Just a few years ago Cleveland-Cliffs (CLF 2.83%) was a steel industry supplier, offering iron ore to steel makers. Through a series of acquisitions, however, it has transformed itself into one of the largest integrated steel mills in North America.
It was a timely transition, with the auto sector quickly becoming a key end customer. However, the auto exposure hasn't worked out as well as the company hoped so far, creating a headwind for the company. But management thinks the auto sector is about to be a very important tailwind.
A quick backstory
During Cleveland-Cliffs' second-quarter 2022 earnings call, management discussed the company's business transition from steel industry supplier to integrated steel mill. The change started with the March 2020 consummation of the company's AK Steel acquisition. Not long after that, the auto sector, a major AK Steel end market, was hit by shutdowns related to the coronavirus pandemic.
Then Cleveland-Cliffs added the U.S. operations of ArcelorMittal not too long after it closed on the AK Steel deal. This further exposed the company to the North American auto sector on an absolute basis, while also broadening the mill's overall diversification. That seemed like a good thing as automakers slowly got back to work following the pandemic-related shutdowns -- at least until supply chain issues, most notably computer chip availability, took a toll on auto production. To put some numbers on that, the average annual production for North American light vehicles had been around 17 million cars. Over the past two years, production of such vehicles has fallen to around 13 million units.
The production slowdown has been partially covered by rising prices in the steel sector, allowing revenue to increase to $6.3 billion in the second quarter of 2022, up from $5 billion in the prior year. Earnings weren't quite as impressive, dropping from $1.33 per share in the second quarter of 2021 to $1.13 in 2022 (though that includes $0.14 per share of one-time charges). Steel-producing peers with more exposure to construction markets, like Nucor and Steel Dynamics, have been posting better (even record-breaking) results.
The auto advantage
But the auto headwind that Cleveland-Cliffs has been facing is really not a long-term problem. The ability of its customers to produce cars has been curtailed by supply chain constraints that will eventually be worked through. And when that happens, steel demand from these key customers is highly likely to pick up. Cleveland-Cliffs thinks the second half of 2022 will be a key inflection point. About a quarter of the company's sales are to the auto sector.
Selling to the auto sector isn't simple. You need to work with the automakers to get approved. The steel is actually quite specific and unique, with automakers trying to balance strength and weight. And once a company is included in the supply chain, it tends to have long-term working relations with its customers. So Cleveland-Cliffs can't be easily supplanted. That means that when the auto industry does turn higher again, this steel giant is highly likely to benefit.
Using fairly simple math, taking the average production and the actual production, it looks like the U.S. auto sector could have produced at least 8 million more cars than were produced over the past two years. Meanwhile, there's so much demand that used car prices have skyrocketed. So it is entirely possible that the 8-million-car shortfall will have to be made up, along with ramping production back to historical levels. That could lead to a multi-year period of robust auto demand for steel.
An offset that sets Cleveland-Cliffs apart
Still, automakers are only around 25% of the company's sales, and steel is a highly cyclical industry. That other 75% of sales could quickly turn into a headwind if there is a recession -- and the U.S. has already experienced two consecutive quarters of declining gross domestic product (an unofficial signal that the country is in a recession). So Cleveland-Cliffs isn't exactly free and clear, but if the auto sector does start to ramp up production again, the steel mill's exposure here could be an important distinguishing factor compared to peers. For long-term Cleveland-Cliffs investors, it will pay to watch the auto sector closely over the next year or two.