Cleveland-Cliffs Inc.
Q1 2017 Earnings Call Transcript

Published: 27 Apr 2017

[Operator:]

Good morning, ladies and gentlemen. My name is Michelle and I am your conference facilitator today. I would like to welcome everyone to Cliffs Natural Resources 2017 First Quarter Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. 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 protections 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 available and being broadcast at cliffsnaturalresources.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 this morning. At this time, I would like to introduce Tim Flanagan, Executive Vice President, Chief Financial Officer and Treasurer. Please go ahead.

[Timothy K. Flanagan:]

Thanks Michelle, and thanks to everyone joining us on this morning's call. Before getting into the review of our first quarter results and outlook for the remainder of this year, I will pick up where I left off on our last call with an overview of our refinancing transactions completed during the quarter, which I would describe as both successful and transformative. The last time we spoke, Lourenco and I stressed the importance of a bulletproof balance sheet that can withstand the ever-present cyclicality in this business. In order to get there, we made de-risking the business our number one focus, not only just reducing our overall leverage, but extending maturities, lowering our interest expense and simplifying the capital structure. Less than three months later, I can happily and confidently say that all four of these goals were accomplished with our equity and unsecured debt issuances completed in Q1. Of the $1.2 billion we raised in February, every cent was put to work on the balance sheet. During the first quarter alone, total debt was reduced by $600 million, the 2020 and 2021 maturity tower reduced by more than half, our annualized interest expense burden was reduced by nearly $50 million, and our layers of secured debt were reduced from three to one. We're also very pleased with the timing of our transaction, which allowed us to minimize shareholder dilution and simultaneously lock-in a new – a low coupon, while issuing new unsecured bonds with a long-dated maturity. As we continue to navigate this ever-cyclical commodity environment, we can now do so with the extra comfort and flexibility that comes with this much lower debt level. That being said, our work in this regard is not done, and we'll always look for opportunities to embrace and take advantage of all parts of the cycle to improve the strength of our balance sheet. Now, moving to our quarterly results, our total company adjusted EBITDA of $92 million was a 156% increase from the prior year first quarter. That number represents an all-around solid performance by our operating and commercial teams in what is always the lightest quarter of the year for us shipment-wise. In the United States Iron Ore, adjusted EBITDA was $64 million compared to $46 million in the prior year quarter. The increase was attributable to higher sales volumes driven by improved market condition. As those listening are aware, the sales volume of 3.1 million long tons is a good number for the first quarter. In Q2, we expect about 3.5 million long tons of sales. As usual, these Q2 shipment volumes will increase further in Q3 and Q4 when no shipment restrictions are in place and the steel mills look to build their tonnages ahead of the winter months. During Q1, USIO achieved lower cash costs since we did not have the negative impact of idled mines that we did in 2016. As for our revenues per ton, we saw year-over-year realizations decline to $79 per long ton from $84 per long ton due to 2016 carryover effects. As Lourenco explained last quarter, because of our shipment schedule and our revenue recognition practices, the majority of the tons sold in the first quarter were based on 2016 pricing formulas. In the full-year 2016, iron ore averaged $58 per metric ton and customer-realized hot-rolled steel prices averaged $450 per short ton, considerably lower than what we've averaged thus far in 2017. As a result, these 2016 full-year averages are much lower than what our 2017 prices should reflect. Now, with all of our carryover tons worked off, we expect a substantial lift in realized prices for the remainder of the year, as the new 2017 formulas kick in. Considering where iron ore prices, steel prices and pellet premiums have averaged through the first four months of the year even with the recent volatility, the formulaic yearly average nature of our USIO contracts should promote significantly improved EBITDA generation for the rest of 2017. Now, moving to Australia, our $54 million adjusted EBITDA performance was more than double the $23 million we reported in the year-ago quarter. This was primarily the result of higher IODEX, which averaged $86 per metric ton during the quarter. With another solid performance in terms of cash costs, we achieved an EBITDA margin of 33%, making our profitability in Q1 one of the highest we have seen in years in APIO. With respect to this business, one emerging trend that really stood out, as we sold our product throughout the quarter, was a growing discount between the IODEX price and our realizations. This is primarily attributable to the price adjustments necessary to meet market competition to compensate for varying qualities of ore. China's recent emphasis on both productivity of their mills and pollution control, combined with high quantities of sub-grade ore in the market, has widened the spread between the benchmark grade ore prices and the prices of the ore that we sell out of APIO. This development, combined with higher freight rates and some unfavorable timing impacts we felt during the quarter, drove our realizations lower relative to the IODEX. We believe that these discounts are cyclical and should ultimately normalize to historical levels. That said, at this time, in our outlook for 2017, we're adopting a similar realized price discount that we saw in Q1 for the remainder of 2017. As for corporate overhead, SG&A expenses of $26 million were down $2 million year-over-year and $10 million quarter-over-quarter. We remain on track to achieve our lowest SG&A levels in nearly a decade. In addition, we recorded a $72 million loss related to the repurchase of certain of our senior notes and the full redemption of our 1.5 lien notes and second lien notes, which had a $0.27 impact on our earnings per share. Let's move on to liquidity. We ended the quarter with about $450 million of total liquidity, including nearly $295 million of cash, plus the ABL availability. Liquidity was down quarter-over-quarter, as typical for Q1. In addition, CapEx ticked up to $29 million the quarter, as we head towards the completion of the Mustang Project next month. As inventory begins to be released and we enter into much more favorable 2017 pricing formulas, our free cash flow generation should drive liquidity higher through the end of the year. As such, we certainly do not anticipate borrowing on the ABL this year. Turning to the 2017 full-year outlook, other than our major interest expense reduction, all other controllable drivers remain unchanged, including sales volume, operating cost, SG&A and CapEx. That said, we've revised our full-year adjusted EBITDA outlook due to the changes in pricing for iron ore and domestic steel, as well as updated assumptions surrounding APIO revenue realizations, including higher discounts and lower lump premiums. Applying April's month-to-date IODEX average price of $71 per metric ton and the AMM hot-rolled coil price of $648 per short ton for the remainder of the year, we would expect a 2017 adjusted EBITDA of approximately $700 million. With that, I'll turn the call over to Lourenco.

[C. Lourenco Goncalves:]

Thank you, Tim, and thanks to everyone joining us on the call this morning. Many of you listening on the call have been here for the whole ride and observed the heavy-lifting that we have done during the last two-and-a-half years, cutting cost across the board, exiting all operations that weren't making us money, taking on and defeating all potential threats, and securing sales volumes by means of multi-year contracts with our clients, which will continue to be in place through the best part of the next decade. In a business environment where our margins for error were so small, our success on all of these things would have been impossible without the perfectly coordinated work of all my team members from the Executive Committee to each one of our USIO employees in Michigan and Minnesota, our entire Asia Pacific team in Australia, Beijing and Tokyo, and to those here at our headquarters in Cleveland. To each one of these Cliffs' employees across the entire company, thank you very much for embracing the strategy, for believing we could overcome all the challenges and for working together to make everything happen. Since joining Cliffs in August of 2014, I have been working very diligently to reduce our debt and to improve our balance sheet. The most visible part of this work has been a series of liability management exercises. Each transaction took advantage of what the market gave us and each transaction was done in preparation for the next one. As we've begun this year, we saw the opportunity in February to execute a big bank transaction, including new equity issuance, redemption of old bonds, retirement of other tranches and issuance of unsecured bonds. This was actually a complex series of transactions that was flawlessly executed within a 24-hour timeframe using two separate lead-left bookrunners, one for equity, Goldman Sachs, and another one for bonds, Bank of America Merrill Lynch. As a consequence of the big bank, we substantially de-risked the company with a big reduction of debt, extension of maturities, lowering of interest expense and simplification of our capital structure. As I said in the last quarterly conference call, I do take dilution seriously, and I am a big shareholder of this company myself. This being said, the February transaction not only gives more upside to the equity holders, as we're set for a massively improved 2017 with $700 million of adjusted EBITDA and nearly $450 million of free cash flow generation, but our much improved debt profile also gives our shareholders far more downside protection in the cyclical environment that Cliffs knows so well how to navigate. Now, with the carryover tons from 2016 behind us in Q1, our results for the balance of 2017 will benefit from positive development in all three of the factors influencing the USIO numbers, hot-rolled steel domestic prices, pellet premiums in Europe and the underlying IODEX price. Let me explain each one of these three factors. First, hot-rolled domestic prices. Current demand for steel in the United States is healthy, and that's pretty much across all sectors. Recent weaknesses made clear during this current Q1 earnings season by a few companies are not indication of any underlying problem with the steel business in the United States. These weaknesses are actually company-specific, and we are glad to inform you that Cliffs and the steel mills that we serve are doing very well. Actually, based on their actual pellet demand and nominations, the steel mills that are clients of Cliffs are running at higher rates than in the recent past and there are no signs ahead that this trend will change anytime soon. Additionally, the clear commitment of the current administration to enforce our trade laws and keep illegally traded foreign steel out of our domestic marketplace will bring a lot of support to what should be a strong performance for the domestic steel industry in 2017. On top of all that, the steel service centers sector is currently carrying less than two months of inventory on hand, as recently reported by the MSCI. As a consequence of such a depleted level of inventory, service centers, distributors and plate flippers (16

[Operator:]

Thank you. [Operator Instruction] Your first question comes from Lucas Pipes, FBR & Company. Your line is open.

[Lucas N. Pipes:]

Hey. Good morning, everybody.

[Timothy K. Flanagan:]

Morning.

[C. Lourenco Goncalves:]

Morning, Lucas.

[Lucas N. Pipes:]

Good job in, of course, navigating this market and cleaning up the balance sheet. And my first question is kind of longer term, especially as it relates to your earnings power. So, I think your stock is pricing in lower levels of iron ore prices. If I were to assume, let's say, $60 IODEX in 2018, I would still estimate about $600 million of EBITDA. Do you think that's the right ballpark? Is that reasonable or would you say maybe higher or lower than that? I would appreciate your thoughts.

[C. Lourenco Goncalves:]

Okay. Lucas, longer term earnings power of this company is great, because our core business sits in a market that's a lot more inelastic than any other market, the United States of America. On top of that, we have contracts in place with all the big clients that are performing well in the United States, ArcelorMittal and AK Steel mainly, and others that are working hard to get better like Algoma (35

[Lucas N. Pipes:]

No, that's – I appreciate long answers, and that was very insightful. You certainly recommended yourself for giving good advice when it comes to activist situations.

[C. Lourenco Goncalves:]

Thanks for recognizing that. I know how these guys think.

[Lucas N. Pipes:]

A quick second question. There have been some rumblings about the revival of Essar Steel Minnesota maybe under new ownership. Do you have any thoughts on that and where do you think that asset fits in domestically at this time? Thank you.

[C. Lourenco Goncalves:]

Well, the process is still ongoing. So, I can't comment too much. What happened yesterday was an auction that we elected not to show up for. Our offer was made. It was public, so I can talk about, was $75 million. And then, I increased that offer to $100 million and that's also public information, so I can talk about. And our offer was all cash, just writing a check. And my offer would also make all the contractors and vendors 50% hold on their money as soon as the process – the bankruptcy process would end. So, they would recover $0.50 on each $1 that were owned (41

[Lucas N. Pipes:]

Well, that's a helpful update and appreciate your color, and best of luck with everything. Thank you.

[C. Lourenco Goncalves:]

Thank you very much.

[Operator:]

Your next question comes from Matthew Fields from Bank of America. Your line is open.

[Matthew Fields:]

Hey, Lourenco. Hey, everybody. Congratulations on the great balance sheet work you did in the quarter.

[C. Lourenco Goncalves:]

Thanks Matt.

[Timothy K. Flanagan:]

Thanks Matt.

[Matthew Fields:]

I think Tim might have mentioned something about this, but I may have missed it or would like some more detail, a little bit on the difference between maybe realized price that you state and the sort of overall revenue per ton and the cash cost of freight in there. Can you sort of flush that out and why the discrepancy in 1Q and sort of how that's expected to normalize over the rest of the year?

[C. Lourenco Goncalves:]

Yes, sir. I will have Tim answering that. Please, Tim.

[Timothy K. Flanagan:]

Yeah. I think if you look at a couple things, while iron ore prices were up year-over-year and certainly we realized – we saw that realization come down, the biggest piece of that is that price adjustment, the discounts that we referred to. But then you also have the timing impact, and timing's really two pieces. One, when the product gets discharged at the port and the way the price is moving at quarter-end into the quarter, so we had an impact there, as well as lag pricing. So, certain of our Australian customers are on a one month – or a full quarter and one month lag, and certainly that impacted us, as the 2017 lag pricing was about $22 lower than that $86 IODEX for the quarter average. Freight, Fe content and all the other adjustments to the IODEX relatively flat year-over-year, quarter-over-quarter. Not much of a big difference there.

[Matthew Fields:]

Okay. So, maybe the biggest content – the discrepancy is just that lag and APAC pricing?

[Timothy K. Flanagan:]

The lag and the discounts that we're seeing. I think second quarter discounts priced out 20%.

[C. Lourenco Goncalves:]

Yeah. Look, the discounts between the ore we produce, that's below 62%, as you know, both lump and fines.

[Timothy K. Flanagan:]

Right.

[C. Lourenco Goncalves:]

And the IODEX 62% will depend on how much BHP and Fortescue and Roy Hill will continue to overproduce. What do I expect? I expect that BHP will get religion one way or another. Fortescue, they don't have a lot of options, because that's the ore they have. They can always control the output, but I don't see that coming. And Roy Hill, well, it's just a time bomb at this point. One day, it – I can hear it tick, tick, ticking, but it hasn't exploded yet. So, I don't give much credence to what they are doing or not doing. So, short-term, same thing. Mid-term, it will improve, that's for sure. As Vale picks up and Rio Tinto picks up with better ores and blending continues to improve and put into use the ore that sits on the port, this thing will continue to be reduced. I just don't want to see the discount reduced for the wrong reason, because IODEX goes down, then the discounts go down. That's bad. I would rather have the IODEX stay where it is than going up and the discounts increase. We make more money, and we make money in dollars. We don't make money in percentages, so.

[Matthew Fields:]

Thanks. And then, given the already tight sheet market in U.S. Steel and maybe compounded or caused by U.S. Steel's – the company's decision to take a bunch of assets down for the year and the next few years, have you seen an increase in activity for your other blast furnace customers for sort of maybe more entry into the spot market to try to fill that gap?

[C. Lourenco Goncalves:]

Well, you know well that we don't have any business with U.S. Steel. So, we don't sell pellets to U.S. Steel. But we sell pellets to the U.S. Steel competitors. From where I sit here, it's clear to me that our clients are benefiting from the current domestic scenario here, and they are benefiting from the retraction, let's call that, retraction of U.S. Steel from the domestic market of steel. Where are they going to sell the pellets, if that is part of your question? I have no idea, because the clients are taking. I will sell to them in 2017, 2018, 2019, 2020, 2021, 2022, and then 2023, one contract of one client will end. And then, 2024, a second contract and then – and it's too far away. By that time, I'll be very old. So, that's the status. So, we're good. Our clients are good, and we are here to support them for more. They should go take business from U.S. Steel. That's probably what they are doing as we speak. So, anyway, I'm happy with that. What else can I tell you?

[Matthew Fields:]

Okay, good. And then, I just kind of wanted to follow-up on Lucas' question about the other Minnesota assets. And I think Chippewa might have been the word you were searching for, Chippewa Capital Partners, put in a bid, and we read it was pretty significant. We read $350 million plus another $1 billion pledge to finish the plant, which seems kind of a lot. And this is the group that's related to the – I think the group that took over the Magnetation assets as well. So, given sort of where we are, sort of a tight pellet market in the U.S., can you comment on what do you think this guy's strategy is?

[C. Lourenco Goncalves:]

Look, if you combine a blind with a handicapped, you are not going to make for an MMA fighter, right. You are going to make for a handicapped and blind men. So, you are combining Magnetation with all their success in the past with Essar Minnesota that has also been extremely successful. So, you combine those two stories of success, you pair with someone that offer $250 million of equity and then increase to $350 million that said that they are going to put a DRI facility for 3 million tons of pellets and they will start up in three years. Their 3 million tons mega model for that type of size does not exist yet, and they are going to start talking to you, that sounds like a great combination of everything. And the other thing is where is the money. Although they (49

[Matthew Fields:]

All right. Thanks very much, Lourenco.

[C. Lourenco Goncalves:]

All right. Nice talking to you, Matt.

[Operator:]

Your next question comes from Novid Rassouli from Cowen & Company. Your line is open.

[Novid Rassouli:]

Hey, guys. Novid Rassouli at Cowen. Thanks for taking my questions. Lourenco, you mentioned that you do not think Chinese HRC spreads matter at this point. What global spreads do you think are more important to focus on now and what is your view of the U.S. HRC prices throughout the remainder of 2017?

[C. Lourenco Goncalves:]

Well, I said that it doesn't matter because at this point in time, we have trade case in place. And in order to increase the spread, you have to do two things. One is China needs to keep pushing prices down. The other one is having United States pushing prices up. And the only third option is both come together. So, if U.S. Iron Ore prices continue to go up based on the absence or the reduction or the enforcement of the trade laws and the absence of imported steel here in this country, it is kind of expected, right, at this point. China coming down, I don't see how come, because they are now entering the second five-year for President Xi Jinping. Usually, in China, this is the time when things get really done. He knows that he needs to continue to fuel the beast over there. So, consumption in China seems to be healthy and continue to grow. And that is a clear message coming from CISA, from Mr. Li Xinchuang, and he is repeating that since 2015, we are not growing indefinitely, we are reducing, we are being more focused, we are controlling pollution. They are going to have to shut down capacity and they will need steel. So, these massive amounts of Chinese steel available to do all kinds of stuff go to Vietnam and then come to the United States or go to other Asian countries and that will displace material that come to the United States. That's all been taken care of already with the antidumping and countervailing against hot-rolled, cold-rolled, galvanized and plate. And on top of that, there is a self-initiated Section 232 trade case that was initiated by Secretary of Commerce Wilbur Ross. Just to give an idea, Mr. Wilbur Ross was the guy that put together Bethlehem Steel and LTV Steel just after the debacle of the two companies around 2001, 2002. And that was a result of trade case. So, Wilbur Ross knows trade cases very well. So, I don't know what you're concerned about. Can you be a little more specific on your views?

[Novid Rassouli:]

Yeah, I...

[C. Lourenco Goncalves:]

So, then I could probably answer better.

[Novid Rassouli:]

Yeah. No, Lourenco, I was just curious – I actually agree with you on the Chinese spreads. But I'm curious what part of the world now you think is more important to be focused on when thinking about HRC prices in the U.S. and what's a reasonable spread, essentially.

[C. Lourenco Goncalves:]

Okay. I'm glad we agree. So, now to the second one. The part of the world that you should be focused on at this point is the United States of America, because our economy is growing. All sectors are in good shape. Some sectors are surprisingly strong at this point like agriculture, like non-residential construction. Automotive has not come down. Actually, we are seeing automotive turning back up. And we have a limited amount of domestically generated steel available for all these uses. And that's why I'm trying to guide you, Novid, that our nominations (54

[Novid Rassouli:]

Great.

[C. Lourenco Goncalves:]

But then, our price would be a lot higher than the international price (54

[Novid Rassouli:]

Got it.

[C. Lourenco Goncalves:]

I'm still learning as of today, but I was not dealing with international trade. So, our prices are higher, have always been. Take a look when that was different, when the gap was different from the gap that we have today. Another point to consider, Novid, let's assume just for you and me like two guys talking about. Like you said, I'm curious. I like when an analyst starts like that the question – I'm curious. You should be curious. So, let me try to placate your curiosity. Let's assume that we have a war in the Korean Peninsula, and then we have a big disruption on the flow of iron ore to China, the flow of iron ore to Japan, the flow of iron ore to South Korea, the flow of products out of the Asia Pacific area. That's a possibility at this point. Finally, the (56

[Novid Rassouli:]

Just one more, Lourenco. Thanks. On entering the DR-grade pellet market in a more substantial form, I just wanted to see if you're able to divulge some of the options that you might be weighing, and then maybe just a potential timeline of when you might be targeting moving into that market in a more substantial way. Thanks Lourenco.

[C. Lourenco Goncalves:]

Novid, the move that we will define – a change in direction for Cliffs will be when we decide on a site to put our first DRI production facility. We have already proved ourselves as a capable producer of DR-grade pellets. We have already proved ourselves as able to deliver high-quality pellets to the ones that produce DRI as we speak. Now, it's our turn to have our own facility to produce our own DRI. Our first facility will be 1.5 million tons of DRI/HBI per year, and that will demand around 2 million tons of our own pellets that we already have and can produce, so we know where we're going to get. So, the next visible step will be the definition of which site we are going to build our DR-grade pellets. Depending on the outcome of the situation in Minnesota, it can be Minnesota. I still believe that it will be Minnesota, but can be somewhere else. And we have a couple of other options that we are actually extremely developed in moving in that direction. All these things considered, we are not going to spend any meaningful capital this year, because time is passing and we are already pretty much in May, and we are not going to break ground just before snow comes to the ground. So, I don't see how we are going to spend money on that project in 2017. In other words, 2017 will be fully dedicated to continue to pay down debt, and we are going to end 2017 substantially below $1 billion in debt, more or less like 1 time EBITDA leverage. That's our goal for this year. And then, next year, we're going to start spending on our first DRI facility. We will continue to be very, very disciplined, and paying down debt continues to be our priority for 2017. And we're going enter 2018 with – we are already with an extremely good balance sheet. And coming January 1, 2018, we are going to be even better. Today is a little more than 1 time EBITDA, close to 2 times EBITDA. We'll be below 1 time or around 1 time coming January 1, 2018. Is that okay?

[Novid Rassouli:]

That's perfect. Thanks Lourenco. Appreciate it.

[C. Lourenco Goncalves:]

Thanks.

[Operator:]

And your final question today will come from Nick Jarmoszuk from Stifel. Your line is open.

[Nicholas Jarmoszuk:]

Hi. Good morning, Lourenco. I wanted to ask you a little more on the...

[C. Lourenco Goncalves:]

Hi, Nick. Good morning. Good morning.

[Nicholas Jarmoszuk:]

Good morning. A little more on the DRI facility. I know previously you talked about using someone else's balance sheet. Is this something now that Cliffs would look to do on its own?

[C. Lourenco Goncalves:]

Yes. Right now, that's the only change actually. We've got the only change that we made to our plans. Until the big bank transaction in February of this year, I was considering the – in order to be able to move forward, I was considering using somebody else's money. So, that need is no longer present. Like I said, we are already in a great balance sheet situation. And by the end of the year, we'll be in a better – even better position to do on our own. So, now, I prefer to decide things alone here with me – myself and my management team and my board, instead of sharing decision-making with a financial partner. That's not always will be totally aligned with Cliffs. So, we are going to do on our own. That's a perfect conclusion. But it will be next year, not this year.

[Nicholas Jarmoszuk:]

Okay. So, with the $450 million of cash flow, how should we think about what potential debt repayments could be versus cash build to pre-fund the DRI plant? And then, what's the CapEx associated with it?

[C. Lourenco Goncalves:]

With the DRI facility?

[Nicholas Jarmoszuk:]

Yeah.

[C. Lourenco Goncalves:]

We don't have a final number yet. We do not. But we are discussing with both suppliers of the technology. They both understand that that will be the first one of a series of potential DRI facilities in United States. We are going to show the way, and that will be very positive for Cliffs, but it will also be very positive for either one of the suppliers of the technology that will work with us. So, we are still in negotiation time. So, we can't talk about numbers yet.

[Nicholas Jarmoszuk:]

Okay. That's all I have. Thank you.

[C. Lourenco Goncalves:]

Thanks.

[Operator:]

And we have no further questions at this time. I turn the call back to our presenters.

[C. Lourenco Goncalves:]

Thank you very much. We will be here in three months, and you should expect Q2 to be a very strong quarter in terms of pellet price realization, in terms of EBITDA, in terms of net income. Our EBITDA in Q2 will be above $200 million. That's what we expect. Thank you very much. I'll see you soon. Bye.

[Operator:]

This concludes today's conference call. You may now disconnect.