as management stays on course, I will be more than happy to add to my existing holdings during major market downturns.

Disclosure: I am/we are long CLF, GM. 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.

Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice.



Via SeekingAlpha.com