Cleveland-Cliffs: NAV Valuation Promises A Huge Upside
Sep. 11, 2021 4:36 AM ETCleveland-Cliffs Inc. (CLF)1 Comment
Long/Short Equity, Special Situations, Mid-cap
Contributor Since 2021
Quantitative equity research analyst. Colliding data science and finance to find a stock's mispricing.
Constantly looking for a reasonable balance between growth and value.
>5 years of experience in personal portfolio management with an average annualized return of ~29%.
Note: I and Danil Sereda, another Seeking Alpha contributor, worked together and are good friends at the moment, so I have to mention the existing association with him. But we do not influence each other's articles and focus on the analysis of different companies.
Summary
In this article, I've made a Net Asset Value DCF model based on Cleveland-Cliffs' 2P (proven and probable) reserves.
The conservative assumptions of my model promise a huge upside potential to CLF's current price.
I've updated my relative valuation models from recent articles. They are talking about the possible undervaluation of Cliffs, too.
There are a whole host of risks that you should be aware of before going LONG.
Despite that, I continue to hold CLF and am willing to buy more if it corrects a
Introduction
If you read my previous articles on Cleveland-Cliffs Inc. (CLF), you probably know that I was very bullish - and this sentiment really paid off:
?
Source: From "3 Reasons Why Cleveland-Cliffs Is A Buy Before The 2Q Report"
However, in previous articles I wrote mostly about the relative valuation of the company - how "fairly" it was trading compared to the peers like United States Steel Corp. (X) or Nucor (NUE), taking into account both market multiples and indicators of business growth and marginality. In this article, I will also update those calculations. But now I'd like to put the main emphasis on a fundamental valuation specific to this particular industry - Net Asset Value (NYSE:NAV) Discounted Cash Flow (NYSE:DCF) modeling.
The idea of this method is pretty simple: we are looking at the company's 2P reserves (proven and probable); we make the assumption that the company no longer explores new mines, but only works with its 2P reserves; we forecast revenue, gross profit, EBITDA and FCFF based on historical dependencies, steel price forecast, trends in business margins, etc. Next, we discount the resulting FCFFs ??at an acceptable WACC (discount rate) and add them up.
The resulting value, by analogy with the classical DCF model, can be compared with the Present Value of Free Cash Flows to the Firm. However, unlike the classical valuation model, after the free cash flow forecasts, there is no terminal value left, since all the mines will run out by the last forecast year. In the end, we have to subtract the current net debt and divide what we got by the number of shares outstanding - that will give us how much the company is really worth based on its free cash flow generation prospects.
So let's value Cleveland-Cliffs
I'd like you to understand straight out the gate that the model I'm about to construct will be fairly simple. It'll be based solely on historical trends and codependencies of financial indicators (for example, the FCFF calculation will come from EBITDA, which in turn will be based on % of revenue). I do this on purpose, because the more parameters I use, the more chances I'll have to "tweak" the final output to meet my primary expectations - I'm a CLF shareholder and, accordingly, an interested person who wants the company to turn out to be undervalued and still investable. Please keep this in mind and treat my findings appropriately.
In 2014, CLF had 4 business segments, including "North American Coal" and "Eastern Canadian Iron Ore". However, since 2015, the company has been actively divesting its non-core assets, focusing exclusively on the "U.S Iron Ore" and "Asia Pacific Iron Ore". In 2018, CLF got rid of the non-American segment, so the company had to completely change its revenue structure - for 2 years (2018-2019) CLF has been reporting on the operating activities of 2 segments: the "Mining and Pelletizing" segment (ex "U.S. Iron Ore") and the "Metallics" segment.
In 2020, due to some acquisition activities, it changed the business structure again and now reports for 4 different segments ("Steelmaking", "Tubular", "Tooling and Stamping", and "European Operations"). All this complicates the analysis of historical trends a little - the rapidly changing business structure forces us to focus on "shorter" average values, which will certainly add risk to the final output. Well, we have no choice but to accept it.
The good news is that despite all the apparent instability in the segment structure, CLF owns the same mines as 5-7 years ago. In its most recent annual report (FY2020), the company stated that its 2P reserves were 2,433 million long tons and its annual production was 17 million long tons of iron ore pellets. In addition, during FY2020 the company produced 4 million tons of raw steel and 1 million net tons of coke.
But let's assume that in the future the company will focus exclusively on iron ore, as it used to. Of course, in reality, this is not the case, but we are trying to value CLF through the value of its net assets, so we need to understand how much it can get from them - it's much easier to do this assuming the extraction and sale of iron ore from existing 2P reserves. In addition, if I take all segments at once, I'll have to take on much more risks - each business segment needs its own selling price forecast.
So, assuming a yearly iron ore production of 20 million long tons (like in normal, pre-crisis FY2019), Cleveland-Cliffs will fully exhaust its 2P iron ore reserves in ~121.5 years. In 2019 and 2020, the average selling prices of 1 tonne of iron ore for CLF were $107 and $114, respectively. In the latest 10-Q, the company does not indicate the selling price of iron ore - this is understandable, because now CLF is a vertically integrated company that extracts, processes, and only then sells the finished product (steel), the sales prices of which it discloses. However, according to the chart by Market Insider, we see that at the moment the price for 1 ton of iron ore is about $135.56 - the result of a fall from >$218 in July 2021:
?Source: From MarketInsider.com
One of Seeking Alpha's users, Krypto, in his calculations, indicated the current (at that time) price of iron ore at $200, however, I think that the average price for the full FY2021 will be ~$160-150 given the current downtrend. After that, I assume that the price will decline to its long-term averages of $90-100. This is quite conservative amid the recent decline in car production - when it comes back to normal ??(which I do not doubt because walking is not what we like to do), iron ore prices may resume their unprecedented growth in the next couple of years.
If with these inputs we assume that COGS will account for ~80% of revenue, and the EBITDA-to-Gross-Profit ratio will be 50%, then even taking into account that FCFFs will be equal to 1% of the resulting EBITDA, the fair value of the company at a 10%-WACC will amount to $23.53 billion, which is more than 2x the current market capitalization of Cliffs.
This is by no means a price/market cap target. The whole point of this calculation is simply to demonstrate how undervalued the company is, even though the stock has soared >274% over the past year, outpacing its main peers:
?Source: Seeking Alpha's charting
All this is happening against the background of multiple contractions - the historical market multiples do not keep pace with the growth of business indicators, the rise of which is regarded by Mr. Market as a temporary phenomenon.
?Data by YCharts
At the very beginning of the article, I promised to update my relative valuation models. Well, they are talking about the possible undervaluation of Cliffs, too:
?
??Source: Author's calculations based on Seeking Alpha's data
Again, I have to warn you that these potential upsides are not the final price targets. Anyone reading this article should be aware of the whole galaxy of risk factors that can affect the strength of my bullish thesis.
Firstly, I started building the model, being confident in the stability of the company - otherwise, I would not have owned the stock myself. So if you regard this article as a manifestation of bias and an attempt to justify my initial bullish sentiment, you may be right. But only partly. Fundamentals are hard to argue with. Despite the apparent corporate instability (frequent changes in business segments), CLF proves that the right people are at the helm - the management seems to clearly understand and control the internal processes within the company. As long as the market situation allows, the company reduces leverage and increases liquidity levels, which will be quite useful in the event of a fall in steel prices.
?Data by YCharts
Secondly, my model predicts too many years (actually, 122) and has too many brittle assumptions. Accordingly, the market itself in which the company operates is not as stable as I regard it in my model. That is why I come to such a huge underestimation - Mr. Market apparently does not believe in the stability of the company at more adequate steel prices.
Moreover, I have to make a reservation again - I was valuing Cleveland-Cliffs based on the potential value of its assets, assuming that it would start selling the iron ore again. That is, the conclusion I came to speaks about the value of the mines based on the potential free cash flows from the sale of iron ore (not steel). In reality, the company is now selling steel, not iron ore. Accordingly, I am a priori wrong. However, I have already explained this above - this valuation model explains how much, in theory, a company should be worth based on the value of its assets. The main thing is that CLF hypothetically has such a possibility, that's why I think my calculations do make sense.
Thirdly, the company's margins are still lame. In my model, I based the FCFF forecast from EBITDA at the level of 2% (which is quite small), but CLF in the context of the last 12 months shows much worse results, even compared to its peers:
?
Source: Author's calculations based on Seeking Alpha's data
Moreover, the marginality gap inevitably leads to relative overvaluation if we change our focus:
?Source: Author's calculations
But despite all the risks, I believe that Cleveland-Cliffs has room to grow even with last year's stock rally. Yes, CLF has a lame marginality, but this is not a problem, because even under quite conservative assumptions, the stock does not cease to remain fundamentally undervalued. This is confirmed when we match the growth of its business with dependent market multiples - in this regard, the company is still trading at a large discount to its main peers. Therefore, based on a combination of factors, I continue to hold CLF and am willing to buy more if it corrects a little.
This article was written by
Oakoff Investments
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Quantitative equity research analyst. Colliding data science and finance to find a stock's mispricing.Const... more
Long/Short Equity, Special Situations, Mid-cap
Contributor Since 2021
Quantitative equity research analyst. Colliding data science and finance to find a stock's mispricing.
Constantly looking for a reasonable balance between growth and value.
>5 years of experience in personal portfolio management with an average annualized return of ~29%.
Note: I and Danil Sereda, another Seeking Alpha contributor, worked together and are good friends at the moment, so I have to mention the existing association with him. But we do not influence each other's articles and focus on the analysis of different companies.
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.
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