Cleveland-Cliffs (NYSE:CLF ) and the Nucor Corporation (NYSE:NUE ) are my two favorite steel stocks. The first is in the midst of one of the most impressive turnarounds in America's industrialized history while Nucor is a more stable, dividend-paying steel giant with a bigger footprint in construction-related industries. In a recent article, I discussed why the long-term commodity super cycle was very bullish for (in this case) Cleveland-Cliffs. However, I also mentioned that my entry strategy was based on mid-term economic indicators, which show the risks of a recession. In this article, I will cover both Cleveland-Cliffs and Nucor and explain how to incorporate a very bullish long-term outlook and an extremely uncertain current economic environment.

On a side note, it's interesting to mention that CLF and NUE cover almost half of the flat-rolled steel market in the US, which makes company comments and numbers even more important for the bigger picture.

Now, let's dive into the details!

Both 2020 and 2021 turned out to be tremendous years for steel stocks. Compared to pre-pandemic levels, Nucor and Cleveland-Cliffs returned roughly 200% and 300%, respectively, beating both the S&P 500 and their steel competitors as the chart below shows.

The upswing was fueled by rapidly rising steel demand and supply chain issues that were behind an explosion in steel prices. Midwest Hot Rolled Coil futures soared as high as $2,000 per ton, up from the longer-term median of roughly $600.

TradingView (Midwest Hot Rolled Coil)

TradingView (Midwest Hot Rolled Coil)

Unfortunately, as the two charts above suggest, the honeymoon is over. Cleveland-Cliffs shares have fallen more than 50% from their peak while the less volatile Nucor has lost a third of its equity market value.

What's interesting - and important - is that developments are fast. I just found two interesting headlines on Bloomberg. One indicating signs of recovery (in August), and one showing warning signs as shipments are expected to plummet. That was in September.

This week, Nucor came out lowering its 3Q22 estimates. It now sees earnings between $6.30 and $6.40. "The street" was looking for $7.74. According to Bloomberg:

Earnings from its steel mills would be "considerably lower" than the second quarter due to shrinking metal margins and declining shipments, the Charlotte, North Carolina-based producer said.

As the first headline in the screenshot above suggests, these comments may come as a shock as participants of the steel convention in Atlanta last month were way more positive, despite prices being weak already back then.

Some of these comments came from Stelco Holdings CEO Alan Kestenbaum who made the case that energy was strong and that demand is still solid despite weakness in automotive and construction demand.

I'm not bringing this up because he was wrong, but because he brought up some good points, that I believe are still valid:

Kestenbaum said the car industry is building about 13 million to 14 million automobiles per year, which is a far cry from the lean period during the 2007-2009 economic downturn. Automobiles use about 1 ton of steel per car.

"It's not like the Great Recession or Covid where demand just totally disappeared," he said. "At that point the auto industry was consuming just 6 million to 7 million tons a year, and during Covid the factories were shutting down."

For example, pent-up demand for automotive production is still high. Because of the pandemic, car manufacturers were unable to turn orders into finished cars. This lowered monthly car production to less than 100 thousand units last year. In 2015, the US economy produced almost 400 thousand units.

Cleveland-Cliffs is the nation's largest provider of automotive steel thanks to the acquisitions of AK Steel and ArcelorMittal USA.

With regard to pent-up demand, this is what CLF CEO Lourenco Goncalves said in the 2Q22 earnings call:

[...] we have all the ingredients for the dynamics of the past two years to shift in our favor. It has been over two years of construction outpacing automotive, but that's no longer the case. The North American automotive industry could have produced 8 million to 10 million more vehicles than they actually did over the past two years. And as a result, relentlessly growing pent-up demand for cars, trucks and SUVs have developed.

In a recent article, I wrote that Ford (F) has three years' worth of production as backlog. That's a huge deal as it sustains steel demand despite recession risks. Hence, Kestenbaum isn't wrong.

However, what we're seeing now are demand fears. Another major steel producer, United States Steel (X), gave a grim outlook. Note that adding X to CLF and NUE gives us comments from roughly 70% of the entire flat-rolled steel market in the United States.

According to the Steel giant from Pittsburgh, Pennsylvania:

"Accelerating market headwinds in the third quarter negatively impacted demand across most end-markets, which is expected to result in lower shipment volumes," U.S. Steel said Thursday in its most detailed mid-quarter statement on the business in years. "Supply chain issues in automotive and appliance end-markets continue, while containers and packaging has softened, and service center buyers remain on the sidelines."

The timing of these comments makes sense as the latest manufacturing data points to increasing risks of a manufacturing recession. I am using the chart below to track manufacturing sentiment in the United States. I updated it to include September data. What we are seeing is that the third quarter (July - September) is the weakest since the 2020 pandemic. Prior to that, weakness was quite severe in 2015.

Using Nucor's stock price history, we see that this is dragging down steel stocks. In this case, I went with Nucor's stock price instead of CLF (or both) as CLF is too volatile. However, like NUE, it also follows these leading indicators.

It's also important to mention that the aforementioned steel companies were pretty much forced to admit that demand weakness is now a thing. After all, analysts have caught up already as earnings estimates for 2022 and beyond have been adjusted quite consistently over the past few weeks - mainly for CLF. The worst thing is that company guidance is often worse than analyst estimates. Hence, the selling on the stock market.

MarketScreener (CLF, NUE EPS Estimates)

MarketScreener (CLF, NUE EPS Estimates)

In my last Cleveland-Cliffs article, I highlighted Europe's de-industrialization issues due to high energy costs. Mr. Goncalves commented on this as well:

So we are starting to see a reallocation of microchips and other things from Europe to the United States. And we're also seeing the growth in orders as a consequence of that. So even though I'm not giving you a number Lucas I'm giving you a lot of good indications that things are starting to turn and we are ready for that.

Now it's time to include a fourth steel stock. ArcelorMittal is now reporting that it sees crude steel production down 1.5 million tons in the fourth quarter from the year before. That's a 17% year-on-year reduction.

At this point, roughly 10% of Europe's steel capacity is offline. And the trend is up going into the last quarter of this year.

The problem is that the benefit for US companies will come with a delay. While deindustrialization in Europe benefits the US because it will be home to more European companies, the sudden decline in demand won't boost short-term steel shipments from the US to Europe as Fastmarkets explained in a detailed report.

"I would say that while there may be a chance for US exports to Europe, I doubt it will be substantial due to the difference in price between the US and rest of the world," Fastmarkets' US analyst Kim Leppold said. "US steel prices, compared with global competitors like Turkey, South Korea, Asia or Latin America, remain high and less likely to compete for sales."

The following chart shows that steel prices have come down everywhere and that US steel prices continue to be more expensive steel in Europe and China.

However, while Chinese steel is cheaper, it's not necessarily getting more attractive. China has a major pollution problem and it is at a point where it will have to deal with the pollution because it is becoming a health hazard - it already is in many regions. Also, the pandemic changed how countries do business with China. We will see increasing supply chain relocations. It won't make Chinese steel expensive, but it's a factor why the US will benefit more than before from halted production in Europe and higher (relative) prices in China.

It remains to be seen how big the benefit is, but Europe won't be able to export as much steel to the US anymore. China will be less competitive and US producers benefit from higher exports to Europe and new companies from Europe in North America.

Needless to say, that's my longer-term outlook. It won't change the current demand situation.

With all of this said, I believe we are in a perfect storm for commodities. A second inflation surge after demand weakness hurts the current inflationary wave. In this case, the perfect storm is bullish. Right now, we have a situation consisting of the following issues (but not limited to):

In other words, I expect the current weakness to be followed by a steep surge in commodity prices when demand comes back. I also highlighted these issues in the aluminum market in this article, as high electricity prices have an even bigger impact on aluminum.

That said, I went with a pretty bullish article title. And I stand by that as I hate clickbait. What we're dealing with is another period of pain followed by what should be a rally bringing both CLF and NUE - two of my favorite steel companies - to their fair value.

In the case of Cleveland-Cliffs, we're dealing with a company that has made the most impressive turnaround among industrials/metals I've ever witnessed. What used to be a low-margin producer of iron ore is now one of America's largest steel producers. In 2020, the company produced zero tons of steel. In 2021, the company produced 15.9 million tons thanks to the aforementioned AK Steel and ArcelorMittal USA acquisitions.

The company has a fully-integrated business model sourcing its own raw materials from US operations, which means higher margins and short (low risk!) supply chains. Moreover, the company operates seven blast furnaces and five next-gen electric arc furnaces. This allows the company to go very high up the value chain, meaning automotive and related steel. More than 27% of sales go toward automotive customers. 31% of sales are used by distributors and converters.

One major benefit of the "new" Cliffs is its ability to generate high free cash flow used to lower net debt. Last year, the company did more than $2.0 billion in free cash flow. This year, FCF could be $2.7 billion (34% FCF yield!), lowering net debt to less than $3.5 billion. Following the current trajectory of falling steel prices, the company could be net cash positive in 2024 - meaning CLF has more cash than gross debt.

That said, CLF is currently trading at 4.5x 2023E of $2.8 billion. That's based on its $12.6 billion enterprise value consisting of its $7.9 billion market cap, $1.6 billion in 2023E net debt, $2.8 billion in pension-related liabilities, and a mere $270 million in minority interest.

Even under "normal" circumstances, CLF should be trading at no less than 7x NTM EBITDA. This would imply a market cap of $14.9 billion, roughly 90% above current levels.

That's below the company's 2022 all-time high. On a long-term basis, I expect that CLF can rise to $50-$60. Free cash flow generation will erase net debt and all major financial obligations on top of the secular economic tailwinds discussed in this article.

Nucor is similar but different.

The company is North America's largest recycler of steel scrap, it produces its own direct reduced iron used in its steel mills, it dominates the flat-rolled steel industry with Cleveland-Cliffs, and it has a history of consistent dividend payments, low debt levels, and high free cash flow. NUE is one of the least volatile and most well-managed steel companies in the world, I believe.

The company's steel is mainly used in construction and service centers. That's the main difference with Cliffs.

Together with its peer Steel Dynamics (STLD), NUE has been one of the most consistent performers in the industry, returning close to 290% over the past 10 years.

NUE Total Return Level data by YCharts

Now, the company is taking it to the next level. The company's already low net debt levels prior to the pandemic (close to 1x EBITDA) are now expected to fall into negative territory next year as the company is likely to maintain an average FCF result of close to $3.5 billion in 2022E-2024E. That's 11% of its market cap.

Nucor is trading at 5.2x 2023E EBITDA of $5.4 billion based on a $28.2 billion enterprise value consisting of its $30.7 billion market cap, $3.6 billion in 2023E net cash (negative net debt), and $1.0 billion in minority interest.

Historically speaking, NUE trades at roughly 8x NMT EBITDA. This would imply that NUE is 50% undervalued.

Longer-term, I believe that NUE will trade well above $200 once demand comes back.

Moreover, the rail strike in the US has been avoided. So far, this hasn't helped steel stocks. Yet, it is something to bear in mind as it did hurt steel stocks prior to the announcement.

These are two comments from S&P Global ahead of the announcement that the strike is off the table:

Philip Bell, president of the Steel Manufacturers Association, said Sept. 13: "Our supply chains are stressed, and any disruption in freight rail service will hurt our economy by adding costs and delays to a rail service system that is already suffering from poor service."

If the parties do not resolve their differences through voluntary agreement, US steelmaker Nucor's tubular division said it expects Congress to intervene as it has in the past to prevent or stop any service rail disruptions, according to a letter sent to customers Sept. 13 and seen by S&P Global Commodity Insights.

The fact that the strike is off the table opens up some short-term opportunities. The question is if investors can look beyond the current demand scare.

In this somewhat lengthy article, we discussed my favorite steel stocks and the bigger outlook for the steel industry. After two years of massive tailwinds, thanks to strong pricing and rebounding demand, steel is once again in a tough place. All major producers are adjusting their outlook as both prices and demand are coming down rather rapidly.

Chinese construction markets are slowing, European production is shutting down, and pent-up demand benefits are fading in North America as general economic growth is quite bad, to put it mildly.

While this is pressuring steel stocks, there is good news. First of all, major producers (CLF and NUE) still have a large backlog to work on, which will smoothen the impact of the possible manufacturing recession on sales.

Moreover, both companies have extremely healthy balance sheets. CLF didn't have that in prior cycles.

On top of that, and this is my key takeaway, I expect commodity prices to explode as soon as demand is coming back, which I expect to happen in 2023.

At that point, we're once again in a situation where supply is curtailed due to halted production in Europe, lower Chinese production, and more careful producers in North America.

I expect CLF to double as soon as the Fed pivots next year (expected). That's from current levels. Any further downside will only increase the upside potential. NUE can also double, however, in this case, I believe it will take 3-4 years for the bull case to unfold as secular trends like supply chain relocations are pricing in slower. Also, NUE is far less volatile than CLF and more than 4x bigger.

Long story short, I believe that both CLF and NUE have tremendous long-term potential. Both are extremely undervalued and poised to benefit from cyclical and secular growth starting in 2023. However, please be careful when buying. More short-term pain is likely as the market is currently panicking due to demand fears. Keep your steel exposure limited and make it a long-term holding.

Other than that, I believe we're dealing with tremendous investment opportunities here.

On a side note, I just bought CLF for close to $15 after the news of that rail strike broke. I like the risk/reward a lot, but as I said, be careful as this isn't a guaranteed bottom.

(Dis)agree? Let me know in the comments!

This article was written by

Disclosure: I/we have a beneficial long position in the shares of CLF either through stock ownership, options, or other derivatives. 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.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.