Cleveland-Cliffs should be at the center of the upcoming capex cycle
Every investor should be waking up to the upcoming massive spending cycle for infrastructure and large physical assets.
Industrial and raw materials companies that have historically struggled may suddenly experience several staggeringly profitable years. Investors need to be ready, even though the credit rating agencies are not.
Today’s company, Cleveland-Cliffs, is getting a particularly harsh rating. Let’s investigate using Credit Cash Flow Prime.
Also below, a detailed Uniform Accounting tearsheet of the company.
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The steel industry has been challenged for some time. Companies in the industry have been pegged to GDP growth for years, often barely returning above the cost of capital.
Even for a vertically integrated company like Cleveland-Cliffs (CLF) that owns everything from the iron ore mining to the steel making process and has outperformed its peers, returns have been volatile.
Driven by a combination of historical under-investment in American physical assets, high demand driving new manufacturing capacity, and federal infrastructure spending, the companies producing raw materials could see sky-high profitability in the coming few years.
We’ve already seen a number of raw materials double or triple in value as companies scrambled to secure supply. It is, therefore, no surprise that Cleveland-Cliffs and its peers are forecasted to triple their profits in 2022 compared to last year.
Once again, the rating agencies appear to be behind the story. S&P is rating Cleveland-Cliffs as a high-risk B+ name, suggesting the company has a 1 in 4 chance of default in the next five years.
That pessimistic rating is likely a consequence of the firm’s $2.5 billion debt headwall due in 2025. That maturity alone is five times larger than the firm’s typical free cash flow.
But rating the company as if it is a hazard to its creditors demonstrates the ratings agencies’ fundamental inability to fairly forecast cash flows. Because Uniform Accounting is so effective at reducing noise in company financials, the Valens team has been able to build the Credit Cash Flow Prime model to predict the most reasonable future cash flow and obligations scenario.
In the chart below, the stacked bars represent the firm’s obligations each year for the next seven years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
A closer look would show you that cash flows should comfortably exceed obligations in the coming few years, and it doesn’t have any debt maturities until 2025. In the preceding years, it will be raking in cash as it rides the CapEx cycle, and it will have plenty of time to refinance if need be.
See for yourself:
That is why on the rules-based Valens scale, Cleveland-Cliffs is a safer XO name. This rating signals that the firm isn’t at imminent risk of default, but may need to dip into its cash reserves to pay down debt in later years.
This precludes it from being a truly “investment-grade” name (as fixed-income investors would put it), but Moody’s high-yield rating swings much too far into the pessimistic territory.
Not all credit stories are pretty. This is certainly true for many steel companies over the past decade. But conditions change, and investors both on the credit and equity side need to be ready for change. And they should be keeping the CapEx cycle in mind when choosing their investments.
To see Credit Cash Flow Prime ratings for thousands of companies, click here to learn more about the various subscription options now available for the full Valens Database.
SUMMARY and Cleveland-Cliffs Inc. Tearsheet
As the Uniform Accounting tearsheet for Cleveland-Cliffs Inc. (CLF:USA) highlights, the Uniform P/E trades at 8.1x, which is below the global corporate average of 24.0x, but around its historical P/E of 8.1x.
Low P/Es require low EPS growth to sustain them. That said, in the case of Cleveland-Cliffs, the company has recently shown an 84% Uniform EPS growth.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Cleveland-Cliffs’s Wall Street analyst-driven forecast is for 249% growth in 2021 and a 6% EPS decline in 2022.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Cleveland-Cliffs’s $22 stock price. These are often referred to as market embedded expectations.
The company is currently being valued as if Uniform earnings were to grow by 22% over the next three years. What Wall Street analysts expect for Cleveland-Cliffs’s earnings growth is above what the current stock market valuation requires in 2021, but below that requirement in 2022.
Furthermore, the company’s earning power in 2020 is 1x the long-run corporate average. Moreover, cash flows and cash on hand are more than 2x its total obligations—including debt maturities, capex maintenance, and dividends. Additionally, intrinsic credit risk is 100bps above the risk-free rate. All in all, this signals a moderate credit risk.
Lastly, Cleveland-Cliffs’s Uniform earnings growth is above peer averages, while the company is trading below its average peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research