Shares of Cleveland-Cliffs (CLF -1.79%) are up by around 200% since the start of 2020 -- a vastly better performance than the "mere" 34% rise of the S&P 500 Index over that period. There are a lot of moving parts to the story of why the steelmaker did so well, including a major corporate bet that paid off in a big way. But investors shouldn't get too comfortable about this stock.
What a difference a few years makes
At the start of 2019, Cleveland-Cliffs was a supplier to the steel industry, providing iron ore largely to North American steel producers. It wasn't a bad business, per se, but the domestic steel sector had been going through some rough times. Some of Cleveland-Cliffs' customers were struggling. By the end of 2019, it announced that it was going to buy one of those major customers -- AK Steel.
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That game-changing move transformed the company from an industry supplier into an integrated steelmaker -- effectively guaranteeing at least one customer for its iron ore. But management wasn't done. In 2020, it bought the U.S. production assets of global steel giant ArcelorMittal. In roughly a year, Cleveland-Cliffs became the largest flat-rolled steel producer in North America. This was a massive bet, largely financed with debt.
Given the stock's performance of late, it's pretty clear that the investments were well timed. Notably, as the economy started to recover from the impact of the coronavirus pandemic, demand for steel rose. That led to price increases and higher production volumes. Earnings followed along for the ride, and in 2021, Cleveland-Cliffs set a string of financial records, including its best-ever annual results for revenue, net income, adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow.
The fly in the ointment
While Cleveland-Cliffs has timed its foray into the steel production space incredibly well, investors shouldn't forget that the steel industry is cyclical. Performance will ebb and flow along with economic activity, and good times will eventually be followed by lean times. The company's current superb performance therefore should not be mistaken for a permanent plateau.
That's important to recognize because buying two large steel operations wasn't cheap. Since the start of 2020, roughly when the company's acquisition spree started, its long-term debt has increased around 150%. Interest costs are a key factor that investors need to monitor, even though they aren't a big deal right now.
Now, at the end of 2020, Cleveland-Cliffs was barely able to cover its interest costs. At the end of 2021, with a huge steel rally taking place, it was covering its interest expenses 12 times over. That last number is wonderful, but likely to be temporary given the cyclical nature of the steel industry. When the sector turns, investors will want to have a clear understanding of the balance sheet risks.
To be fair, management used the low-interest rate environment to lock in favorable rates for its debt. And there's still ample room for it to both use the current industry upturn to further reduce debt and take advantage of lower rates afforded by a recent credit upgrade. But if performance starts to ebb, a large debt balance still has the potential to become a concerning issue.
CLF Times Interest Earned (TTM) data by YCharts
Adding to the risk is that the company makes heavy use of blast furnaces, which can be very profitable when production rates are high, but tend to bleed red ink when production rates are low. So when industry demand eventually softens, Cleveland-Cliffs' business could quickly go from churning out tons of cash to burning it.
Remember the risks
Although it's clear that Cleveland-Cliffs made a timely move into steel production, given the massive run-up in the stock since the start of 2020, most investors should probably shy away from buying it today. That's not a knock against the company, per se, as all steel stocks are expensive right now. However, given its debt-fueled corporate makeover, the nature of the steel industry, and Cleveland-Cliffs' production assets, the risks for investors will be elevated when -- not if -- the next industry downturn arrives.
