Cliffs Natural Resources Wants You to Know These 5 Things About the American Steel Market

Cliffs' conference calls are always a great look into the details of the iron ore market. Here's what management had to say this past quarter.

Tyler Crowe
Tyler Crowe
Jun 15, 2017 at 9:33AM
Energy, Materials, and Utilities

Investor conference calls are boring. Management teams go to great lengths to not talk about their competitors and continuously use the same phrases they learned at their respective executive training classes like "focused on shareholder value" and whatnot. The one exception to this dull affair is the management call for Cliffs Natural Resources (NYSE:CLF), where CEO Lourenco Goncalves has absolutely no issue speaking what is on his mind concerning the iron ore and steelmaking markets. 

These statements can be incredibly helpful for investors trying to make sense of the global market for iron ore and the quirks that lie within. Here is a selection of quotes from the company's most recent conference call that should help investors wrap their heads around the global steel market and what Cliffs has in store for the next several years. 

Iron ore rail loading facility

Image source: Getty Images.

What steel problems?

This past quarter, steel maker U.S. Steel (NYSE:X) reported an extremely disappointing earnings result and suggested it is behind the curve when it comes to equipment upgrades. To some investors, this was a sign that the U.S. steel market is still struggling to deal with cheap imports and weak demand.

Goncalves squashed this idea early on in his statement. Not only did he indicate that the American steel market is in a much better place today than in the past. He also reminded investors that U.S. Steel is not a Cliffs customer. 

Current demand for steel in the United States is healthy, and that's pretty much across all sectors. Recent weaknesses made clear during this current Q1 earning season by a few companies are not indication of any underlying problem with the steel business in the United States. These weaknesses are actually company-specific, and we are glad to inform you that Cliffs and the steel mills that we serve are doing very well. Actually, based on their actual pellet demand and nominations, these steel mills that are clients of Cliffs are running at higher rates than in the recent past, and there are no signs ahead that this trend will change anytime soon.

The ripple effects of Samarco

Back in November of 2015, a dam at BHP Billiton's and Vale SA's Samarco mine ruptured and caused almost irrevocable damage. Since then, the facility has been shut down and isn't expected to start up for some time as the companies work through various lawsuits and cleanup. This is critical for the global iron ore market because Samarco was a supplier of high-quality iron ore that is used in the U.S. and Europe. With Samarco down, Goncalves predicts there will be a ripple effect on pellet-grade iron ore prices.

First world countries need high-quality steel and produce that steel via blast furnaces, but they do not tolerate pollution. That's why the utilization of high-quality pellets is prevalent as the basic source of iron units for blast furnaces in Europe and in the United States. However, with the Samarco disaster in November of 2015, the availability of high-quality pellets in the international market has been reduced by approximately 30 million metric tons per year. The production of pellets in Brazil from other sources is restricted to a limited amount from Vale, and it's almost all earmarked for world-class mills in Japan, South Korea and Europe as well as DR-grade pellets to the Middle East and the Caribbean. Most importantly, the major iron ore producers in Australia: Rio Tinto, BHP, Fortescue [Metals Group] and Roy Hill are all located in the water-constrained Pilbara region and therefore, they do not produce pellets.

With pellet grade production constrained, it gives Cliffs both the opportunity to expand its operations and benefit from an uplift in prices. Goncalves also continued saying that getting Samarco back online will take some time, and it may never get back to its pre-disaster production levels. 

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Meeting the changing demands of the iron ore market

Making steel has changed a lot, especially in the United States. The most significant change has been the switch from traditional blast furnaces that use raw iron ore and metallurgical coal to electric arc furnaces (EAF) that consume recycled scrap steel or a specialty iron product known as direct reduced iron (DRI). Cliffs has traditionally supplied blast furnaces in the U.S., but Goncalves sees the writing on the wall.

[O]ver the past few years, we have had a lot of success selling DR-grade pellets to new clients, and we are now getting ready to expand our role in serving the EAFs. With the significant cash flow we expect to generate over the next couple of years, we are currently in the process of evaluating the best course for a more substantial entry into this market. We have a number of options some of which are not incredibly capital intense and would position us to feed the EAFs with what they desire, high-quality virgin iron units.

The key there is keeping the capital intensity low. If it can leverage its existing facilities and combine with some direct reduced iron production facilities, it will help ensure Cliffs' long-term future. 

Learned from previous mistakes

When Cliffs investors hear the words "expansion" or "spending," they have a visceral reaction. That's because the company got into a lot of financial trouble trying to expand the business and left it with a mountain of debt just as iron ore prices started to crater. Goncalves has spent the better part of two years cutting spending and repairing the balance sheet. He wanted to ensure investors that this capital expansion plan won't be taken lightly.  

[W]e must evaluate all of these opportunities very seriously and apply high hurdles when it comes to return on investment. While we now have the luxury of having a much-improved capital structure, we must recognize what gave Cliffs the debt problems of the recent past, poor allocation of capital by previous management. The beauty of this current scenario is that there is no gun to our head, and we can be patient in evaluating opportunities.

Patience is a great word to hear right now. Iron ore prices remain volatile, and Cliffs has yet to string together several quarters of strong results to build its cash position.

Getting ready to expand again, but first...

One of the items that will help to build that cash position is to keep paying down debt. Today, Cliffs has $1.6 billion in long-term debt. According to Goncalves and CFO Tim Flanagan, those capital spending plans won't happen until at least 2018 because there are more pressing uses for that cash today.  

2017 will be fully dedicated to continue to pay down debt and we are going to end 2017 substantially below $1 billion and in that more or less like onetime maybe that will average.

If Cliffs can get to $1 billion in debt and meet its guidance of $700 million in annual EBITDA, that would put the company at a debt to capital ratio of 37% (that's with today's market capitalization) and a very healthy debt to EBITDA ratio of 1.4 times. That kind of balance sheet strength will give the company many more options when it does come time to start spending on those new direct reduced iron production facilities.