Cleveland-Cliffs Stock: Risks In Trying To Catch A ‘Falling Knife’ (NYSE: CLF)

Stock Market


caching a falling knife

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The past few months have seen growing tension across the global economy. Some sectors are still finding strong momentum while others unwind much of their lockdown-era gains. The reversal trend is clearly seen in highly cyclical segments such as industrials and construction. Steel producers have seen huge swings as the ongoing slowdown in China’s economy is leading to a return to glut dynamics.

The price of steel has swung dramatically lower over the past six months. Recently, this has led to a sharp sell-off in most steel producers, with major names like Cleveland-Cliffs (CLF) down around 20% over the past six months, ~ 16% of which has occurred over the past month. I first warned about this shift back in October in “Cleveland-Cliffs: Great Competitive Value, But Industry Outlook Is Weak,” which highlighted the significant potential for the crash in China’s construction industry to negatively impact the entire global steel market. Since then, international steel and iron prices have remained depressed while US Hot-Rolled Coil steel futures have fallen dramatically – currently ~ 40% below the August 2021 peak. See below:

Sharp rise in steel, iron, and CLF

Iron ore, steel, and CLF’s price chart since 2015 (TradingView)

The light blue line above represents the Chinese iron ore futures price, the darker blue line is the US hot-rolled coil futures price, and the orange line is the Cleveland-Cliffs stock price. All three have been moving in tandem over the past five years, with a sharp boom in 2020 following massive production cuts that year and leading to immense shortages in 2021.

Macroeconomic Forces Impacting Cliffs

Looking forward, we’re seeing a material increase in steel production levels with a potentially sharp decline in steel demand. The increase in production is relatively evident with US steel and iron capacity utilization and the highest sustained levels in years. Further, many steelmakers such as Cliffs have been particularly aggressive in expanding capacity due in part to the beneficial impact of the 2018 tariffs. More recently, this has led to a significant increase in steel mill inventory levels. With the US manufacturing PMI rapidly dropping, there may not be a vital source of demand for all this steel. See below:

Chart
Data by YCharts

Overall, we’re seeing solid signs of high production, falling demand, and rising inventories – telltale signs of a glut. Notably, the steel industry is different from other metal producers since they do not directly benefit from inflation. They produce “value-added” products with high input costs from coal, iron ore, and energy. As such, rising inflationary forces do not necessarily benefit companies like Clevland-Cliffs and can work against them as inflation turns into stagflation, as we appear to be seeing today.

While we’re seeing initial indications of a broad slowdown in US manufacturing, certain factors may have a tremendous impact on Cliffs today. Most notably, the sustained and significant depression in total vehicle sales and production in the US accounts for around a quarter of Cliffs’ end-market industries. Additionally, the considerable crash in hot-rolled coil steel prices is likely to prove very detrimental to Cliffs which generated ~ 30% of known 2021 sales (Q1-Q3) on that segment (10-Q pg. 44). Equally important components such as Stainless steel have likely continued to see strong performance as the PPI for stainless and electrical steel (wire) continued to rise as of December 2021.

For now, the slowdown appears to be limited to the “heavier” industries, partly aided by the seemingly unending microchip shortage, which is impacting automotive production dramatically. If the overall economy continues to slow, as I suspect, then it seems likely that Cliffs’ other demand segments will see tightening. However, for now, my view is that the economic slowdown will be most dramatic in service-oriented segments with higher labor costs, while raw goods producers like Cliffs may not see as extreme cyclical shocks as in the past.

Even still, the crash in China’s industrial segments may make Asian steel producers more competitive overseas (as production shifts away from Chinese construction steel), potentially leading to a more considerable sustained decline in US steel product prices. This is particularly true if Biden’s administration lifts steel tariffs which have undoubtedly aided domestic producers like Cliffs. However, for now, it appears tariffs are only likely to be raised on friendlier countries like Japan and the UK, which do not have the same competitive advantages as China (stemming from weaker environmental and labor protection).

Has Cleveland-Cliffs Bottomed?

The situation facing Cliffs and its peers is complex today because the economy is transitioning. Fundamental macroeconomic forces such as COVID lockdowns and immense government stimulus are over with newer forces such as rising interest rates taking hold. During such transitions, it is not entirely clear where demand for products such as steel is headed. However, I expect overall demand to wane in the US, but I doubt prices will fall back to “glut era” levels as it seems generally likely that the US will continue to protect domestic production.

The current analyst outlook estimates for Cliffs show a 2022 revenue estimate of $ 22.26B and an EPS of $ 5.91 – virtually the same as 2021 levels. Prospects are anticipated to wane in 2023, with the sales forecast falling to $ 16.9B and EPS to $ 2.75. In my view, it is unlikely that Cliffs’ 2022 performance is equal to its 2021 levels, given the recent significant decline in Hot-Rolled steel prices. Further, continued increases in energy prices, labor shortages, and coal are likely to exacerbate input cost growth – potentially constricting margins.

Of course, compared to peers, Cliffs is very vertically integrated, giving them protection on the coal and iron ore front and on scrap metals prices that are very high today. Significantly, as these input commodities rise, it will likely negatively impact Cliffs ‘peers more, giving Cliffs’ a potentially sizeable competitive advantage. Thus, while it is apparent that Cliffs’ 2022 performance may not be as strong as most analysts currently predict, a slowdown could create a long-term growth opportunity for the company as acquisition targets become cheaper.

CLF is slightly more expensive than its smaller, less-integrated peers, but it is cheaper than Nucor (NUE). Though I expect EBITDA outlooks for all steelmakers to shrink, CLF’s is currently “EV / EBTIDA” 2.8X while Nucor’s is 4.2X and Reliance (RS) at 5.3X. Thus, CLF may be at a discount today, potentially drawing from lower investor interest due to its lack of a dividend. Additionally, even if Cliffs’ 2022 earnings are closer to the 2023 predicted EPS of $ 2.75, that would still give the firm a very healthy forward “P / E” of ~ 6-7X. In my view, this is a strength for the company since it is likely that it will find higher returns by reinvesting its cash flow into tangible productive assets – likely giving superior ROIs than are found in stocks.

The Bottom Line

Overall, I remain neutral on CLF and see a higher immediate downside risk with solid long-term potential. I expect that if stocks and the economy crash, CLF’s price may fall dramatically as investors will assume typical cyclical behaviors will ruin the steel industry as they have in past recessions. However, we live in a highly untypical period, with the primary economic issue not being a lack of demand but a lack of supply. This supply issue has pushed prices up significantly, causing companies and people to reduce purchases. Fundamentally, I believe this type of recession (stagflation) will likely hit service-oriented firms (with high labor expenses) much harder than goods producers like Cliffs’.

At this point, I do not believe this critical point is well-understood by the market, creating a strong possibility that Cliffs (and similar firms) becomes highly oversold in the event of a widespread stock market crash. It appears Cliffs’ is likely slightly undervalued compared to peers and is far cheaper than most stocks outside of the materials and industrial sectors. However, it is deadly to catch falling knives since emotional factors usually cause them to cut far deeper than most expect. Thus, while I do see long-term value in CLF at its current price, I believe it is best to “wait and see” for a more attractive price point in the future.



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