Description

Cliffs Natural Resources is an iron ore miner and supplier of critical iron pellet feedstock to steel manufacturers in the US and Asia. Cliffs is a 170 year old company in the midst of an upturn driven by an improving balance sheet, an acceleration in free cash flow, an encouraging policy environment, rising infrastructure needs and increasing opportunities to invest for growth alongside one of the top management teams in the industry. Cliffs’ iron ore mines are in Minnesota and Michigan with a position close to the Midwest steel manufacturing centers that supply the significant automobile, appliance, and construction material end markets. The company does maintain iron ore assets in Australia, but in the current market environment these assets will wind down in the 2020 timeframe. In the valuation, cash generated by the Australian assets are accounted for, but are not part of the long-term value drivers of the enterprise.

Cliffs is now on a strong path to generating free cash flow (over 15% of the equity capitalization) and growing top and bottom line through reinvestment in new attractive projects. There are several possible policy changes and reforms that may benefit Cliffs under the new administration in the US but the changes are not required for the investment in Cliffs to produce attractive returns. There are many policy actions that could bring more stability in the steel/iron-ore marketplace that include fair trade practices, anti-dumping enforcement, black market brokering, stricter pollution standards on top of a possible infrastructure bill, however policy actions are all wildcards as it relates to its influence on market prices. A demonstrable influence on the global steel market in the upcoming years will be China’s focus on pollution reforms that could drive a shift in the Chinese steelmaking process from sinter-fines toward electric arc furnaces. This shift could have a profound impact on the global cost curve. The desire to have a less polluting industry should drive Chinese demand for scrap metal to feed their electric arc furnaces and be supportive of a high scrap price. This higher demand for scrap should translate to higher demand for the direct iron units that Cliffs plans on producing. After having gone through a period of poor capital allocation, Cliffs is now under strong management leadership which will have laser focus on high returning projects and shareholder returns. 

Key Investment Highlights

·         High Barriers to Entry

o   4 out of 7 iron ore mines in the US, location advantage to MidWest demand centers

o   Three start-ups have attempted to enter the market have all ended in failure

·         Captive Customer Base, High Switching Costs

o   Dependent customer base, iron ore and pellets are key ingredient to making steel and high-quality products

o   Long term contracts – take or pay with price transparency

·         Attractive Margins and High Return on Investment

·         Improving Balance Sheet

o   Credit ratings upgrades are synonymous with lower equity cost of capital and attractive stock performance

·         Attractive Valuation

o   High teens free cash flow yield

o   Attractive growth opportunities should drive free cash flow growth

o   Valued as upstream company when more like a midstream asset

·         Changing Industry Landscape

o   China focus on pollution control will drive more demand for high quality ore and scrap

·         Strong Management

o   CEO Lourenco Gonclaves has had 3 previous successful tenures at CSN, California Steel, and MetalsUSA

·         Bearish Macro Sentiment

o   18% short interest

o   Popular way to express a short thesis on China’s overcapacity in steel

Business Description

Cliffs is part of a regional oligopoly serving a 50mm metric ton market with ~19 mm metric tons of supply to blast furnace steel manufacturers Arcelor Mittal, AK Steel and Essar Steel. The other larger supplier in the Great Lakes, US Steel, is a vertically integrated producer so its competitors have historically been reluctant to purchase iron ore from them, making Cliffs the supplier of choice. Based upon the proprietary information that would need to be shared between blast furnace manufacturer and iron ore producer, it is unlikely this dynamic will change.

Additionally, Cliffs has a high degree of customer intimacy as it designs specific iron pellets for its concentrated group of customers. For example, the mustang pellet for Arcelor Mittal and various “superflux” pellets for AK Steel and Essar. Customers have tried to source and finance other iron ore projects, but have failed to achieve success.  Some recent failures include: AK Steel backing Magnetation where it had a 49% stake, seeing this entity eventually file for chapter 11; Essar steel backed ESSM which failed recently in 2017 and Steel Dynamics Mesabi Nugget plant which failed in 2015.

Many analysts have written about vertically integrated producer US Steel’s underinvestment in its iron ore mining assets and finishing steel mills, which gives an infrastructure and asset advantage to Cliffs. Providing customer steady and sure supply should afford good vendors with better contract terms. There could be an opportunity longer term for Cliffs’ if in fact US Steel decides to divest its mining operations. It is possible that pricing may justify the development of lower ore grade deposits over time, but again, this would be in the backdrop with higher earnings power at Cliffs. 

Map of Cliffs Core Assets and Mine Lives (capacity and share in long tons)[1]

* Hibbing’s contribution to EBITDA is pro-rata; the PPE is not on the balance sheet

** Empire is currently shut. Management has indicated that a restart is possible in the future.

Competitors Mine Lives (capacity and share in long tons)[2]

* Keetac is idled

** No definitive reserve life to date, previously indicated 40 years. Asset still needs financing

Location Advantage

Cliffs mines are in Minnesota and the Upper Peninsula of Michigan. From a logistics standpoint, it is relatively straight forward process of manufacturing pellets at the mine sites and shipping them on the Great Lakes to their two largest customers: ArcelorMittal and AK Steel. Three of ArcelorMittal’s largest blast furnaces are located on the Great Lakes: Burns Harbor, Cleveland Works and Indiana Harbor. From an AK Steel perspective, Cliffs assets are near the company’s Middletown, OH facility and its Dearborn Works. The relationship with Cliffs’ assets and the waterways and infrastructure that is in place on the Great Lakes, coupled with the fact that large consumers of steel, such as GM, Ford, Whirlpool, Caterpillar and John Deere are in the vicinity should give the company a transportation advantage.

Customer Concentration and Long-Term Contracts

Cliffs’ sales are concentrated among ArcelorMittal and AK Steel, which account for 78% of sales. These customers, along with Algoma, have signed long term “take or pay” supply agreements that ensure adequate supply for customers and a known calculation for price. Cliffs designs custom pellets for each customer’s plant that meets the specific parameters for the plant equipment, efficiency and end products. Replicating these pellets would take significant investment, execution, and time risk and serves as a durable competitive advantage for Cliffs. In addition to exact specifications for trace elements, the alteration of the texture of the pellet can have severe implications on the amount of coal required to optimize the blast furnace and the amount of sludge and dust that is generated by the facility. With steel makers striving to compete globally, cost savings associated with optimizing a blast furnace are material and would be an area that facility engineers would focus.  Given these exacting standards, customers would be hesitant to switch away from Cliffs. See appendix for Arcelor Mittal contract.

Cliffs Opportunity to restore the Golden Goose

Cliffs has long been the go-to supplier of iron ore in North America, but the previous management team attempted to grow outside of its core Great Lakes operations. The company attempted to become a diversified miner by buying chromite, coal and foreign iron ore assets at the peak of the cycle, using leverage. This nearly bankrupted the company.

An activist shareholder forced a course correction to this strategy in 2014 by installing new management bringing more focus on divesting these non-core operations and deleveraging the balance sheet through asset sales and equity issuance. While the activist campaign (see figure below from 2014 Casablanca Capital Presentation[4]) is over, the road map continues to be followed. The company had previously indicated that a capital return program is possible, but it appears that management is focused on debt reduction to achieve a leverage target of 1x EBITDA before directing cash flows elsewhere. Given the medium to long-term prospects for DRI/HBI plant capacity increases, management’s desire to increase exposure to this higher value-added product should drive earnings power and free cash flow over the long-term.   

While the improvements are far from complete, management team that was put in place in 2014 is making substantial improvements. This is borne out by EBITDA per employee. While iron ore prices have decreased by 58% since 2013, EBITDA per employee has had only a corresponding decrease of 4% during this time. With the significant cuts that have occurred at the company operating leverage has improved significantly lowering breakeven costs while capturing more upside in an upturn.

New Management Improvement Metric: EBITDA/Employee

Improving Balance Sheet

Cliffs is Misunderstood

Cliffs’ US iron ore and pellet business is not being valued appropriately by the market given Cliffs’ captive customer base, location advantage, long term contracts, healthy margins, and ability to generate consistent free cash flow. Future quarters should more accurately reflect Cliff’s updated contract terms with customers that provide higher cash margins per ton given the value Cliffs’ provides to its customers. Management has provided some soft guidelines as to the new contracts through its annual guidance, however the specific details of contracts are redacted for competitive purposes. The essence of the renewed commercial arrangements is to protect the customer with steady volumes with selling prices tracking three major price indices 1) Platt’s Iron Ore 62% index 2) Atlantic Basin pellet premiums and 3) Hot rolled coil steel prices that protect Cliffs from price downside but also limits significant upside to the benefit of the customer for more overall certainty of cash flows. This mechanism should reduce cash flow volatility and thereby increase the value of the steadier cash flow stream. CEO Lourenco Goncalves is a great communicator and has articulated this message during the turnaround but 2^nd quarter of 2017 is the first quarter under the new contracts which might be what the market is waiting to affirm before discounting the higher certainty into the share price.

There is a growth aspect to the investment thesis which the market has not priced in to the value of the shares. In addition to dividends and buybacks, given balance sheet improvements there is a reinvestment opportunity that has emerged which entails supplying higher value add iron units to the mini mill steel market. Mini mills use scrap steel as an input to make steel products whereas integrated steel mills use iron ore and pellets to make end products. The opportunity ahead of Cliffs is significant because it involves supplying EAFs (electric arc furnace) or “mini mill” companies like Nucor and Steel Dynamics which it has never historically served. Cliffs has announced its first HBI (a DRI analog) facility and additional facilities are likely. These manufacturing facilities should be helpful to Cliffs earnings power and it is also helpful to the EAF producers as they look to produce higher qualities of steel.

Chart: BOFs vs. EAFs growth over time[5]

These HBI facilities factor in CEO Goncalves’ longer-term thesis that the steel industry is on the cusp of switching to electric arc furnaces on a global basis, to combat pollution. Globally, 71% of steel is produced through blast furnaces, versus the United States where 72% of steel is generated through electric arc furnaces (based upon May World Steel data). Goncalves expects that the global steel market over time will trend more toward electric arc furnace production, due to the environmental benefits and the flexibility that is inherent in the technology. This transition will lead to increased demand for scrap and with the U.S. currently having the deepest scrap reservoir, it is easy to foresee domestic prices for scrap moving higher which would also be supportive of Midwest hot rolled coil prices.

A further benefit to this strategy is that HBI/DRI products sell at a premium to scrap because of their ability to produce higher quality end products. This future shift toward an industry where volumes will be growing is a tremendous driver of free cash flow, for a company that is already generating significant amounts of free cash.

The company has already begun to execute under this strategy with Cliffs recently announcing a $700m HBI plant in Toledo, Ohio. This facility will have an annual capacity of 1.6mm tons that will be dedicated to supplying EAFs, a new customer base for Cliffs. Cliffs can produce HBI at a cost advantage because it already owns the iron ore supply and access to low cost natural gas from the Utica/Marcellus shales. These volumes could realize 2 to 3x the margin per ton dollars that the base business currently makes. By 2020, these investments could deliver an additional $5 a share in value and there could be several of these plants over the next decade. 

Example HBI Plant Economics[6]

While CLF shares have been relatively volatile over the past 5 years, with a beta of 1.6, this should decrease with meaningfully less exposure to seaborne markets. Even during the depths of the 2008/2009 recession the company’s North American operation remained profitable and with the company’s Australian operation nearing the end of its useful life, this operation could quickly be permanently shut in a weak iron ore pricing environment, thus creating less risk of losses through a cycle. It’s worth highlighting the relative stability in pellet pricing in the chart below.[7] 

Over the next 3 – 5 years, pellet premiums over fines could move materially higher. This is driven by the demand growth that is likely, but it is also driven by the fact that the pellet market has been underinvested in relative to the less environmentally friendly types of iron ore. As the door closes on sintering of iron ore, likely on a global basis, it is probable that pellet premiums will move sustainably higher to properly serve a growing market. Charts below show historical supply growth and forecasted demand growth for iron ore pellets vs. sinter fines.[8]

Tackling the Bear in the Room: Iron Ore Prices

Most investors will ask what prevents iron ore prices from falling to sub $40 dollars again. This bearish thesis is driven by a recognition of a Chinese investment bubble coming to a halt from a looming credit contraction. There’s no question this a major risk in the short-term driven by a hypothetical Chinese market rebalancing. But we believe that the cost curve is supportive of higher pricing and we would note that pellets make up only a fraction of the overall cost curve, approximately 10%, and demand for these more environmentally friendly raw materials should be better supported. Looking at the current cost curve, we do not believe that it fully captures the cost of palletization. As the world climbs the Kuznet curve, we believe that there is another $20 - $30/mt palletization price in the cost curve as we transition from sinter fines to pellets and additional costs as the world uses more HBI/DRI.

Another critical factor which should be supportive of the long-term price of iron ore is the lack of capex that is being devoted to the sector. If prices were to move meaningfully higher, capital could be directed back towards the iron ore sector, but lead times, even among the majors, are extremely long from the initial investment to the initial production. BHP recently announced an expansion project and indicated that it would take at least four years before a brownfield expansion to complete, which will only replace lost production. It is likely that greenfield production, if any entity could get financing for this, would take at least a decade, like the Fortescue development timeline, before first production. Thus, it is unlikely that any large supply will come to the market over the near-term, once Vale completes its S11D mine, which appears to already be priced into the market expectations. 

Company Comparable Valuations:

Long Term Strategic Outlook:

CEO Lourenco Goncalves has articulated a compelling long-term strategy. He foresees major global changes in the manufacturing of steel driven by pollution control objectives by China. China plans to crack down on coal fired industrial manufacturing and that steel could well be one key area where this is addressed (roughly 20% of china’s energy needs for manufacturing currently use coal). The sintering of iron ore is a major source of pollution in China, and while removing this will not solve the environmental crisis that is occurring, it coupled with the decrease in basic oxygen furnace steel manufacturing will significantly help. Sintering has not existed in North America and Europe for several decades and Chinese regulators will move in this direction over time. 

The Kuznet Curve is a fitting analog. This theory states that as a country is initially industrializing, excess pollution may be tolerated, but as per capita income continues to move higher, the populace will no longer tolerate pollution and the population will demand cleaner environmental standards. This will have far ranging implications on the ability for China to continue to produce low cost basic materials, particularly energy intensive raw materials. Two examples of the Kuznets Curve Japan and Korea provide a good analog for China’s transition.[9]

It is anticipated these efforts to control pollution will have far reaching implications on China’s steel cost curve, driving production cost meaningfully higher. Almost immediately, China will move to higher grades of iron ore, and many industry participants believe that that the glut of iron ore that has accumulated in ports is a symptom of this. But over the longer-term, as China converts to EAF production, demand for scrap in China will move higher. China’s scrap supply chain is not particularly robust and the country will have to turn to the seaborne market to supply its needs. With the US having one of the deepest reservoirs for scrap, the seaborne market will source a portion of China’s requirement here. This should be supportive of Midwest hot rolled coil prices, which will be supportive of Cliffs earnings power.

Additionally, there will be a continued divergence in prices between higher quality iron ore, such as the pellets Cliffs produces, and lower quality iron ore which is more pollutive. Fortescue is at risk long term given its lower Fe content and 0% lump iron ore. This dynamic should drive demand towards Cliffs high quality iron units, both their pellets and HBI, domestically and abroad.

Finally, natural gas pricing in China is substantially higher than what it is in the US. It is possible that additional reserves will be found in the future, but currently natural gas pricing is 2-3x the price of natural gas production in the US. As China will likely transition from scrap to DRI over the long-term, higher prices for natural gas should be supportive of Chinese and global steel prices.

Chart: Chinese BOFs vs. US EAFs (Mini Mills) Relative Cost Structures

Optionality on M&A and other areas of growth

Cliffs has several ways to deploy capital for growth investments that range from acquisitions of more domestic iron ore properties, direct investments in new HBI/DRI plants, and further downstream opportunities. There are two mines undergoing chapter 11 processes that maybe opportunities long term. There is also an idled mine in Cliffs’ portfolio that can be revived. That being said Cliffs’ does not have to reach for investments to drive strong shareholder returns as there may be opportunities to high grade the existing asset base.  

Top decile management team – CEO Lourenco Goncalves

There have been several notable CEOs in the metals and mining sector throughout its history namely Paul O’Neill at Alcoa in the late 80’s through the 1990’s and Ken Iverson at Nucor. CEO Lourenco Goncalves is at similar caliber executive bringing a wealth of experience, talent and determination that is already helping transform Cliffs’.

Cliffs Natural Resources is not Goncalves’ first turnaround, it is his third turnaround and his fourth successful stint as a successful executive at a steel company. Goncalves came from humble roots in Brazil, before attending a military institute for his undergraduate education. His first position was at the Brazilian steel company, CSN. During his tenure at CSN, he worked his way up from the factory floor, to an executive role where he helped lead the initiative to privatize this state controlled entity. From here, he was approached by Brazil’s largest mining company, Vale, to fix a joint venture partnership in the U.S. California Steel. After fixing this operation, he was offered the CEO job of Metals USA, where he took this stock from $3 to $22 from 2003 to 2005, when the company was taken private by Apollo. Metals USA generated a 5.5x return for Apollo on their initial investment and the company was eventually sold to Reliance Steel and Aluminum.[10]

Goncalves’ greatest accomplishment so far, may have been to keep Cliffs Natural Resources out of bankruptcy in 2015/16. Goncalves cut significant costs from the company, sold underperforming assets and opportunistically repurchased debt, that was trading at a steep discount. Goncalves was able to These moves have returned the company to relative health, if the base case projections hold the company’s cash position will be net debt negative over the next 12 months.

The CEO has bought over 600,000 shares out of his own pocket equating to over $5mm of investment. Further, Goncalves has been awarded restricted stock of several million shares that vests over a period incentivizing him to create shareholder value.  

Base Case Valuation  

 Bear Case  

Bull Case

Catalyst

Debt paydown 

Return of capital 

HBI plant