Cleveland-Cliffs Inc. (NYSE:CLF) Q1 2023 Earnings Call Transcript

Cleveland-Cliffs Inc. (NYSE:CLF) Q1 2023 Earnings Call Transcript April 25, 2023

Cleveland-Cliffs Inc. beats earnings expectations. Reported EPS is $-0.11, expectations were $-0.19.

Operator: This is Daryl, and I am your conference facilitator today. I would like to welcome everyone to Cleveland-Cliffs’ First Quarter 2023 Earnings Conference Call. . The company reminds you that certain comments made on today’s call will include predictive statements that are intended to be made as forward-looking within the safe harbor protection of the Private Securities Litigation Reform Act of 1995. Although the company believes that its forward-looking statements are based on reasonable assumptions, such statements are subject to risks and uncertainties that could cause actual results to differ materially. Important factors that could cause results to differ materially are set forth in reports on Forms 10-K and 10-Q and news releases filed with the SEC, which are available on the company’s website.

Today’s conference call is also being — is also available and being broadcast at clevelandcliffs.com. At the conclusion of the call, it will be archived on the website and available for replay. The company will also discuss results excluding certain special items. Reconciliation for Regulation G purposes can be found in the earnings release, which was published yesterday. At this time, I would like to introduce Celso Goncalves, Executive Vice President and Chief Financial Officer.

Celso Goncalves: Thank you, Daryl, and good morning, everyone. Our Q1 results marked the rebound in profitability from the trough in Q4, as we effectively doubled our adjusted EBITDA from the previous quarter. We outperformed on our 3 most important metrics: selling price, unit costs and steel volumes. We guided to a Q1 implied selling price of around $1,120 per ton and realized around $1,130. We indicated that unit costs would decline by $50 per ton and they declined by $60. We said volumes would rise to around 4 million tons, and we delivered 4.1 million. 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 3 quarters of the year.

Q1 free cash flow was lower, largely because we invested in working capital due to strong demand. As pricing and volumes went up, we saw higher receivables and higher inventory tons. In Q2, we expect this trend to continue, but EBITDA will be so much higher and CapEx will be so much lower, but the massive amount of free cash flow coming in Q2 should far outpace any further build in working capital. Adjusted EBITDA in Q1 was $243 million, a 98% increase from the previous quarter, driven almost entirely by reduced unit costs, a function of normalized repair and maintenance spend, lower input costs and higher steel production. Our Q1 shipment volume of 4.1 million net tons was roughly 250,000 tons higher than the previous quarter, making Q1 of 2023 our highest steel shipment quarter since Q3 of 2021.

Automotive demand was robust, service center buying behavior has improved, and we did not have any significant maintenance outages like we did for much of last year. Q1 selling price of $1,128 per net ton came in ahead of expectations due to higher tonnage and higher value-added mix in automotive. A little more than half of our sales are index-linked with lags generally varying from 1 to 3 months. Due to these lags, the recent rise in flat-rolled index pricing was barely reflected in our Q1 results. This improvement is now in full force, which will benefit our results meaningfully here in Q2 and beyond. We have been successful in implementing several spot price increases over the past few months. We have also achieved continued increases in our fixed price contracts for the April 1 renewal cycle.

Taken together, these improved prices will propel our realizations in Q2. In addition, due to the same factors that drove Q1 costs lower, our unit cost should continue their downward trend going forward. We also expect that our strong volume performance will carry over into Q2 as the order book remains full, and we run at our configured capacity levels. As pricing and volumes improved in Q1, particularly in the month of March, we built around $230 million in receivables, contributing to the lower free cash flow quarter-over-quarter. As these receipts come in, our cash flow performance will ramp up significantly in Q2, particularly as we have already received $110 million in tax refunds here in April. This comes after a tax refund receipt of $25 million received during Q1.

Furthermore, we expect our Q1 CapEx of $188 million to represent the peak CapEx quarter for this year due to some carryover maintenance projects from 2022. So Q2, Q3 and Q4 CapEx should each be lower than Q1. In fact, we have lowered our total expected full year CapEx range by $25 million, to $675 million to $725 million, reflecting primarily sustaining projects. Touching now on the capital structure. 2 weeks ago, we completed a 7-year unsecured notes offering for $750 million, pricing at only 325 basis points above the comparable treasury. This was our tightest spread on any unsecured high-yield bond ever. We took advantage of the inverted yield curve to issue these notes, which are priced off of lower longer-term rates and used the proceeds to pay down our ABL, which is priced off of currently much higher short-term rates.

We have been comfortable using our ABL as an effective source of liquidity for some time given it was nearly free money, but with the rapid rise in the Fed fund rates, this is no longer the case. So terming some of this ABL balance out with longer-term bonds was a no-brainer. In fact, the coupon on these new notes is effectively the same as the all-in interest rate on the ABL. The additional liquidity provided as a result also gives us more flexibility for whatever market conditions or opportunities may come up. This being said, this swap of shorter-term debt with longer-term notes does not change our capital allocation priorities. We intend to continue using the robust free cash flow we expect to generate this year toward continued debt repayment and opportunistic share buybacks.

We still have over $1 billion in prepayable debt on the ABL and another $1.5 billion in callable bonds. For now, the main priority for debt reduction will be to continue driving down the ABL balance. When that has been paid off in full, we will then target redeeming our 2026 secured notes. As we’ve shown in the past with aggressive bond buybacks, even our noncallable long-dated unsecured bonds are effectively prepayable since we can also opportunistically buy them back in meaningful amounts in the open market. We plan to continue this capital allocation strategy until our net debt gets down to around $3 billion. And assuming market conditions remain as they are now, we should achieve that at some point this year. With that, I will turn it over to Lourenco for his remarks.

Lourenco Goncalves: Thank you, Celso, and good morning, everyone. During the past quarter, order release rates from our automotive clients were the strongest and the most consistent we have seen since becoming a steel company 3 years ago. Also, service center buying behavior in Q1 came back to more normal levels. These 2 factors, combined with reduced imports of flat-rolled steel forced the buyers to increase their order levels with domestic producers. In addition, the excess scrap and metallics inventories that were built by other steel companies in response to the war in Ukraine were ultimately drawn down, forcing scrap prices back to what we believe are higher but is still acceptable and sustainable levels. We used all of these factors in our favor to implement several spot price increases, which have ultimately driven index pricing higher.

Our conviction that this country’s prime scrap and metallic shortage will continue to tighten over the coming years is at the core of our strategy. Last year’s strange scrap movement in the second half of the year has been proving to be an outlier and the prime scrap market is back in a shortage position. There is less than 20 million tons of annual prime scrap and metallic supply in North America currently. And unless you are a producer of only rebar and nothing else, you need prime scrap and metallics. Our in-house production of 2 million tons of HBI per year at Cleveland-Cliffs is an integral part of our own internal supply chain. We use our HBI primarily to feed our own blast furnaces to reduce coke rate and CO2 emissions, and that results in very limited availability to sell HBI to third parties.

We anticipate that with the new electric arc furnace coming online, demand for prime scrap and metallics will be at 30 million tons by 2026. This will require significant levels of imported metallics. The largest sources of these imports up until last year were Russia and Ukraine. More than a year after the invasion of Ukraine, that import avenue remains heavily disrupted. Said another way, unless one is rerouting Russian supply through other countries for transshipment, which is, by the way, illegal, they cannot get all the feedstock they need. Because prime scrap is a byproduct of manufacturing, and we, as a country, have been moving manufacturing offshore. Prime scrap supply has been shrinking in this country for over 50 years, bringing more manufacturing back to the United States over the coming years should help alleviate the situation, but that will take time.

The alternative to address the scrap shortage would be additional metallics production, but that requires iron ore. As the largest producer of iron ore pellets in North America, this plays right into our favor. For the majority of the last 3 decades, flat-rolled steel production with EAFs took advantage of cheap and plentiful prime scrap. This historical situation is changing fast. Greenfield flat-rolled production from EAFs also plays into our favor in the automotive market. As some EAF start-ups have been demonstrating for a few quarters now, the metallurgical challenge in automotive is too big for them. This fact, along with our customer service and our R&D capabilities are the 3 main reasons why Cleveland-Cliffs remains the supplier of choice to the automotive industry in the United States.

That also helped us achieve annual price increases from all and each one of our major automotive clients. Some of this price increase will only show in our Q2 results as they are effective April 1. Our shipments in the first quarter to our direct automotive customers were the highest they have ever been in our 3 years as a steel company and at higher prices. This was the biggest reason for our strong quarterly shipment number of 4.1 million tons and why we are running all of our steelmaking shops at full capacity. Our higher levels of steel production have led to the partial restart of some operations at our iron ore mining and pelletizing swing facility at North Shore earlier this month. As you may recall, North Shore has been totally idle since the spring of last year.

We will continue to treat that facility as our swing operation. And at this time, we still do not expect to operate North Shore in full any time this year. The remarkable improvement in automotive demand is a combination of the easing of their supply chain issues and the American consumers’ growing appetite for new cars. Out of sales seasonally adjusted annual rates usually called SAAR in the United States averaged about 15.2 million units during Q1, a massive uptick after averaging 13.7 million units during all of 2022. As such, our forecast for North America automotive builds in 2023 of 15.5 million light vehicles is the best in 4 years, with one car equaling roughly 1 ton of steel and with Cleveland-Cliffs representing nearly half of the flat-rolled market for automotive steel, you can do the math on the additional volume this will bring.

The auto sales and production increases we have been seeing are further confirmation of our view on how steel demand in the U.S. will shift in our favor. For the last couple of years, nonresidential construction has been the outperformer in the steel market with automotive lagging significantly behind. As you know, Cleveland-Cliffs is not a big player in non-res. That said, given the massive backlog that has been created as a result of supply chain issues over the past few years and with the Federal Reserve reaching the end of their interest rate hike in Marathon going forward, all signs point to automotive being the outperformer. Cleveland-Cliffs is ready to accommodate any improvements in demand from the automotive sector, whether that be from internal combustion engine vehicles or EVs. And our clients know that very well.

At Cleveland-Cliffs, we are agnostic to whatever ways that demand materializes over the coming years as we are the clear-cut leader in supplying steel for both types, electric or conventional vehicles. That said, earlier this month, President Biden’s administration put forth the latest push to drive large-scale EV adoption in the United States. The proposal includes a projection that 2 out of every 3 new cars sold in the United States in 2023 — 2032, I’m sorry, in 2032 will be electric compared to about only 7% today in 2023. This is a structural reset that we have dedicated our research and innovation center efforts toward since we acquired AK Steel in March of 2020. Put simply, due to our size as a supplier of automotive steel in the United States and also due to our unique technical capabilities, these goals of the U.S. government cannot be reached without Cleveland-Cliffs.

We are an integral part of this transition from ICE vehicles to EVs in the United States, regardless of whether it happens at a fast or at a slow pace. This includes our supply of exposed body parts, structural cages, battery support and oriented electrical steels for Motors. Regarding oriented electrical steels, we call NOES, and responding to growing demand from our existing customer customers, we have already deployed $30 million as CapEx into our Zanesville, Ohio facility to increase our production capacity of NOES by another 70,000 tons annualized. We should start operating this new capacity in the third quarter of this year. Also as a reminder, Cleveland-Cliffs is the sole producer and a well-established supplier of both GOES, grain-oriented electrical steels and NOES in our country.

That’s our technology originally from ARMCO, the A in AK Steel. The market for these products is huge. But any new entrants to this market will have to first learn the products and then perfect the manufacturing process. Then the producer will have to qualify these products with each one of the clients. That’s not our case. We are already in the house with all of these clients. A couple more things before we open for Q&A. Earlier this month, we published our 2022 sustainability report. We are pleased to report that as of 2022, our absolute Scope 1 and 2 greenhouse gas emissions were already below our aggressive target for 2030 of 25% reduction, in compared to our emissions in 2017. That was when we made our decision to build our state-of-the-art Direct Reduction Plant.

This early accomplishment of our target was made possible primarily by the use of massive amounts of HBI in our blast furnaces, helped by hot metal stretching through the increased utilization of scrap in our BOFs and natural gas injection in our blast furnaces. We also reported that our Scope 1 and 2 emissions intensity from our blast furnace and BOF operations in 2022 was down to 1.60 metric tons of CO2 per metric ton of steel. This number puts Cleveland-Cliffs in the third percentile of integrated steelmaking emissions worldwide and compares extremely favorably to the global average of tons of CO2 per metric ton of steel. Because of the metrological requirements and quality needs of our automotive customer base, we remain committed to the blast furnace is still making route, and we will continue to work to make it less carbon intensive.

In order to further reduce these already low-emission numbers, we are pursuing potentially high IRR projects in emerging technologies, particularly carbon capture and storage and iron reduction by hydrogen. As things progress on these fronts, we will continue to keep you informed. With that, I’ll turn it over to Daryl for questions.

Operator: . Our first questions come from the line of Emily Chieng with Goldman Sachs.

Emily Chieng: My first is just around the electrical steel market. I wanted to follow up here and understand a little bit more about what’s happening. Could you perhaps talk to the size of the nongrain-oriented and grain-oriented electrical steel markets and growth outlook. And perhaps what electrical steel production capacity Cliffs will have after the 70,000-ton capacity investment later this year?

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Q&A Session

Lourenco Goncalves: Sure. Emily. Look, first of all, the oriented electrical steels are totally associated at this point with the pace of adoption of electric vehicles. We have developed a special product called the MOTOR-MAX and the MOTOR-MAX is for this type of high-end applications in oriented electrical steels. This investment, that was not a massive investment. We’re talking $30 million, which, by the way, has already been deployed to produce another 70,000 tons of NOES, will take care of that. And we’ll take care of that for the time being and freeing up capacity to produce more grain-oriented electrical steels at our Butler, Pennsylvania plant, because today, we basically do both in Butler. So we are moving 70,000 what is significant when you notice that our production capacity is around 240,000 tons at Butler.

So we are really growing our ability to supply more growth. GOES is related to the grid because it goes into, no pun intend it goes into the production of laminations and core for transformers. And transformers are utilized everywhere into the grid, and we are, at this point, the sole suppliers of these materials. So as monies are deployed and there are monies to be deployed coming from legislation that will free up capital to be invested in the improvement of the grid and also in the improvement of charging stations that is coming. We’re going to have to continue to grow the production of growth. So that’s pretty much what we have at this point. And I think we are rightsized for the pace of the growth of the market at this point.

Emily Chieng: Understood. That’s very helpful. And a follow-up, if I may, just around the cost outlook there. I think Celso, you mentioned there was a $60 a ton decrease in 1Q in terms of the cost profile. And I think previously, you’ve also talked about further reductions in 2Q and 3Q. Do you have any numbers as to help us frame where those numbers could land? And remind us what the moving pieces driving those costs down on a dollar per ton basis?

Celso Goncalves: Yes, sure. Emily. We’ve already decreased costs by, call it, $140 a ton in just 2 quarters. And the Q1 cost reduction of $60 a ton is $10 more than we guided down $50 for the quarter. As the inventory continues to come out, you can expect further cost reduction here in Q2. Now the magnitude won’t be as great as it was here in Q1, but we’re still working hard to bring costs down. Call it, a $15 to $20 a ton reduction here for this coming quarter, Q2.

Operator: Our next questions come from the line of Lucas Pipes with B. Riley Securities.

Lucas Pipes: My First question was also — is also on the electrical steel side. And Lourenco, I wondered if you could maybe frame up the project pipeline after this year. I assume kind of capital intensity would move up somewhat, but maybe that’s a wrong assumption. And yes, I would really appreciate color on the potential growth opportunities after this year and what the capital intensity would look like for you for your competition.

Lourenco Goncalves: Lucas, first of all, I would like to position electrical steels in a historical perspective. That’s always very helpful to understand. When I acquired AK Steel back in March of 2020, Butler and Zanesville are both slated to be shut down. Actually, the first meeting that I participate represent AK Steel happened in a meeting in Washington, D.C. 4 days before we closed. And I said in for the — for Roger Newport, then CEO of AK Steel, he was very kind to allow me to be there and speak. I basically put everybody on notice that if nothing would happen, we would just go ahead and execute the shutdown process that was slated to happen. So long story short, we being slaughtered by imported steel at that time. We’re able to stop that.

We’re able to bring back production to the United States. We’re able to shut down the backdoor production of lamination and coarse coming mainly from Mexico and Canada using steel — electrical steels from Korea, Taiwan and Japan. So we fixed the market in a way that we are no longer losing money. At this very point, Lucas, electrical steels is our most profitable line of business. So we are very happy with the fact that we are growing our own capacity with the pace of the demand. We are not going to run ahead of the demand. We are aware that the competition will try to participate in this market. Be my guest, it’s not an easy market. It’s a complicated product. So we know that a lot of the attempts to fail and this business will come back to us.

So at the right time, we will deploy capital. It’s not a priority right now. We are happy with what we have. We are happy with the expansion that we deployed in Zanesville, for NOES that will free up more goals out of Butler, we are in good shape for now.

Lucas Pipes: Very helpful. And then my second question is also a little bit more on the near term. I wondered if you could comment on the second quarter pricing outlook. You mentioned the April batch on the fixed contracts was reset very successfully, and then spot prices obviously moved up very nicely year-to-date. So I wondered if you could comment on what the whole package would look like on the pricing side in Q2?

Lourenco Goncalves: Lucas, as far as Cleveland-Cliffs is concerned, the outlook is great because, as you know, our contracts with automotive and other clients, but particularly in the automotive business that’s big for us is fixed price. So when underlying hot-rolled price in the spot market is $1,000, if I’m selling to — and I’m making this up, just to give you the picture. So don’t take the number to the bank. But if underlying hot-rolled prices are $1,000 and my contacts $1,200, then I’m selling for $1,200. If underlying market price is 1,400, my underlying — my price for the automotive clients is also $1,200. Long story short, it doesn’t matter where the spot price will go up or down, a lot down, a lot up, our price with automotive slice of the business that’s in the quarter was 36% of the business will stay where it is.

So we are feeling very good about that because we are protected in a very, very important part of the market. Celso, do you want to complement something on that?

Celso Goncalves: Yes. Sure. Lucas, just to add some numbers to that as well. 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 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.

Lucas Pipes: Terrific. This is super helpful. Really appreciate your color and continued best of luck.

Operator: Our next questions come from the line of Carlos De Alba with Morgan Stanley.

Carlos De Alba: Yes. Just on the — a couple of questions. One is on CapEx, how should we think about the CapEx going forward given that it’s running below $800 million due depreciation, which a lot of time we used a reference for sustaining CapEx is closer to $900 million, $950 million. So how do you see — for how many years do you think you can keep your CapEx below this threshold of depreciation without jeopardizing the equipment? So that will be very useful for the projection of cash flows.

Lourenco Goncalves: Yes. Just to give you a color on what you have just said. The depreciation is a good reference because it’s a good average, but it’s not good in short term as a reference because remember, when we acquired the assets, they were mistreated. We had to deploy more capital than the depreciation. And that’s why we’re still paying in our accounting for the higher costs and lower production during the time that we are doing just that. So when we ever back what’s happening this year, and it’s going to happen next year with what happened last year, we’ll probably go back to your depreciation number. But we are now in the back end of the stuff that we have already done, money that we have already spent and we are not going to spend again. I don’t know if Celso wants to complement.

Celso Goncalves: Yes. Sure. Carlos. So if you think of 2022, we spent over $900 million in CapEx, but that included a lot of maintenance repairs, that cycle is now behind us. So the new sustaining level for 2023 and at least 2024 is that $700 million level. Now when you get to 2025 and beyond, and then you have some additional relines and things like that, it could increase again. But for the foreseeable future, what we can see here in ’23 and ’24, that $700 million is a number that we’re comfortable with.

Carlos De Alba: All right. And just you mentioned, Celso, when is the next relining, just for us to have it here in the record?