I believe that the EBITDA from the new Hot Briquetted Iron (NYSE:HBI) production plant will push Cleveland-Cliffs’ (CLF) share price from $7 to more than $9. A conservative DCF model reveals that the new plant would bring, at full capacity, $150 million EBITDA per year. That’s not all. Using a terminal EV/EBITDA multiple of 5.5x-7x, I got an implied share price ranging from $9.99 to $10.41. In most of my case scenarios, the company is undervalued at the current stock price.
Why Valuing The New HBI Plant Is Important?
Cleveland-Cliffs Inc. is said to be the oldest independent iron ore mining company in the United States. It’s well-known by most traders as the company has been operating since 1847.
What people could not know is that by 2020, Cleveland-Cliffs is expected to have the first production plant of Hot Briquetted Iron in the Great Lakes region. The company is currently building the plant and expects to generate the first HBI sales in 2020 and 2021. In my opinion, the assessment of the EBITDA will provide valuable information. Not every trader will know about the new asset and its valuation. The traders with information about the future FCF will have an edge over the rest.
I have taken into account all the company’s assets to get an objective share price. The company has two operating segments: the Mining and Pelletizing segment, and the Metallics segment. The first segment is composed of one iron ore mine in Michigan and three iron ore mines in Minnesota. The Metallics segment consists of the HBI production plant.
Most sophisticated traders will say that I should value each of Cleveland-Cliffs’ mines. That’s fair enough. However, I will not do so. I am more interested in the value of the HBI production plant. Besides, market analysts and Cleveland-Cliffs don’t offer sales and EBITDA expectations of each mine. They provide figures for the whole company.
Mining and Pelletizing Segment
As per the last annual report, the company had an annual rated capacity of 27.4 million tons of iron ore pellet production. Cleveland-Cliffs’ equity ownership of the mines gives the company annual rated production capacity of 21.2 million tons. In 2018, Cleveland-Cliffs’ mines worked at full capacity. Hence, we don’t expect the Mining and Pelletizing Segment to increase its sales significantly. They will only increase if the company acquires other competitors or the commodity price increases.
According to Zion Market Research, the Global Iron Ore Pellets Market CAGR is expected to grow by 8.1% between 2018 and 2024. In 2018, the company saw its sales increasing by almost 25% amounting to $2.332 billion. I want to be very conservative, so I used sales growth between 1.85% and 3.5% from 2020 to 2024. I obtained a sales CAGR of 1.236% from 2018 to 2024, which I think is quite achievable. Concerning the number of years projected, I believe that a period of six years makes sense. Cleveland-Cliffs signs on the average six-year contracts.
In 2017 and 2018, the COGS/Sales was equal to 74.94% and 65.29% respectively. To obtain the sales margin, I utilized a COGS/Sales figure of 70.11%, which is below the average number obtained from 2017 and 2018:
Source: Author and Market Consensus
I studied the net income in 2017 and 2018. Net income comprised of 19.46% and 48.37% of sales. Thus, in my view, using a net income of 40% of sales from 2019 to 2024 is conservative. In the period 2018-2024, I get a net income CAGR of -1.919%.
Analysts expect debt to increase from $1.27 billion in 2018 to $1.812 billion in 2021. I believe that the company needs the money to finance the construction of the new plant. In 2022 and 2023, I as well as market analysts think that the debt will decline. In line with this trend, I increased interest expenses in 2019 to -$171 million and included 2024 and 2023 interest expenses of -$120 million. Finally, I utilized the same tax rate benefit/sales seen in 2018 and increased the depreciation and amortization expenses slightly. Grabbing all together, I obtain annual EBITDA in 2019-2024 from $756 million to $807 million. In 2018, the company had EBITDA of $878 million, so I think the values obtained are achievable:
Source: Author and Market Consensus
Metallics Segment And Total EBITDA
The company expects to have its production plant working by the first half of 2020. The total capacity will be equal to 1.6-1.9 million tons. Thus, I believe that a production of 0.7 million tons in 2020 and 1.6 million in 2024 is very conservative. I studied the prices of HBI and concluded that $300 per metric ton is fair, which makes a revenue of ~$480 million in 2024:
In 2018 and 2017, the company’s EBITDA margin was close to 20%-40%. Traders could expect higher margins, but I will be using 33%, which implies terminal 2024 EBITDA of $158.40 million.
In total, I believe that the company could generate 2024 Sales of $2.99 billion and 2024 EBITDA of $965 million. It is not far from estimates of other Seeking Alpha authors.
Expected Free Cash Flow, WACC, And Implied Share Price
In 2017 and 2018, the company’s CFO/sales were 18.12% and 20.52% respectively. I used the expected sales and CFO/sales from 25% to 15.86%. In my opinion, future CFO will not fluctuate a lot from the figures obtained. With regards to the purchase of property and equipment, I assumed that it would decrease after the company finishes the HBI Plant in 2020:
While calculating the WACC, I obtained the weight of equity of 0.4 and the weight of the debt of 0.5. Then, taking into account the risk-free rate of 1.540, a beta of 2.5 and the cost of debt of 5%, I get that the WACC is more significant than 9%. The assumptions made while calculating the WACC do not matter much as I will run a sensitivity analysis. The same applies to the terminal EV/EBITDA multiple. In the last 30 years, peers traded at 5.5x-7x EBITDA. Hence, I will also run a sensitivity analysis with EV/EBITDA multiples from 5.5x to 7x.
Sensitivity Analysis: The Shares Are Worth More Than $9
I first ran the first model with WACC of 9%, terminal multiple of 5.5x, the debt of $2.1 billion, share count of 270 million, and cash of $377 million. My results revealed the market capitalization of $2.69 billion and an implied share price of $9.99:
If I assume a WACC of 9%-12% and EV/EBITA multiple of 5.5x-7x, the market capitalization becomes $4.419-$6.115 billion. Besides, the implied share price ranges from $9.99 to $10.41:
If I use 5.5x EBITDA multiple and terminal EBITDA ranging from $900 to $1050 million, I obtain an implied share price of $9.19-$7.02:
In the light of these results, I believe that the company is undervalued at the current price of $7.0-$7.20. In my opinion, once CLF starts its HBI production, EBITDA will creep up to $0.950-1.050 billion. Also, when traders understand the value of the new plant, in my view, the share price will go up to more than $9.
I made many assumptions about the future company’s sales, EBITDA, margins, and WACC among others. I tried to include very conservative financial figures and based my analysis on the work of other market analysts. However, the company couldn’t fulfill expectations. In this case scenario, I don’t think that the downside risk is significant, but the share price could decline below $7 and 5x EBITDA.
If global economic conditions deteriorate, it will push the price of iron down. Also, the international demand for iron ore products is driven by the economy in China. If the trade negotiations between the United States and China do not succeed, I believe that the company’s business model will be negatively affected.
For the year ended December 31, 2018, three large clients together accounted for 95% of the company’s Mining and Pelletizing product sales. It is a considerable risk. Cleveland-Cliffs Inc. will not have a lot of bargaining power to negotiate higher prices. Clients know that there are not many companies in the United States willing to acquire large quantities of Cleveland-Cliffs’ production.
Cleveland-Cliffs Inc. appears to be undervalued. I think the market did not assess the EBITDA correctly from the new Hot Briquetted Iron production plant. In my opinion, in 2020, as traders get to know about the new plant, the share price will gradually creep up to cross the $9 mark. Then, in my view, if the company can hit an EBITDA of more than $1 billion, the implied share price could even touch the level of $10.41.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.