Edited Transcript of CLF earnings conference call or presentation 20-Feb-20 3:00pm GMT

CLEVELAND Apr 8, 2020 (Thomson StreetEvents) — Edited Transcript of Cleveland-Cliffs Inc earnings conference call

CLEVELAND Apr 8, 2020 (Thomson StreetEvents) — Edited Transcript of Cleveland-Cliffs Inc earnings conference call or presentation Thursday, February 20, 2020 at 3:00:00pm GMT

* C. Lourenco Goncalves

Cleveland-Cliffs Inc. – Chairman, President & CEO

* Keith A. Koci

Cleveland-Cliffs Inc. – Executive VP & CFO

Citigroup Inc, Research Division – Director & Head of Americas Metals and Mining Sector

B. Riley FBR, Inc., Research Division – Senior VP & Equity Analyst

* Seth R. Rosenfeld

Cowen and Company, LLC, Research Division – VP of Industrials and Metals and Mining and Senior Equity Research Analyst

Good morning, ladies and gentlemen. My name is Christina, and I’m your conference facilitator today. I would like to welcome everyone to Cleveland-Cliffs 2019 Fourth Quarter and Full Year Conference Call. (Operator Instructions)

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 is set forth in reports on Forms 10-K and 10-Q and the news release filed with the SEC, which are available on the company website. Today’s conference call is also available and being broadcast at cleveland-cliffs.com (sic) [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 this morning.

At this time, I would like to introduce Lourenco Goncalves, Chairman, President and Chief Executive Officer.

C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [2]

Thank you, Christina, and good morning, everyone. I appreciate you all joining on what should be our last call as a stand-alone iron ore company. After the closing of our acquisition of AK Steel, Cleveland-Cliffs will be a steel and iron ore company. We are very excited with this unique transaction and looking forward to all of the benefits that will come with controlling their ore pellets and HBI feedstock as well as their steel products, including flat-rolled coils of stainless and carbon steel and highly engineered, manufactured parts for the automotive industry. Over the past several weeks, we have come away captivated by the untapped potential that clearly exists for AK Steel assets and very impressed by the quality of the people on the ground. The opportunity ahead of us is actually bigger than what we first envisioned.

Before I lay out why, I will start with an update of where we stand with regards to our closing time line. As you could probably gather, with this call being moved up by 1 week, we are progressing remarkably well on all of our necessary checkpoints to close the transaction; thanks to a great combined effort from both Cleveland-Cliff’s and AK Steel’s transaction teams as well as our outside counsel, Jones Day. We received regulatory approval from the United States on January 22, Canadian approval on February 12, and expect to receive Mexican approval by February 27. In addition, our S-4 registration statement went effective on February 4, allowing us to set our special shareholder meeting date of March 10, with the transaction closed following soon thereafter on March 13.

Our dealings with AK Steel over the last several weeks gave us the conviction that Cleveland-Cliffs and AK Steel have a lot in common and are both very different from the other companies and the vast majority of companies out there. Similarly to Cliffs, AK Steel has not saved money by skipping necessary maintenance that would, over time, make equipment and products a lot worse. Not the case with Cliffs. Not the case with AK Steel. Also, both AK and Cliffs rely on the North American market, and should thrive with a strong economy we currently have, and will continue to have, here in the United States. Differently from the vast majority of companies these days, our businesses do not depend on China. With the acquisition of AK Steel, Cleveland-Cliffs becomes the most relevant supplier of steel to the automotive industry in the United States, fully integrated from iron ore on the ground to auto parts as a Tier 1 supplier of finished parts used in the assembly line of the car manufacturers. The pro forma numbers show that even before we account for synergies and cost-cutting actions, the new Cliffs command the highest EBITDA margin among all steel companies in North America. And that includes all integrated mills and all EAF steelmakers. Last but not least, on day 1, we are resolving for good the AK Steel balance sheet issue. With that, we will be running a company with a 4-year window of no maturities and managing the business from a position of financial strength.

AK Steel serves the high-end markets that prefer stability in prices, with the biggest concentration of automotive share among all steel mills in our industry. This relatively stable revenue stream does not mirror its cost structure, which varies a lot more, particularly due to the variations within the price of iron ore. By marrying our 2 businesses, we can mitigate this intra-year volatility with a combination of stable costs and prices, while providing the new company with a level of margin predictability that’s not common in the metals and mining world. There are 2 other U.S. integrated steelmakers who control, totally or partially, their iron ore supply. But neither have the same level of penetration in the automotive market. And they both have a lot more exposure to spot steel prices.

The rationale for the deal was explained in our announcement on December 3, 2019. Upon the completion of our acquisition of AK Steel, the commodity indices that investors use as a proxy for Cliffs’ performance will be a lot less influential, as our revenues will be far more in our control. We understand that EAF mills continue to grab market share from the so-called high-cost blast furnace producers. This being said, treating all integrated steel producers as if they were all the same is not a good simplification. In fact, there is a massive disparity among different integrated mills. Also, as far as EAFs are concerned, some serious technological limitations exist in the types of steel that each EAF mill can or is willing to produce. The vast majority of the sophisticated steel products that AK Steel supplies are not just something any steel mill is capable of making. That’s 1 of the important

(technical difficulty)

the steel industry in countries with meaningful automotive manufacturing power, such as Japan, Germany, France and South Korea, is completely dominated by blast furnaces. These blast furnaces are operated by a handful of well-run and properly capitalized companies, such as Nippon Steel, ArcelorMittal and POSCO, among a few others. In the world of highly sophisticated steels for the automotive industry, well-operated integrated mills prevail by a large margin. Automotive and blast furnaces, good blast furnaces, I mean, go together.

There’s a small group of high-end steel producers in the world that have all 3 necessary strengths to be part of this select group. One, the technological capability; two, the R&D resources; and three, the staying power of a strong balance sheet. While the legacy AK Steel has only 2 of the 3, the new Cleveland-Cliffs will have all 3 strengths, and therefore, belongs in this very select group of the steelmakers.

The importance of AK Steel as a well-established supplier of the automotive industry is even more relevant at this time, when we approach a very interesting inflection point in the North American market for cars and trucks. We find ourselves in the very early moments of a transformational change from the use of combustion engines in passenger vehicles, to that of electric-powered cars and trucks.

Right now, electric vehicles still make up a very small percentage of cars on the road, with Tesla being a star and an undeniable reality as the first company to show a presence in the market for EVs. However, as several other car manufacturers catch up with the market and get ready to introduce new models of electric vehicles over the next few years, particularly in our favorable American markets, supported by low interest rates and full employment, a vertically integrated and downstream-oriented Cliffs-AK Steel will benefit from the trend.

With AK Steel’s unique technical expertise, we are the best-positioned company to supply what’s needed for this change of the fleet from traditional combustion engines to EVs. AK Steel produce the most sophisticated products, including engineering parts to the automotive industry as a Tier 1 supplier in highly automated facilities operated by Precision Partners in several strategically located plants in the U.S., Canada and Mexico. Moving forward, we will leverage and increase our downstream businesses and AK Tube and Precision Partners will be core to our business and to our commercial strategy.

We at Cleveland-Cliffs are profit driven, and we have proved our good commercial execution through very successful contract renegotiations with our pellet clients, in some cases, surprising the outsiders with our ability to succeed. By improving the utilization of our unique R&D resources in a more commercially focused way, the new Cliffs-AK can and will provide the advanced steel solutions needed by the car manufacturers to produce select vehicles for the mass market.

These car manufacturers are well-established, long-term clients of AK Steel. And some of them have contacted us at Cleveland-Cliffs during the last several weeks to express their support to our transaction and their willingness to do business with a stronger entity, as the combined Cliffs-AK Steel will be. With the balance sheet relief we will provide to the stand-alone AK Steel, this rare window of opportunity in the market for cars and trucks can and will be explored to our benefit. That, of course, would never happen had Cleveland-Cliffs and AK Steel stayed put as 2 separate companies. This example just scratched the surface of what we are prepared to do as a combined entity, while achieving and maintaining a strong financial profile for a well-capitalized Cliffs-AK Steel. We have already executed a successful exchange offer that strips the relevant covenants from AK Steel bonds, providing us with a great deal of uniformity and flexibility in our capital structure. We have also arranged and put in place a new $2 billion asset-based loan for the combined entity. Our new ABL will provide us with substantial liquidity and with an easy way to pay down debt quickly and with low prepayment penalty.

Last but not least, subjected to market and other customary conditions. In the near term, we will be refinancing AK’s 2020 and 2023 bonds. With all that, at closing, on March 13, the new combined company should have a much stronger financial profile than the current AK Steel, including the nice and comfortable no-maturity window going forward 4 years that we currently enjoy as a stand-alone Cleveland-Cliffs. I will be able to go into much more details once the deal is closed, including our operational plans, synergy achievement progress and footprint optimization initiatives. Until then, our combined teams will continue planning and setting the stage for our takeover on day 1. For now, our Mining and Pelletizing business remains steady and reliable as always. One of the other benefits of the AK Steel transaction is that we now control our own destiny with our pellet supply and have picked up a lot of optionality as a supplier of iron ore products. We have roughly 85% of our pellets order book secured through 2026. For the remaining 15% of pellet production, we have several options. We can either extend third party contracts, sell DR-grade pellets or leverage the AK Steel blast furnace footprint to sell merchant pig iron. We will only make that decision later.

And we’ll do it in a way that allow us to maximize the profitability we enjoy from the unique position we have in the iron ore pellets and HBI markets. This flexibility with our pellets was made possible primarily because of the construction of our HBI plant. Within a few months, we will be producing and selling hot briquetted iron. As I confirm, right now, we will start up our HBI plant in June of 2020 and expect to generate healthy EBITDA and healthy free cash flow from our Toledo operation, it’s due in 2020. We also expect to achieve our nameplate 1.9 million metric tons of HBI in 2021, which will be the first full calendar year of operation of our Toledo plant. In advance of our start-up, technical and commercial activities are well underway with our new electric arc furnace clients. With a high 3% carbon content, Cliffs HBI is a differentiated premium product, several steps above the low-carbon HBI and DRI commonly produced. In fact, our HBI is a direct replacement for imported pig iron. Also very importantly, our Toledo plant is exclusively supplied with uniform pellet feedstock from a single source, our Northshore mine, which is a defining factor to allow for a stable operation and a very homogeneous product.

With that, I’m pleased to inform that based on actual ongoing commercial activity, Cliffs HBI will be sold, not only in our natural market within the Great Lakes, Indiana, Ohio, Kentucky, Illinois, among other states, but also to electric arc furnace plants located in states farther south, such as Mississippi and Arkansas. Between the Toledo HBI plant and the upgrade of the Northshore mine to produce DR-grade pellets Cleveland-Cliffs has spent more than $1 billion to develop a new use for taconite iron ore from the Minnesota iron range. This meaningful investment has generated more than 150 new full-time high-paying jobs in Toledo and brought a very relevant economic benefit to both Minnesota and Ohio, including approximately 1,650 construction jobs in both states during the last couple of years. We are very excited that we are just a few months away from starting replacing Russian and Ukrainian pig iron with our made in U.S.A. HBI, to the benefit of our new EAF clients, our employees, our shareholders and the economy of Toledo and Northwest Ohio.

On that note, I would like to invite our CFO, Keith Koci to discuss our fourth quarter and full year 2019 results.

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Keith A. Koci, Cleveland-Cliffs Inc. – Executive VP & CFO [3]

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Thanks, Lourenco, and good morning to everyone listening today. Cliffs concluded 2019 with fourth quarter adjusted EBITDA of $111 million and full year adjusted EBITDA of $525 million. This represented an industry best 28% EBITDA margin even after dealing with precipitous drops in both steel pricing and pellet premiums during the year. Most notably, our cash flow generated from operations continues on a positive upward 6-year trend. Net cash from operating activities was $563 million in 2019 compared to $478 million last year and our highest since 2013. Our Mining and Pelletizing segment’s quarterly EBITDA of $153 million was driven by 5.8 million long tons of shipments, including 400,000 tons of intercompany sales. This put us at 19.4 million long tons of sales for the full year, roughly in line with our previous guidance.

Our pellet price realization of $90 per long ton in the fourth quarter was negatively affected by the volatility in hot-rolled steel prices and pellet premiums that we saw during the back half of the year. That caused us to record an unfavorable revenue true-up adjustment in the fourth quarter. The true-up was primarily a function of having to revalue our entire year sales at the full year averages for HRC pellet premium and IODEX, negatively impacting our Q4 rate. After all of that, our full year revenue rate was $100 per long ton, which came in at the midpoint of the spot price guiding range that we’ve provided last quarter. Cash costs for the fourth quarter was $64 per long ton, which also put us right in the midpoint of our full year guidance range of $64.50 per long ton. As for CapEx, we are now through our peak year spend of $656 million and expect to see roughly half that amount in 2020, as we wrap up the construction of the HBI plant in Toledo.

On the finance side, we are grateful to end such a heavy spending year, maintaining a healthy liquidity position, including $350 million in cash and an untapped revolver. With our reduction in capital spend, cash needs in 2020 will be much lighter. Along with reduced HBI construction costs, we will no longer have the $45 million minority interest payment that we were contracted to pay in each of the last 3 years.

And finally, we still have our steady flow of tax refunds continuing with another $60 million expected in the middle of this year and 2 refunds of $30 million in each of the next 2 years. In 2020, we expect to sell between 20 million and 20.5 million long tons of pellets, including approximately 1.5 million long tons of DR-grade pellets to be delivered to our HBI plant. Due to the additional pellet tonnage produced last year that is currently in inventory, we also have flexibility to increase beyond that sales amount in 2020 should demand warrant.

For full year guidance on a Cliffs stand-alone basis, we have provided an expected 2020 adjusted EBITDA range of $550 million to $575 million. In order to maintain consistency, we have used roughly the same forecast and pricing assumptions that have been put forth in other publicly filed documents using analysis that was developed last November. I would also flag that as HRC prices have come down, our revenue rates have become slightly less sensitive to movements in iron ore prices and pellet premiums due to the nature of our pricing formulas. Both our revenue sensitivities and our EBITDA guidance range will not be relevant after we complete the acquisition of AK Steel, and as such, will be deemphasized by us going forward. Nevertheless, while we are still a stand-alone business, I should note that we are now at a point where the Atlantic pellet premium sits below the cost of pellet conversion for most players in this market. And we have already seen supply begin to come out of the market.

On top of that, currently, the Chinese pellet premium is actually higher than the Atlantic, a pretty rare occurrence and often a signal that the Atlantic premium is too low and likely to rise. For the first quarter 2020, as always, we are in the middle of restricted shipping on the Great Lakes, forcing us to limit most deliveries to rail only. Q1 should represent only 3% to 5% of our full year revenues on a Cliffs stand-alone basis. Assuming we close on our expected date of March 13, our next quarter’s results would reflect AK’s results only for those last 18 days of the month. So we may see a small prorated influence from AK’s earnings during Q1, but would not see the full benefit of their earnings in our results until the second quarter.

With that, I will turn to Lourenco for his final remarks.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [4]

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Thanks, Keith. With both the upcoming completion of the AK Steel acquisition and the Toledo HBI plant coming online, 2020 will be the most transformational year in our 173-year history. We are very excited to welcome our new customers, Nucor, David J. Joseph, Steel Dynamics, OmniSource, Big River Steel, North Star BlueScope and several others to our list of clients as they acquired a massive tonnage of HBI for the burden of their electric arc furnaces. In the meantime, we will need our shareholders’ support to make the acquisition of AK Steel by Cleveland-Cliffs a reality. To those Cliffs shareholders of record as of January 31 listening on today’s call, you should have already received the necessary materials to vote for the transaction. Your vote is necessary, and I appreciate your support.

As you know, I’m a big shareholder of Cleveland-Cliffs myself, one that has bought several million dollars’ worth of CLF stock in the open market and never sold a single share, except for offsetting taxes before the shares become mine. Speaking as a shareholder and to all of our shareholders, I believe the acquisition of AK Steel under my guidance, with the leadership of my management team and with the addition of key players from the AK Steel management team is the optimal path to maximize the value of our CLF shares. If you have any questions about the rationale for the deal or how to vote, please feel free to reach out to us using the contact information provided in your materials or on our website. One more time, your vote is important. And I look forward to receive your affirmative vote on or before March 10.

With that, I will turn it back to Christina to direct Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from Lucas Pipes from B. Riley FBR.

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Lucas Nathaniel Pipes, B. Riley FBR, Inc., Research Division – Senior VP & Equity Analyst [2]

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Congratulations Lourenco and team on the continued progress on HBI and moving so quickly on completing the AKS acquisition. Lourenco, I wanted to start out with some higher level questions. So first, on AKS. You mentioned the long-term strategy and the commercial opportunities there. But are there pieces of the AKS portfolio that might be less relevant, that could be candidates for monetization? Any thoughts on that would be appreciated.

And then reading through the S-4, it appears this marriage started with a date about Ashland. And I don’t think you mentioned Ashland in your prepared remarks. Could you maybe update us on the thoughts on that asset? And then lastly, I appreciate your comments regarding the EV revolution in your prepared remarks. Folks don’t typically think about steel in the context of EV. Kind of what are your thoughts there? What products feed into that market and transition specifically? And what do you think the impact will be to AKS longer-term there? So appreciate all the color on those kind of 3 questions.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [3]

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Okay. Lucas, that’s a lot to shoot. But let’s try to get it done. First of all, the thoughts on assets. But I’ll be very careful in terms of what I can and I cannot talk about because there are a few things in the M&A regulations and some touching the law in terms of gun jumping provisions that I — I’m not in charge of the company yet. So we are working on preparing a plan. And of course, we have a plan. But in a general way, without being specific on anything, the assets that are not going to be part of the core, and there are some that are not going to be part of the core, will be monetized. We did that with the Cliffs. That was a lot more difficult, a lot more complicated, a lot more specific in terms of potential buyers. With AK, we have a few things that actually we’re receiving reverse inquiries in terms of — without soliciting anything, they’re coming here and they are calling in and making proposals on doing this and doing that. We are listening to everybody. And we are taking our own plan to paper. And on day 1, we will start to execute. So you should expect that noncore assets will be taken care of and monetized to the best of our ability. That’s the first.

As far as Ashland, look, we were developing a market for HBI. We’re doing extremely well. We are done now. We are — we believe that our commercial efforts and our technical efforts came to fruition. We are very pleased. I gave names of clients that are going to be buying massive tonnage of HBI from us. And I did not — by the way, I did not mention AK Steel because we are concentrating the effort on HBI to outside clients at this moment. So we are not even planning to use our HBI within AK Steel at the very beginning. So just to give an idea how hot is the HBI products in the marketplace right now. But back to Ashland. I started Ashland — I started to be interested in Ashland because I was seeing the high level of interest for our HBI. So it would be, in my opinion, an opportunity to create an expansion in this metallics market and develop Ashland as a producer of pig iron for the marketplace.

However, when I start doing that, we have to do market analysis. If you do market analysis, you realize that there is only so much that the EAFs can get to before they get into a ceiling that they can’t pass. And then if they can’t produce certain types of products, then you cannot, in all fairness, to continue to supply them with metallics because they will not need it if they have other alternatives that might be more economically viable for these intelligent EAFs. And they will not be buying pig iron just because pig iron might be available. In other words, they — they, meaning the EAFs, will not be producing exposed parts for automotive if they have pig iron available because that’s not their restriction to produce exposed parts. We really realized that we are getting to a point with our HBI that we’re pretty much optimizing the market for EAFs. And so will Ashland happen? At this point, I don’t know. I don’t believe so because we are going to, first and foremost, maximize AK Steel capabilities. Because when I realized that the EAFs would not be able to get there, I also realized that there was an untapped potential with AK assets that I could develop.

Even more important, some other integrated producers that have a traditional history of producing the products for the automotive market are walking away, they’re going backwards. So they are going from a car to a bicycle. So let them do that. I’m good with that. AK Steel has the R&D capability, has the technical capability, has the patents, has the products, has the clients. So we only need to improve it commercially, besides the balance sheet, that will be done before we land there on March 13. So that’s our forte. That’s what we do for a living, 39 years and 6 months in this business. So Ashland, at this point, is in the back burner. I don’t believe the market needs Ashland. The market definitely leads our HBI. But I’m not sure if they need Ashland. And I’m going to do everything I can for the market not to need Ashland because I’m going to grow the business of AK Steel.

You also mentioned the electric vehicle revolution. I agree with your terminology. It’s a revolution. Even more important, it’s a steel revolution. Remember, the Tesla S was all aluminum. The Tesla 3, the evolution of the Tesla and the Tesla that you see on the street is all steel. So there is a potential towards steel as well. And finally, the traditional car manufacturers are now at a point that they realize that Tesla is for real. And the EV is for real. So they’re all jumping into this thing. And guess what, they are all clients of AK Steel. So we are going to be developing EVs, material for EVs inside our R&D center in Middletown, Ohio, and actually, we are going to start it right away. So it’s coming. AK Steel will be a big beneficiary. And when you see companies like Volkswagen, Volkswagen’s CEO saying Tesla is — to his executives, Tesla is real. If you don’t believe, you don’t belong to Volkswagen at this point. That means something. General Motors is coming with a bunch of EVs. Ford is going towards that. There’s a company producing trucks called Rivian, producing trucks in Illinois. They are a huge client of AK Steel. We’re going to continue to support their development. So there’s a lot coming in this thing. And here in the United States, we are going to be pretty much, I would not say alone because we have ArcelorMittal USA also participate in the marketplace. But I think that they’re going to have a lot of business for us, Cleveland-Cliffs, AK combined; and our big client, ArcelorMittal USA. So we’re good in both sides, in the auto side and in the pellets side.

Sorry, if my answer is too long, but you gave me 3 very interesting and very provocative points to talk about.

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Lucas Nathaniel Pipes, B. Riley FBR, Inc., Research Division – Senior VP & Equity Analyst [4]

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I really appreciate all the color, Lourenco. It’s never enough. I’ll keep it really short for my second question. A breakdown of capital expenditures in 2020. Keith, you may have mentioned it in your prepared remarks, but if you could just reiterate it if in case I missed it. I would appreciate it.

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Keith A. Koci, Cleveland-Cliffs Inc. – Executive VP & CFO [5]

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No problem, Lucas, we’re — 2020, we’re — the range we provided, $350 million to $400 million breaks down. HBI’s going to be — or Toledo’s going to be $270 million to $290 million to complete, virtually all of that will happen in the first 6 months. Sustaining CapEx for Cliffs, $70 million to $90 million, somewhere in there. And roughly $20 million of capitalized interest during the year to complete the Toledo plant. So that’s the breakdown.

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Operator [6]

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Your next question comes from Alex Hacking from Citi.

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Alexander Nicholas Hacking, Citigroup Inc, Research Division – Director & Head of Americas Metals and Mining Sector [7]

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I just wanted to follow up with a question on the HBI. You said you’ve made a lot of commercial headway there, and congratulations on the success and it sounds like you have all the offtake — or a lot of the offtake already sorted out. But I’m curious on the pricing. Can you give us any color, if possible, on the pricing structure in terms of what type of contracts that you’ll be entering into? Will that kind of be in terms of duration? And then also in terms of the pricing mechanism for the HBI? Will it be linked to indexes in any way? And how often will the prices reset? So any color there would be very helpful.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [8]

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Alex, the HBI product is being sold to clients that have a way of doing business. I have been saying that forever. I have been saying that before we built the HBI plant. We have to respect the way the clients do business. We can’t try to impose a new way of doing business before entering a market. So these folks buy in short-term. They buy per order. These orders are more loosely agreed upon in terms of tonnage for the quarter, and price is set on a monthly basis. The biggest reference for price for us would be the price of pig iron, adjusted for the value we use that our HBI — I mean, pig iron delivered to the client, of course. It’s not pig iron F.O.B. Tubarao Brazil or F.O.B. Ponta da Madeira or F.O.B. some port in Europe. No. Delivered to the United States, delivered to the site. And adjust for the values.

Remember, pig iron has 4.5% carbon. We’re going to have 3% carbon. It’s close, but it’s not there. So we’re going to generate a little less heat. We have a little more gain because we are low silica, but we are not 0 silica. On the other hand, we have a very high metallization. So there are a lot of gives and takes that will be defined by the values, but the values will be developed after the client is really using their product. So we are going to have 6 months or 7 months between June and December of 2020 to be adjusting these parameters. But by and large, we are set, we are happy, and we are going to continue to develop this business that way. It will be very profitable for us. The payback, the IRR that I promised, will be — when we first started, will be easily built.

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Operator [9]

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Your next question is from Seth Rosenfeld from Exane BNP.

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Seth R. Rosenfeld, Exane BNP Paribas, Research Division – Research Analyst [10]

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If I can touch on 2 points. First, on HBI and then secondly on Ashland, please. When it comes to HBI and the CapEx budget, your release talked about the CapEx being, I think, fast tracked — the development being fast tracked in Q4. Obviously, on track for ramp-up before the end of H1. When it comes to CapEx, my understanding was that the 2020 CapEx budget was closer to $300 million, implying that we’re looking at $50 million, $100 million above that. What are the moving parts in that? Keith, thank you for the color earlier, but is HBI CapEx 1 of those elements? Or is there actually an increase in expected budget there?

And then secondly, please, when it comes to pig iron at Ashland. Your comments about market research pointing to a metallics market well supplied based on just your own HBI. It seems to run counter to what we heard from you back in December at the time of the deal announcement when Ashland growth seemed to be 1 of the key incremental growth drivers for the story. Just to clarify, what’s changed from that time? Is this a new market research you completed after the acquisition was announced? Or was it always in line with your expectations going back to December?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [11]

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Well, first of all, let’s set the record straight here. You said that HBI throughout the world, particularly here in the United States, is a widow maker. So my wife is still married. So I’m still alive. So remember, when you said that, that HBI was a widow maker because HBI generates budget overruns and people can’t complete construction on time? Remember that, Seth?

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Seth R. Rosenfeld, Exane BNP Paribas, Research Division – Research Analyst [12]

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I do, and I’m glad your wife is not a widow.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [13]

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So I’m right here. So our HBI is on time. Our HBI is actually ahead of schedule and our HBI is on budget. So we are good with that. Second, the fluctuation in the numbers for CapEx has just carried over from last year, things that for 1 reason or another, we did not pay last year. Because if we can pay later, we’ll pay later. We don’t pay earlier. So that’s pretty much a rule of thumb when you’re building something. If everything goes on time and you are not being forced to deploy the capital earlier, you can deploy the capital later, why not to do it? So it’s just a move from 1 year to another.

As far as Ashland, that’s what due diligence is for. When we do a due diligence, we are really deep — diving deep into AK Steel. We are — as far as public information is concerned, we did not hear too much from AK in public conference calls and things like that. A lot of their automotive business, we heard a lot about their balance sheet, we heard a lot about their bonds that were not refinanced. We heard a lot about pension. But we didn’t hear a lot on their business. And when we started digging into their business, their business is phenomenal. Their technical capabilities are immense. And I would have to produce pig iron to support EAFs out of Ashland. I’m going to support EAFs out of HBI, so I’m not denying the importance of EAFs. So there is no conflict with previous statements, just that due diligence showed that’s a real potential for the ongoing, for the existing AK business, particularly in works related to automotive. It’s extremely impressive. Our first Investors Day for AK Steel will be done at the research and development center of AK Steel in Middletown Ohio, and I’m sure you’re going to be there, Seth. You’re going to be surprised, as other research analysts will as well. So there is no conflict. It’s just due diligence. That’s what — why companies do due diligence when they’re acquiring other companies, to really learn what they are getting into. So we realized that we’re getting into something a lot bigger and a lot more relevant and a lot more important in terms of return to the shareholders than just producing pig iron to the marketplace out of Ashland. I’m not saying that’s not going to come, I’m just saying that this was now way behind in the scale of priorities.

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Operator [14]

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Your next question comes from Nick Jarmoszuk from Stifel.

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Nicholas Jarmoszuk, Stifel, Nicolaus & Company, Incorporated, Research Division – Analyst [15]

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A question for you on the EBITDA guidance, does it assume any contribution from the HBI plant in the second half of the year?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [16]

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Well, here’s the thing. Keep in mind that as far as 2021 comes, we’re going to have 9 million tons of intercompany sales. Don’t forget that. So that will change everything in terms of the things that you see in this EBITDA guidance. But I will let Keith Koci go into the details of the numbers related to that guidance.

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Keith A. Koci, Cleveland-Cliffs Inc. – Executive VP & CFO [17]

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Right. And as far as the start-up of HBI, we’re pretty modest with the back half and we’ve only put in $30 million of EBITDA coming from HBI in 2020. And it’s mainly just due to ramp-up, and there’s always some additional costs in getting started. The number grows immensely in 2021 as we expect to have a full year running at our nameplate capacity. So we’ve — we’re looking at roughly $200 million of EBITDA generation in 2021. And that’s what we’ve got in our guidance.

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Nicholas Jarmoszuk, Stifel, Nicolaus & Company, Incorporated, Research Division – Analyst [18]

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Okay. Regarding…

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [19]

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Let me complement 1 thing about that. As far as 2020, assuming $650 for hot-band in the United States is still a very modest number and should be a number easy to achieve. $90 for IODEX. Well, to date, $91.10, the IODEX that was posted this morning. So the new normal is unabated. Even Vale was unable to destroy the IODEX. They did destroy the pellet premium, no doubt about that. When you reopen contracts that are set in stone with the clients and you accept clients crying wolf, then pellet premiums go down. The biggest problem is that the biggest victim of this absurdity is Vale. So they are losing tonnage. They are giving away revenue by giving away the pellet premium. So very soon, they will need to come to reality. And the pellet premium will go up. Like Keith explained, for the vast majority of pellet producers in the world, the current pellet premium doesn’t cover the costs. So they are in trouble. Vale might be okay because of the manipulation of the Brazilian real that’s now trading at — $1 for BRL 4.37. So it’s pretty absurd. So that currency gives the impression that they have all costs under control, but they don’t. So they have to play catch-up with the pellet premium very soon. That’s why we put a $50 number for our expectation because we believe that will be high.

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Keith A. Koci, Cleveland-Cliffs Inc. – Executive VP & CFO [20]

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And Nick, 1 more follow-up to my comment real quick. The $30 million that I quoted does not include the intercompany margin. So we also recognize then the margin that — the price that we’re charging to ourselves. So there is an additional margin in the HBI product that would be in the Mining and Pelletizing division. So it’s…

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [21]

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Good point. It’s just the profitability of the Metallics division.

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Keith A. Koci, Cleveland-Cliffs Inc. – Executive VP & CFO [22]

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That’s right.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [23]

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Yes. Not the profits that we make selling pellets at market price from Northshore to our own units, so from Northshore to Toledo. Because we have to do it that way because, among other things, we’d pay royalties to Mesabi Trust based on market price. So we don’t mess with that.

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Nicholas Jarmoszuk, Stifel, Nicolaus & Company, Incorporated, Research Division – Analyst [24]

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Okay. And with the customers that you mentioned, does that fully contract the nameplate capacity of Toledo?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [25]

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No. What do you mean? If I have awarded for 1.9 million metric tons for 2021? Of course not. Nobody has that. Nobody has that for any product, why should I have for HBI. I don’t have for pellets either. No steel company in the world has for steel. So why are you asking this question? Are you trying to say that I don’t have orders for HBI? Is that what you’re implying?

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Nicholas Jarmoszuk, Stifel, Nicolaus & Company, Incorporated, Research Division – Analyst [26]

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No. I was just curious as to how much of the capacity is contracted?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [27]

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Everything that we are going to produce at the beginning, and then it’s up to us. If the product is good, as we believe the product is and the clients believe that the product is, we are going to have a great business. If the product is like other producers and even one here in the United States in Texas, we will probably have trouble. But we are not them. We are us. We have a single source of pellets coming from Northshore. We know how to deal with iron ore. We have been dealing with iron ore for 173 years, so we learned one thing or 2. And we also understand how to deal with contract business to supply feedstock to clients. But we are going to be fine, Nick. We have the orders and we need to start. And then we will go from there.

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Nicholas Jarmoszuk, Stifel, Nicolaus & Company, Incorporated, Research Division – Analyst [28]

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Okay. And then returning to the pellet discussion. Do you have any thoughts that Vale could be looking to give some sort of discount to their European customers to maintain blast furnace throughput? Then they’ll — once the margins in Europe improve, then they’ll get a little more aggressive with the pellet premium. Is that — do you think that’s a reasonable way to think about it?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [29]

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I think the reasonable way to think about that, that too many people getting trained on the job — on-the-job training at Vale. As soon as they learn the business that they’ll start to charge the clients what they need to charge. But it is for Vale to resolve — to the board members of Vale to resolve. It’s a Vale thing. And Vale at this point has other things to resolve. They have a few people going to jail. It’s a mess out there. So I don’t know. You got to ask them.

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Operator [30]

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Your last question comes from James Finnerty from Citigroup.

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James Peter Finnerty, Citigroup Inc, Research Division – Former Director [31]

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Just on the AKS that you intend to refinance, the ’21s and ’23s. Will the ’21s be unsecured and guaranteed like the ’25s and ’27s?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [32]

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Look, as you know, being a high yield bond analyst, I can’t talk about that right now. So we will announce this deal at the right time. We have a track record of doing these types of transactions and doing the transaction right. Look at back, check the last 5.5 years, we have plenty of comparables just here within Cleveland-Cliffs, but I can’t show my hand right now. And I will not disclose that at this point. But we are set. We’re good. Stay tuned.

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James Peter Finnerty, Citigroup Inc, Research Division – Former Director [33]

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Okay. And then — and the timing is still to be determined. So it could happen in conjunction with the closing of the transaction or it could happen afterwards. Is that still true?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [34]

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I said that’s all going to be done by day 1. I mean we’re going to hit the ground running. We are going to be done. Remember, we already stripped the covenants of the AK bonds, check the box. We already arranged the ABL. So check the box. So the last piece missing is the bonds. So we are going to take care of that. And when we land there, we’re going to have a 4-year window of opportunity to work and get AK Steel refocused on commercial, refocused on developing steels and more important than anything, charging the clients a price that will be proper for the type of technology that is embedded in the steel that we produce.

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Operator [35]

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And your final question comes from Tyler Kenyon from Cowen.

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Tyler Lange Kenyon, Cowen and Company, LLC, Research Division – VP of Industrials and Metals and Mining and Senior Equity Research Analyst [36]

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So you’ve given us some stand-alone EBITDA guidance based on some commodity price inputs for Cliffs. Wondering if you could provide a little bit more detail on the embedded pellet volumes, cash costs and perhaps SG&A assumptions within that $550 million to $575 million range?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [37]

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Keith, do you want to take that?

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Keith A. Koci, Cleveland-Cliffs Inc. – Executive VP & CFO [38]

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Yes. I mean the stand-alone, I mean, SG&A kind of similar year-over-year. Cash cost of production up roughly 3%. Mainly, product mix is a big part of it because we’ll be producing a lot more DR-grade pellet, the DR-grade pellet costs more to produce. But you’ll also see some additional maintenance cost in the year. You’ll see some higher costs at Tilden stripping because we’ve extended the life of the mine as you’ll see soon as we disclose on our 10-K. And the natural increase in labor cost each year. So you’ll see a little bit of increase there. What was the other factor?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [39]

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At today’s prices, we need probably $1.50 increase, something like that. Less than $2.

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Tyler Lange Kenyon, Cowen and Company, LLC, Research Division – VP of Industrials and Metals and Mining and Senior Equity Research Analyst [40]

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Okay. Great. And then anything just on volume assumptions for third-party pellet sales?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [41]

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Volume will be in the 20 million to 20.5 million tons range.

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Tyler Lange Kenyon, Cowen and Company, LLC, Research Division – VP of Industrials and Metals and Mining and Senior Equity Research Analyst [42]

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And any sense you could provide us just on how much will be going to HBI in terms of inventory build?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [43]

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No, inventory build; we already built the inventory. So we don’t have any more inventory build to do. Actually, in 2020, we are considering that we’re going to be moving only 1.5 million to 1.8 million tons of pellets because it will be a ramp-up year. And starting 2021, we’re going to go in a steady state, it’s — to produce 1.9 million metric tons of HBI, we are going to need 2.8 million tons of pellets moving into Toledo. But that will be 2021 and beyond. Christina?

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Operator [44]

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There are no further questions at this time. Do you have any closing comments today?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. – Chairman, President & CEO [45]

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Just to wish everybody a great Thursday. Keep paying attention. We are moving fast. We are doing everything we have to do. We are excited about the transaction. We’re excited about HBI. We’re excited that we have a transformational event that will change Cleveland-Cliffs going forward, and we will guarantee that this company will be here for the next 50 to 100 years.

We are pleased with what we have done. We appreciate the support of our shareholders. So far, the votes coming in are massively in favor of the transaction. We appreciate each one of the retail investors and the institutional investors that continue to demonstrate every day their support to our strategic moves. We are together. I am one of you. I’m a big shareholder of this company. My family will be involved with this company for 2 or 3 generations going down. So that’s how we see this business. There is no short-term thing here. We’re working for us, shareholders of this company. Thank you very much, and have a great day.

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Operator [46]

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Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.