Cleveland-Cliffs (CLF -0.49%) has transformed its business in a very short period of time. To some extent, it was working to protect its customer base, but the end result is that this one-time iron ore miner is now an integrated steelmaker. With the transformation over, management has been working to fix the balance sheet risks left behind.
A brief history
In late 2019 Cleveland-Cliffs agreed to buy AK Steel for roughly $3 billion, including debt. At the time, AK Steel was struggling through a steel industry downturn, and it looked very much like Cleveland-Cliffs was stepping in to save a key customer. Less than a year later Cleveland-Cliffs agreed to buy the U.S. steel operations of ArcelorMittal in a roughly $3.3 billion deal. Although this, too, seemed like a supplier saving a customer, the end result is that Cleveland-Cliffs very quickly became one of the largest steelmakers in North America.
Image source: Getty Images.
Those big strategic moves, however, came with notable financial implications. By the time the two deals were completed, Cleveland-Cliffs' long-term debt had increased by more than 150%. Its debt-to-equity ratio stood at nearly 6 times at the start of 2020, way out of line with its closet peers. Even U.S. Steel (X 1.56%), which had been struggling with its own leverage profile, had a drastically better balance sheet. U.S. Steel's debt-to-equity ratio didn't rise above 2 times, even at the worst point in 2020.
From the start, Cleveland-Cliffs was aware that it needed to fix this problem. An industry rebound has been highly beneficial on this front.
Getting better and better
Since the steelmaker's debt-to-equity ratio peaked in 2020, it has used improved financial performance and debt reduction to bring that key leverage metric down to around 0.55 times. That's still above its peers, but it is no longer worryingly high.
NUE Debt to Equity Ratio data by YCharts.
The calendar year 2021 was an incredible year for Cleveland-Cliffs, with earnings of $5.36 per share compared to a loss of $0.32 in 2020. The company used the improved earnings to buy another company, this time in the scrap steel space, further diversifying its steel footprint. And it also started down the debt reduction path.
However, the commitment to debt reduction was really on full display in 2022. Although the company's earnings dropped to $2.55 per share, management reduced debt by roughly $1.1 billion. That's a big figure, but the really interesting fact comes when you consider that number relative to the company's free cash flow, or the cash left over after funding the business and necessary capital investments. Cleveland-Cliffs calculated its 2022 free cash flow to be $1.5 billion, so it used 73% of its free cash to pay down debt.
That's a big number, and it helps to explain why the company's balance sheet strength has been able to so quickly come back in line with peers. Adding to the improved debt profile has been a roughly 75% reduction in the company's pension obligations, which were another long-term financial headwind. Although the pension issue was largely addressed via negotiations with the company's unions that reduced its obligations, it was another notable step in the right direction.
The leverage improvement wouldn't have been possible without the industry recovery that took place. So, in some ways, Cleveland-Cliffs has gotten lucky. Reaching an agreement with its unions on pension obligations was also a decidedly positive outcome, given that union negotiations are often tricky. But it is also true that these improvement wouldn't have happened if management didn't make a choice to work toward these ends, living up to a standing management goal of improving the company's financial positioning.
A different company
After the two big steel acquisitions, Cleveland-Cliffs looked like a highly risky investment option. Just a couple of years later, despite being more highly leveraged than its peers, there is much less of a reason to worry about this steelmaker's future. While an industry downturn will still sting, Cleveland-Cliffs' debt reduction efforts and reduced pension obligations have changed it in a dramatic way. Indeed the chance that the next steel downturn, which is going to happen sooner or later, could push the company to the financial brink seems highly unlikely.
