[Ferro0Alloys.com] Cleveland-Cliffs: Steelmakers Face Significant Recessionary Pressures

Summary

• The US steel industry has seen higher profits since 2020 but no further improvements since 2021 due to declining demand and increased production costs.
• Major steel producer Cleveland-Cliffs has maintained improved valuations but faces challenges due to falling product prices and rising input costs.
• Despite a strong long-term outlook for the US steel industry, Cleveland-Cliffs may face sharp earnings losses and balance sheet pressures due to falling steel prices and declining macroeconomic demand.
• I expect CLF to decline in value over the coming year as recessionary pressures cause the company to face negative operating cash flows.
• In the long run, CLF may be a dip-buying opportunity due to the immense need for improved North American steel production.

After a stellar performance in 2020, the US steel industry entered a prolonged period of positive stagnation. Most steel producers are seeing much higher profits than in the previous decade; however, since 2021, there have been no further improvements in the US steel market. Major steel producers such as Cleveland-Cliffs (NYSE:CLF) have maintained improved valuations but have not seen a positive trend since 2021. In general, these stocks benefit from having lower "P/E" valuations of around 10X, with many investors having a bullish outlook due to reduced competitive pressures in the steel market. However, the declining demand outlook may soon override the production shortage, potentially causing major steel stocks to face another round of declines.

In late 2021 and early 2022, I maintained a neutral position on Cleveland-Cliffs. At that time, most investors were very bullish on the stock due to its stellar performance the year prior. My view was that the company would continue to benefit from its competitive advantages as well as the depressed production levels among its competitors; however, it also seemed that the post-COVID demand spike would not continue. Today, production levels amongst steel producers are generally improved, while waning demand indicators suggest that steel demand will fall. Further, Cleveland-Cliffs may struggle with falling product prices if that is met with a continued rise in input costs, notably labor, and energy. Additionally, CLF has outperformed many of its competitors through its aggressive growth strategy, leaving it with higher leverage levels that may bite the company in the event of a prolonged earnings recession.

Steel Demand Outlook is Falling Quickly

The sharp decline in US manufacturing levels in 2020 led to abnormal fluctuations across many industries that primarily served to boost prices artificially. I say "artificially" because those price hikes were unsustainable and primarily driven by extreme and very short-term output declines in 2020 that created prolonged shortages until the end of last year. Demand for steel products generally did not decline in 2020, as most construction, automotive, and related companies had strong sales outside the forced business shutdowns earlier that year. The result was a significant increase in commodity prices, notably Hot Rolled Coil steel, CLF's primary product. Its stock has largely tracked this commodity.

Since the 2020 spike and 2021 peak, HRC steel prices have slowly trended back toward their pre-COVID range. Significantly, the cost of producing steel has likely risen significantly since 2020 due to increases in labor, energy, transportation, and other operational costs - as is the case with most manufacturing companies. In December of 2022, Cleveland-Cliffs, and later its peers, increased their selling HRC prices after cautioning that prices were nearly falling to breakeven levels. Over that period, the HRC price index rose from around $1000/T to nearly $1300/T. However, since then, the index has declined to the level before the price increases, indicating that HRC and likely most other steel products are now back near breakeven prices.

As a result, there has been a general decline in steelmakers' capacity utilization, typical of a manufacturing recession. More broadly, total US manufacturing activity is declining, as the contracting manufacturing PMI indicates. PMI levels below 50 suggest that most US manufacturing companies are seeing negative trends in business activity. The current level of 46 suggests that the declines are the fastest since the 2008 recession, excluding the artificially induced extreme decline in early 2020.

The general decline in steel capacity utilization since 2021 strongly indicates that steelmakers are more concerned with a glut than a shortage, as they were following 2020. In recent months, there has been a small divergence between the negative PMI trend and a slight rise in steelmaker capacity utilization. However, more up-to-date American Iron & Steel Institute data indicates that steelmaker capacity utilization returned to a negative trend over recent weeks.

Core drivers of CLF's steel demand, automotive and construction, also show signs of peaking. US vehicle sales have been low since 2020, primarily due to massive supply chain shortages in that sector. Commercial property construction spending has been high due to significant planned or delayed projects from 2020 and sharp increases in construction prices. Vehicle production is much higher today, as indicated by capacity utilization, but vehicle sales remain generally lackluster.

These data suggest that the current automotive and construction demand for steel is relatively strong but is likely on a negative trend. Considering commercial real estate's many issues, I suspect few new projects are being pursued compared to the boom we've seen since 2020. Vehicle production levels are the strongest they've been since ~2018, but growing weakness in household financial stability and higher vehicle interest costs should limit performance in that market.

One challenge in assessing Cleveland-Cliffs is the vast difference between the short-term and long-term supply and demand outlooks. In the short term, the steel demand outlook appears overwhelmingly negative. Combined with improved production capacity amongst steelmakers, prices may soon fall well-below breakeven levels, forcing a significant decline in output to counteract losses. In my view, this situation may soon result in very sharp earnings losses for CLF and most of its peers, potentially creating some balance sheet pressures. On this note, the ongoing collapse in China's immense steel industry due to its construction activity declines may further imbalance the global steel market; however, this issue is limited due to the beneficial 2018 steel tariffs, which may be expanded soon.

However, the long-term outlook remains strong, with the US needing to invest heavily in manufacturing and energy infrastructure facilities over the coming two decades to replace worn and outdated infrastructure and transition toward cleaner vehicles and energy. Additionally, North American steelmaking capacity has declined over the past decade, while the prime steel scrap supply has fallen almost entirely since the 1970s. Accordingly, Cleveland-Cliffs has the potential to play a critical role in renewing the zombified American manufacturing base, with the benefit of the many technological improvements created since the 1970s-1980s (the rough age of most US infrastructure). Of course, long-term prospects such as this do not translate into immediate earnings, the primary driver of CLF's stock price.

What is CLF Worth Today?

On the one hand, CLF is nearly 50% below its peak 2021 price level and just over 25% below the range it's generally held since late 2020. However, the stock is also over 50% above its range from 2015 to early 2020. Additionally, the company's EPS outlook is the lowest in years, with an EPS of $1.56 expected this year. Further, I suspect the company's earnings may be below the current consensus estimate due to the more recent contractions in steel price indices and the broader declining macroeconomic demand outlook. Indeed, based on prices falling at or below breakeven levels, Cleveland Cliffs may have negative operating income over most of the coming year or two. Combined with the sharp rise in its interest costs, the company may face net losses of over $250M per quarter.

Compared to its peers, Cleveland-Cliffs is not well-positioned for the expected significant earnings recession. The company has grown aggressively recently, benefiting it significantly during the high-price season in 2022. However, the company is left without significant leeway should its income become negative for a prolonged period. Crucially, CLF has the lowest quick ratio amongst its peer group and the poorest Altman Z-score, an index of numerous solvency and liquidity measures.

These data indicate that CLF has the worst financial stability in its peer group today, most notably in its lack of liquid assets compared to liabilities. The company has a low cash position because it has deployed significant cash flows to reduce its heavy debt burden. However, should its cash flows turn negative, the company must pursue external financing, likely at a high debt or equity cost. Accordingly, the firm is not well-positioned for a recession, primarily due to its potentially due to overly-aggressive growth strategy pursued since 2018.

Despite its weaker balance sheet, Cleveland Cliffs trades at a premium to its peer group with a TTM "EV/EBITDA" of 6.6X compared to most of its peers in the 2-5X range. Its forward "P/E" of 10.8X is also much higher than most of its peers, ranging in the 6-9X levels. CLF's premium primarily extends from its strong EPS growth over the 2020-2021 period; however, in light of its debt situation, I believe the company should not trade at a premium, with a small discount seeming more reasonable in light of the recessionary manufacturing trend. Personally, I would not buy CLF at a forward "P/E" over 7X, corresponding to a price target of ~$10.8, or around 35% below its current level. That price target would discount an expected more significant earnings recession and the risks associated with its aggressive balance sheet.

The Bottom Line

Overall, I am moderately bearish on CLF and believe the stock will suffer more significant declines due to a growing negative trend in the US manufacturing demand outlook. Major negative catalysts will likely include vehicle sales, which I suspect will reverse sharply amid constraining consumer conditions. Should the industry maintain high steel output levels, CLF could suffer more significant declines as it requires high prices to profit due to its more substantial debt level. That said, a significant decline for CLF may become a dip-buying opportunity as a recession among steelmakers may set ideal conditions for an extended long-term bull market, mainly if US businesses make concrete plans to restore long-term manufacturing capacity.

Source:Cleveland-Cliffs: Steelmakers Face Significant Recessionary Pressures

• [Editor:tianyawei]