On the surface, the steel industry seems pretty simple (make steel, sell it). But underneath, there are a lot of moving parts -- which is why investors shouldn't be too downbeat about Cleveland-Cliffs' (CLF -1.24%) weak first-quarter results. Management is very confident that the rest of the year will turn out pretty well. Here's what's going on.
Costly production process
Cleveland-Cliffs makes heavy use of blast furnaces. That's an older technology that involves massive steel plants. They need to run at high utilization rates in order for the steel mill to make money. That fact runs headlong into the cyclical nature of the steel sector, since demand for steel rises and falls along with economic activity. When times are good, Cleveland-Cliffs can make a huge amount of money. When the economy cools, low utilization rates can lead to red ink.
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There are other factors that play into all of this as well, notably the prices that Cleveland-Cliffs and its peers can charge for steel. The current going rate for steel isn't always as helpful as you would expect in predicting what a company will earn in any given quarter. For example, Cleveland-Cliffs works heavily with the auto industry (roughly a third of its business), which involves long-term contracts.
The prices that auto customers pay for steel are reset at specific intervals, often yearly. So a price increase may not actually show up at the same time as the industry pricing increases. The time lag between the market price change and the price change for the contract can lead to short-term earnings that look weaker than investors might expect. That's what's going on right now.
Getting better
During Cleveland-Cliffs' first-quarter earnings conference call, CFO Celso Goncalves explained:
Relative to Q1, we expect Q2 average selling price to increase more than $100 a ton, call it, $120 a ton compared to Q1, and that's largely driven by higher HRC [hot rolled coil steel] pricing, higher slab pricing. And then most importantly, those lags that we experienced in Q1 from the sub-$700 index pricing environment in November, December, those all fall off in Q2. So that's why you see the big jump in sales price.
That is why CEO Lourenco Goncalves was so positive about the future, stating in the first-quarter earnings release that "With the final batch of yearly fixed-price contracts -- the ones dated April 1st -- successfully renewed, our outlook for a significant EBITDA expansion in Q2 remains intact."
That said, adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) is already moving in the right direction. In the fourth quarter of 2022, EBITDA was $123 million. That rose to $243 million in the first quarter of 2023.
Looking out further, the CEO noted, "Most importantly, we set the stage for another highly profitable year in 2023, which we expect to further materialize with a much higher Q2 EBITDA and strong free cash flow generation in the last three quarters of the year." That's helped along by cost-cutting efforts and some other one-time items, but all in, Cleveland-Cliffs is clearly hinting that the near-term future is looking bright despite the first-quarter loss.
The downside
So the big story with Cleveland-Cliffs is that the company's long-term supply contracts have reset to reflect higher prevailing steel prices and that will be a big boost to financial results throughout the rest of 2023. But investors also need to remember that the lag works the other way as well.
When steel prices fall, those contracts allow the company to earn more until they reset to lower prevailing rates, which can lead to something of a profit cliff. For now, though, the news here is far more positive than it looks thanks to the positive contract resets that have taken place.
