Cleveland-Cliffs (NYSE:CLF) — a Cleveland, Ohio-based steelmaker — has made it very clear that it expects to significantly reduce its debt this year. That could mean great things for CLF stock.
Essentially, this reduction is a direct result of the company’s free cash flow (FCF) generated in the second quarter, as well as what it expects for the rest of 2021. As such, look for CLF stock to move a good deal higher by the end of the year.
In my view, this stock could rise at least 26% over the next year, even before any growth in FCF. Here’s how.
CLF Stock and Debt Reduction
As of Jun. 30, this company had $5.368 billion in long-term debt, as can be seen on in its latest 10-Q filing released on Jul. 28 (Page 21). However, during the June quarter, the company was able to produce $511 million in cash flow from operations (CFFO). After capex expenses of $162 million during Q2, its FCF was $349 million for the quarter.
That means that it can reduce its debt by $1.4 billion over the next year, if it can keep producing this kind of FCF over the period. If that cash flow is used to pay down long-term debt, it will fall by 26%.
My view is that CLF stock will directly benefit from this. For one, lower debt will de-risk the company. For example, so far in 2021, Cleveland-Cliffs has already extinguished $421 million in long-term debt. At this pace, it could pay down $1.6 billion over the next year. That will significantly lower its risk going forward.
Secondly, it will lower the company’s interest-rate expenses. And third, it allows the company to have more flexibility to eventually pay out a dividend to shareholders.
Management has also made it clear that it expects to see free cash flow. Here is what the company said in the 10-Q filing (Page 35):
“Now that business conditions have improved and we expect to generate healthy free cash flow during 2021, we have the ability to lower our long-term debt balance […] We anticipate that the current strong market environment will provide us ample opportunities to reduce our debt with our own free cash flow generation.”
What Cleveland-Cliffs Is Worth
If the company can produce three more quarters of $350 million in FCF by the end of 2021, it will be able to reduce debt $1.05 billion. And, assuming this continues in 2022 — albeit at 80% of that rate — the debt could fall by another $1.12 billion. That means by the end of 2022, total debt would fall by $2.17 billion. This represents a 40.4% drop in its overall debt.
Keep in mind that I have not included any cascading effect from lower-interest expenses, which would lead to higher FCF. In fact, I used 80% of the Q2 FCF rate for 2022 since analysts are now projecting lower revenue for 2022.
Nevertheless, I suspect that there will be a one-for-one direct benefit to the CLF stock price as a result. A 40% drop in debt could lead to a 40% higher price by the middle to end of next year.
This implies that CLF stock is worth $33 per share, or 40.4% over the Jul. 28 closing price of $23.56. And as I said, it could increase even more if the company’s FCF comes in higher from continued demand for steel in the United States.
What to Do with CLF Stock
Right now, CLF stock is very cheap. According to Seeking Alpha, it trades for just 4.37 times the 2021 earnings per share (EPS) forecast and 7.56 times 2022 EPS.
The second-year price-to-earnings (P/E) multiple here is higher because analysts are always skeptical of highly cyclical companies like steel producers. They tend to believe that revenue and earnings will be lower, even though there is no recession prospect on the horizon.
Nevertheless, I have shown that — as long as the company stays profitable and FCF positive — Cleveland-Cliffs’ debt will fall. This automatically increases the underlying value of CLF stock, regardless of its P/E multiple. So, look for CLF stock to hit $33 sometime in the next year as the company reduces its debt.
On the date of publication, Mark R. Hake did not hold any position in any of the securities mentioned in the article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.