Cleveland-Cliffs Inc

NYSE:CLF

Earnings Call Transcript 2019-Q1

[Operator]

Good morning, ladies and gentlemen. My name is Denise and I am your conference facilitator today. I would like to welcome everyone to the Cleveland-Cliffs’ 2019 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 protection 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 the 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 cleveland-cliffs.com. At the conclusion of the call, it will be available for replay on the website. 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.

[Lourenco Goncalves, CEO]

Thank you, Denise, and thanks to everyone for joining us this morning. Before we start, I would like to introduce our new Chief Financial Officer, Keith Koci. Keith worked with me for 10 years, for the 10 years I ran Metals USA. He was Director of Budgeting in 2003. At the time, we listed the Metals USA on the NASDAQ and became the Controller of the company shortly after.

At the time we took the company private in 2005, Keith was promoted to Executive Vice President, Business Development, in charge of M&A and CapEx. With Keith in that capacity, we made several very successful acquisitions, which were properly integrated into our then Metals USA way of doing business. He was also very instrumental to me when we IPOed Metals USA in 2010 and listed the company on the New York Stock Exchange. And he was my most valuable player when we sold the Metals USA to another publicly traded company, Reliance Steel & Aluminum in 2013.

Keith has stayed with Reliance Steel as CFO of Metals USA until earlier this year, when I invited him to relocate to Cleveland and join me here at Cleveland-Cliffs. With the conclusion of the construction of our HBI plant number one in Toledo coming soon and with the several different alternatives related to future growth, we are currently considering for this great company, I could not have a better CFO here at Cleveland-Cliffs.

So with that, I'll turn it over to Keith Koci for the financial overview portion of this call. Keith?

[Keith Koci, CFO]

Thank you, Lourenco and good morning to all of you listening in on today's call. After about two and a half months as Chief Financial Officer of Cleveland-Cliffs, it's hard to contain my excitement about the potential for this company. Coming from a long career in the dog eat dog service center world, I have a huge appreciation for the competitive advantages we have in our company, as suppliers of customized feedstock for the American steel industry. With our unique geographical position inside The Great Lakes, as well as the premium market, we will carve out in the EAF space as suppliers of HBI, our future is extremely bright, and I am thrilled to be a part of it.

That said, I will begin my remarks with an overview of the quarter before kicking it back to Lourenco for his comments. As all of our investors should be aware, our first quarter will always be the lightest quarter for our pellet business due to the annual closure of the Soo Locks, where most of our volumes pass through on their way to our customers in the lower Great Lakes. This fact limits shipments for the majority of the quarter to rail deliveries, which typically have among the lowest net back realizations in our portfolio. As such, our Q1 total company adjusted EBITDA of $21 million represents a small fraction of what we anticipate generating for the full year.

First quarter mining and pelletizing sales of 1.6 million long tons were in line with last year and outperformed our own expectations due to better than expected performance by our rail carriers and also due to our ability to deliver extra vessels in the quarter. With the locks now open, even as considerable levels of ice remain on the lakes through this point in April, our second quarter shipments expectation is 5 million long tons, representing a significant increase from Q1 as usual. Also, our sales expectation for the full year is 20 million long tons and that includes 500,000 long tons of DR grade pellets to be delivered from our North Shore pellet plant in Minnesota to our HBI plant in Toledo during the third quarter.

Our Q1 pellet price realization of $94 per long ton was lower than our full year indicative guidance range, since as we noted our customer mix is less favorable in Q1 due to the heavy weighting of rail shipments. During last year's first quarter, because the AMM hot rolled coil price rose from $653 to $860 per short ton from the beginning to the end of the quarter, we had an enormous favorable revaluation adjustment. With HRC price remaining relatively flat during this year's first quarter, we had no such adjustment at this time, explaining the year-over-year decline in revenue rate. For the remainder of the year, our second, third and fourth quarter revenue rate will be much higher as the larger sample size of shipping volumes is more closely representative of our full customer mix.

Very importantly, due to the increases in iron ore pricing, our indicative full year expected pricing range has increased compared to what we provided last quarter, applying prevailing spot prices for iron ore at $94 per metric ton, hot rolled at $676 per short ton, and the Atlantic pellet premium at $66 per metric ton for the remainder of the year, our revenue expectation would land in the range of $111 to $116 per long ton. As we typically note, the figures we have utilized do not reflect our internal view on pricing, they just represent points in time in the market.

Regardless of what pricing does for the remainder of the year, we find ourselves in an excellent position as far as revenues because right now in late April, we are through almost a third of the year and we already have an incredibly strong actual index performance in the books. Because in most cases, our contracts are based on pricing formulas on full year index averages, we have an excellent base set for one third of the entire year.

Similar to last year, similar to last year, our first quarter cash costs of $62 per ton were near the lower end of our guidance range, as our use of standard costing methodology artificially alters DD&A per ton to a higher number in a low volume quarter. Going forward, based on our improved earnings forecast and the corresponding estimates for profit sharing and royalties, we expect full year cash cost to trend closer to the higher end of our costs guidance range of $62 to $67 per long ton, which we are obviously more than recouping on the revenue side. All other spending and maintenance items have remained consistent with our prior forecasts.

Other P&L items I would like to point to are SG&A and miscellaneous. Our SG&A expense was $28 million during the quarter, which included a severance pay of $2 million. Our budget for SG&A for the full year was maintained at $120 million. As for miscellaneous net, just like we saw in Q1, we will continue to record about $5 million per quarter in this line item related to the Empire idle, a good chunk of which is non cash ARO accretion. This amount will be slightly, but not materially higher over the next two quarters.

On the cash flow front, as customary, during the first quarter, we built pellet inventory, which translated into a $225 million cash outflow. That will be largely recouped as shipping outpaces production throughout the rest of the year. Capital expenditures were about $135 million during the first quarter, of which 104 million went toward the HBI project as planned. This was consistent with our expected pace thus far as we remain on track for a middle 2020 completion.

Our capital expenditures budget this year remains unchanged at $555 million. This is our peak year for spend on HBI and the final year of spending on the North Shore DR upgrade project. Next year, total expected CapEx should be done by nearly 50%. And by 2021, we expect to be back to a simple sustaining rate of approximately $100 million. Also during the quarter, we purchased $124 million in common shares, bringing the total spent in share buybacks to $171 million since the beginning of the program. With that, we have reduced the number of shares to a total share count of 282.8 million shares as of March 31, 2019.

And finally, I will wrap up my comments on the tax side. Along with the obvious competitive advantages that Cleveland-Cliffs has, as CFO, I was also thrilled to step into a tax position that is the envy of the industry. We will not only be a zero cash taxpayer for the foreseeable future, but we also have nearly $240 million of remaining AMT cash tax refunds coming our way over the next four years. Our expected receipt of the first $117 million has moved up to earlier than previously expected and we should see it in our cash balance by the time we report again next quarter.

Between this, the restart of the vessel season, and the favorable pricing conditions we expect to enjoy for the rest of this year and beyond, I look forward to watching our cash pile grow as the year progresses.

With that, I will turn back over to Lourenco.

[Lourenco Goncalves, CEO]

Thanks, Keith. Throughout my nearly five year tenure as CEO of Cleveland-Cliffs, I have always tried to be several steps ahead of the pack, working out our strategy maneuvers two or three years in advance. Instead of following the herd mentality, so prevalent among pretty much all the players in this industry, I have elected to use my own perspective on the business, not to hire consultants, and to predict what will happen using our own internal resources. We use it to our advantage and we act accordingly.

Let me list a few examples for you. First example. Knowing for a fact that we would not go bankrupt, while almost the entire market disagreed with that and some investors shorted our bond allows us to buy back a lot of our bonds sent on the dollar, particularly during the first couple of years of my tenure as Cliffs’ CEO.

By doing so, we paid down a huge amount of our debt very quickly and effectively. I cannot thank enough the folks shorting our bonds at that time. They provide us with a fantastic shortcut, pun intended, to save this company. The cheap bonds we’re able to buy in the open market enhances our ability to reduce our debt loads. That was accomplished a lot faster than we would be able to do, if this so called investors were not shorting our bonds. I call these folks, good short.

Second example. We predict the demise of the top executives of the major iron ore mining companies due to their incredible ability to destroy shareholder value, during the time that they were all trying to outperform each other as the lowest cost producer of iron ore in the world. There was a time also known as the Australian Brazilian championships of the stupidity. That departures brought back some sanity to the markets and a much more rational value over volume approach to the business.

And third, we also predicted a push toward environmental compliance everywhere in the world and particularly in China. For that reason, we introduced the pellet premium as an important part of our pricing structure. And we did it at a time when the pellet premium was not even an object of discussion. Well, since it's inclusion in our pricing formulas, the pellet premium alone has added about $300 million in annualized EBITDA to our company, all other things being equal.

Beyond this three great examples, the most relevant one was our announcement of the HBI plant construction in June of 2017. Several investors, analysts and industry participants thought that such huge investment was a mistake. And even worse, because we elected not to have a financial partner. Fast forward two years and after several announcements from trustworthy EAF stewards of new projects and the expansion of existing ones, we are now being asked when we will build more HBI plants.

If I had waited until now to move forward on HBI number one, we will be way behind on this EAF supply expansion. Since we correctly predicted and were able to get going ahead of this, by the time some of these new EAFs come online, we will be already selling a proven product that the Muse will be fighting over. We'll talk more about this later in today's call.

For now, this all brings me to a fundamental point, an underlying theme of my tenure as Cliffs’ CEO has been to explain time and again, why this is not a cost driven business. When I first arrived at Cliffs five years ago, there was no appreciation for the fact that the pellets we produced in the United States are substantially more valuable than the center feed iron ore finds extracted from the ground in Australia.

Cliffs was labeled a high cost producer of iron ore, despite of actually producing a manufactured product called pellet, all while maintaining the highest safety and environmental standards in the entire industry. Meanwhile, Vale, Rio Tinto, BHP and Fortescue all rated to see who could get the lowest C1 cost number, as if that was their most important indication of success.

As I have been repeating since 2014, mining is a capital intensive and potentially dangerous business and cutting necessary costs just for bragging rights or to please Wall Street might jeopardize important areas like safety, days management and environmental stewardship. As a result of the actions taken, and even more so, actions not taken by the majors a few years ago, we are currently entering what is shaping up to be a multi-year shortage of iron ore and pellets.

Several people directly or indirectly involved with the industry initially believed that the lost production in Brazil would not be meaningful and would be easily replaced or brought back online. That did not happen and will not happen. In fact, the annualized shortfall of iron ore from Brazil has been accounted for as 10s of millions of metric tons. Furthermore, as [indiscernible] become object of heated discussion by mainstream media, governments and courts of law become much more serious about investigating the root causes and punishing the perpetrators.

The distraction of multiple very costly and very serious lawsuits, including criminal liability, related to the loss of life of hundreds of Brazilian systems should only continue to confirm throughout this year and next that Brazil as a supplier of iron ore to the world has become a totally unreliable supplier. There is no short or medium term solution for this massive shortages, and as such, iron ore and pellet prices should remain elevated for the foreseeable future.

That will not get better or easier anytime soon and it might get worse. Welcome to the new normal, get used to the new normal. With the Córrego do Feijão catastrophe at Vale in Brazil exactly 90 days ago and considering vessels in transit from Brazil to China and port inventories at both ends, we are just now at a point where the physical impact is starting to be felt in China and throughout the world. So how did we add at Cliffs take advantage of the market not reading this major event appropriately?

We bought back our own stock with both hands exactly like I said we would do. As I have always said, I don't fight the tape. I do not fight the tape. I take what the market gives us. Four years ago, we added hundreds of millions of dollars in value to this company by buying back our bonds, cents on the dollar. And now, we are doing the same by buying back our CLF shares at very low prices.

Our revenues in 2019 will be taking another step up from last year. And at this time, we expect EBITDA for 2019 to be above $800 million. As a direct result of these improved EBITDA forecasts, and even considering that this year will be our big year for CapEx, we should still generate in 2019 enough cash to continue to pay down debt and to continue to return meaningful levels of capital to our shareholders.

In that regard yesterday, in our board meeting, our board of directors approved an additional $100 million toward our share buyback program, bringing our original $200 million authorization up to $300 million. With that and after the $171 million already spent since the inception of the program, we still have almost $130 million available for share repurchases this year.

Our mining and pelletizing operations remain in great shape. This winter was especially harsh compared to what we have seen in the past few years. But our operations in Minnesota and Michigan are well equipped to handle and manage through inclement weather. One thing, pushing costs up this year is the fact that we're making a lot more money, actually a good problem to have, which drives up the profit sharing pace to our employees and royalties.

Why steel pricing has declined from its peak, the hunger for our pellets has not, as distributors continue to order pellets at healthy rates. Additionally, we believe that steel prices will improve, not only in the United States but throughout the world, mainly driven by the new normal for iron ore and pellets with scrap ultimately following the trend dictated by the new normal. That should allow the domestic mills to increase the price they charge for steel in United States. And by doing so, avoid a profit squeeze that would otherwise happen to them caused by more expensive feedstock.

While we're discussing market dynamics, I would also like to address the latest theme some so called experts and a couple of steel market analysts are pushing that the additional capacity expansions will destroy HRC prices and the domestic steel markets. Just like with iron ore, these folks are always looking for the next gloom and doom scenario. As a reminder, iron ore prices have been predicted to crash in each of the last four years. And the ones making these predictions have been embarrassingly wrong every single year.

It's a long history of excuses and moving the goalposts to another year later. With domestic steel, it will be the same. The evolution of the United States in to a service based economy is a luxury that can only be afforded with a solid manufacturing foundation, providing a consistent number of good paying middle class jobs. The United States will continue to be a manufacturing country and the underlying demand for steel will continue to be strong.

On the supply side, the entire history of the steel industry in the United States and Canada for that matter is newer steel facilities replacing older steel facilities. And like always, some marginal players in the United States, in Canada or in both countries will become uncompetitive versus newer ones and will naturally fade away. So, the fear of the supply glut is definitely exaggerated.

As for the impact of this new steel capacity on pricing, the United States continues to be a net importing country. So we do have underlying domestic demand and room for fairly priced steel. On top of that, by now, it is abundantly clear that the United States domestic market is no longer the playground for cheaters it used to be until a few years ago. Besides the number of traditional barriers against unfair trade, including anti-dumping and countervailing duties, we also have tears in quotes. That's the law of the land.

And things will get a lot worse for the cheaters, when mainstream finally starts to understand how much the Chinese steel industry balloons and destroys the environment of the entire world. At that time, imported steel from China will be treated as poison and China will no longer get the free pass they still get today. That being said, you will always have a marginal high cost player, either a less competitive furnace within the US or an importer that has to pay a tariff to keep the price at a reasonable level.

Even if this new furnaces replace all the importers, it's not reasonable to believe that steel mills will operate at a loss for an extended period of time. This analysis also doesn't consider how the EAF raw material market played into all this. With all of these new capacity coming online from the EAF side, we're going to have many more buyers fighting over the same amount of scrap and metallic.

These fundamentals for raw materials are strong enough to support a decent level for domestic steel prices. Without that, there's a real problem that could lead to a premature death of certain blast furnaces in North America their inability to secure enough long term pellet supply. With the way the market is presently situated, by 2021, there will be a 3 million long term shortage of pellets in the Great Lakes. By the time our HBI number one plant will be consuming at its full pellet supply need of 2.8 million long tons, leaving one or two blast furnaces short-handed and unable to run.

There is no good solution for these blast furnaces. Important balance from outside our market is not a good option for them, given the logistics, disadvantages, and cost implications for pellet suppliers located outside the Great Lakes. Last quarter, I was asked if Cliffs had inability to expand production to fill the shortfall. I brought up the possibility of an Empire mine restart, which will backfill these needs.

However, we will not invest any capital at Empire, unless we can secure a long term take or pay guaranteed contract at a minimum price with a client to lock in the IRR for the benefit of Cleveland-Cliffs. Without this type of arrangement, we will not be bailing out any blast furnaces for their failure to think strategically about their long term raw material needs. And the Empire reserves will remain on the ground. The HBI number one plant will be demanding that full allotment of pellets by the time certain contracts expire at the end of 2020. And if current operation rates hold, someone among the existing blast furnaces will be left starving.

The shift in market dynamics from blast furnace to EAF is something we saw coming long ago. And that's why owning 100% of our HBI number one plant is so important to Cleveland-Cliffs. Thanks to our long term strategic planning and flawless execution, regardless of who prevails in the battle of blast furnaces versus EAFs, Cleveland-Cliffs is set up to win either way.

On our HBI project specifically, the first quarter marked another period of remarkable progress. Like Keith Koci said, we remain on track for a mid-2020 completion. Our budget for the 1.9 million metric tons plant remains $830 million. [indiscernible] has begun and as of this morning, the structure stands about 120 feet high. We have strong controls in place to monitor progress and so far so good.

To illustrate the amount of work being done, right now, we have approximately 600 workers on site. By the end of April, the amount of work hours completed through the first four months of this year will have already surpassed all the hours completed in the entire last year. As for our $90 million project at Northshore, we are close to completion and close to being able to start producing DR grade pellets on a commercial scale at a rate of up to 3.5 million long tons per year.

The DR grade pellets, which are 67.3% Fe and 2% silica are fewer than our center pellets and are tailor made for the direct reduction process in our HBI number one facility. I continue to be impressed with the progress made at both Northshore and Toledo and commend each project team and respective project leaders for the phenomenal work they have done so far. They know that they are on the forefront of bringing Cleveland-Cliffs into the next generation of clean steel making. And we all appreciate very much the great work.

Wrapping up, for the reasons explained in this call, the catastrophic events in Brazil have provoked a radical change in the supply demand dynamics of iron ore and pellets in the main markets and consumption hubs outside the United States, particularly in China, Europe, South Korea and Japan. Furthermore, there's no easy solution for the significant problems created by these catastrophic events. And it is completely unreasonable to expect things to go back to the previous stable business environment.

As a matter of fact, except here in the United States, where Cleveland-Cliffs’ supplies the merchants market for pellets and no steel mill buys, the world is now entering in an extended period of time characterized by massive shortages of iron ore and pellets, affecting virtually all markets outside the United States. And there is no solution in sight to address this, at least for a few years. Going forward, that's the new normal. Welcome to the new normal.

With that, I'll turn it over to Denise for the questions.

[Operator]

[Operator Instructions] Your first question comes from Matthew Fields with Bank of America Merrill Lynch.

[Matthew Fields, Bank of America Merrill Lynch]

Welcome and congrats Keith. Two things for me. One, Lourenco, thanks for the discussion of the iron ore market. Just something that's been surprising to us and just want to get your thoughts on. Obviously, IODEX has reacted quite strongly to the Vale tragedy. Why do you think the Atlantic pellet premium has not reacted a little stronger? It's been kind of hovering in the $66, $67 per ton range.

[Lourenco Goncalves, CEO]

Thanks for the question, Matt. Look, first of all, the biggest company affected by the Atlantic pellet premium is Vale, because Vale is the biggest supplier of pellet or was at least, still is, even with the massive reduction that they provoked in the marketplace, they still are the biggest suppliers of pellets in the international market by a lot less, but is still the biggest. And Vale was leading the negotiations of the pellet premium, the individuals at Vale that were leading the negotiation of the pellet premium, we spent a lot of time moving the goalposts from the 62% iron content to the 65% iron content.

A lot of time was spent with that specific portion of the negotiation. And when that discussion was done or close to be done or exhausted, because they could not get a consensus. But anyway, it was what it was at that time, 65 was replacing 62, then came the catastrophe at Córrego do Feijão, and the same folks that are negotiating had the responsibility for that thing. And they started to have to respond to lawyers and prosecutors and having their houses being raided by federal police in Brazil. And they had a few other things to get concerned about and the pellet premium got abandoned. That's the reason. So I believe that the new Vale CEO one day will take over and we'll finish what they never finished. That's the status of things. It’s coming? That's Vale be focused again.

[Matthew Fields, Bank of America Merrill Lynch]

Okay, thanks. And then one more, just kind of interesting in terms of the history lesson you like to give, you left out a little bit about, in 2015, when you were doing your secured bonds, people often thought about how ArcelorMittal would not renegotiate with you and they would squeeze you and put you out of business. And now it seems like in the next couple of years, with the shortage of long tons in the basin, there might be another dynamic to a weaker blast furnace. Can you just talk about the puts and takes of essentially losing a major customer, potentially if there's not enough tons versus giving a break to keep a kind of a valued customer kind of ongoing in your portfolio?

[Lourenco Goncalves, CEO]

Well, first of all, we never had this discussion with ArcelorMittal. We never threatened each other. Our relationship was always very respectable both ways. We always treated them with the importance that they have for us. And I believe that ArcelorMittal, particularly ArcelorMittal USA always treats us with the same level of respect. We heard a lot of that in our participation in conference from investors, some analysts, but I never heard from the horse's mouth, because if I had heard from the horse's mouth, the outcome of that negotiation was probably very different.

So this being said, the outcome was outcome that had to happen. They had a massive need of pellets, two quarters that they were expiring and we were an able supplier to continue to supply them with no disruptions. We developed the new pellet for them, the must have pellet to invest money at the United. And life is good, we still have 8 few years to go. So if you are implying that ArcelorMittal might be at risk of losing the pellet supply, I would like to remind you that we still have eight years of a good contract going for both of us. The contract is binding on both sides. So they have their supply guarantee that we have our resources allocated for them. So there is nothing to be concerned about.

[Matthew Fields, Bank of America Merrill Lynch]

I was talking about a different supplier who has a contract that's near term expiration that…

[Lourenco Goncalves, CEO]

With whom?

[Matthew Fields, Bank of America Merrill Lynch]

With AK Steel in 2023?

[Lourenco Goncalves, CEO]

Oh yes, the AK Steel has a portion, AK Steel has a portion of the contract expiring by 2020, so does Algoma in Canada. So, there are others, so does ArcelorMittal Dofasco in Canada for a portion of their needs that they buy from us. So these are the three main contract situations that we have defined by 2020. And other than Algoma that pretty much make or break for the other two, it's a portion that's not really the major portion. So I don't see any big issues for AK Steel for that matter. History tells that our relationship with AK Steel continues to be very good. And all things being equal, I don't see a reason for AK Steel to be treated as if they were at risk.

Did I answer your question or am still dodging your question?

[Matthew Fields, Bank of America Merrill Lynch]

No, that's a great answer.

[Operator]

[Operator Instructions] Your next question comes from Curt Woodworth with Credit Suisse.

[Curt Woodworth, Credit Suisse]

Lourenco, I wanted to get your take on the announcement from the union agreement with Bedrock which as you know is 50% owner to acquirer or not acquirer, but to restart at the point or pellet plan which I know you guys used to own. That would seem to imply that there would be more pellet coming into the market, if obviously restarted, do you have -- can you provide some views around that, obviously, you know the asset very well.

[Lourenco Goncalves, CEO]

Yeah, we know the asset very well, we shut it down. And we shut it down because that asset, at the time, we shut it down, was totally hopeless. And the announcement of the Union didn't -- was not really confirmed by Stelco. So I haven't seen Stelco announcing that they are going to invest hundreds of millions of dollars to bring the point to our pellet placed back to operation. They will need to spend a lot of money over there.

It was a lot more money that I was willing to spend in order to keep that thing operating. But, pointing for me was irrelevant, was useless and was an asset that we did not want to handle. It's a high cost profile in Canada, no access to natural gas, operates in a different fuel basis. And it's very far away from the consumption side, the Great Lakes, making for a voyage that's pretty complicated. You have to come down there, down the river to get the pellet here inside the lakes.

With all this being said, I don't sell to Stelco. So for me, it’s not a problem. There was a supply to Stelco, should be thinking about, I just give you the answer based on my knowledge of that asset that for me was totally absolutely useless.

Did I answer your question or you need more color?

[Curt Woodworth, Credit Suisse]

Yeah, no, no, that's helpful. Thank you. And then just a follow-up?

[Lourenco Goncalves, CEO]

But I could give you the color of the roof, the color of the roof there is brown with the holes, so we need to start putting a new roof over there because it has been raining and there is noise inside that pellet going for a long, long time. That’s the extra color I can give to you.

[Curt Woodworth, Credit Suisse]

Yeah. I appreciate it. And then I guess on HBI, can you, I guess, talk to commercial discussions you're having at this point. I mean, clearly, by spending a little capital to get more capacity, you feel very good about uptake. And then in your prepared remarks, you talked about other growth project potential. I mean, do you envision, given your superior crystal ball that there would be potential for a second HBI plant. And can you just talk to kind of your commercial discussions at this point in time?

[Lourenco Goncalves, CEO]

Look, we are not going to talk about second HBI plant until we have the first HBI plan up and running and IRR accomplished and money in the bank. Remember, capital allocation is an exercise of optionality. At this point in time, the best IRR that I can get in this company is not building our second HBI plant, is buying back my stock. It's obvious that, if the market continues to deny value to our equity, the market in the stock exchange every day, I'm going to continue to buy back stock. And the domestic US market will starve for metallics.

They will beg for me to build a second HBI plant and the second HBI plant is not going to happen. Because it's -- again, it's an exercise of optionality and allocation of capital. Our second best use of capital right now would be paydown debt. And we proved that every quarter, it’s not just speech. Remember, we bought $124 million of stock in Q1, and we bought back $10 million of debt. So it's hard for me to tell you that buying back debt and buying back stock is at par, they're not. Buying back stock is a lot more rewarding for the company right now than buying back bonds.

HBI next, while we have one in the making. And you know well Curt, I like shortages. It's good to start with a shortage. So HBI number 1 is reality, we are gearing up to start to deliver great pellets to Toledo. But we are not in a hurry to build HBI number two.

[Operator]

Yeah, I agree. And congrats to the great start to the year.

[Operator]

Your next question comes from Phil Gibbs with KeyBanc Markets.

[Phil Gibbs, KeyBanc Markets]

Lourenco, curious, I think you mentioned in your prepared remarks about various growth options that you had for the company, just curious if you could provide a little bit more color behind what you're thinking there, given you've got a lot on your plate right now with DRI, excuse me, HBI.

[Lourenco Goncalves, CEO]

Yeah. HBI is DRI brick asset. So calling it DRI, if you call my HBI DRI, my HBI will tell, yes, how can I help you? So DRI and HBI are the same guy. But any way, you're talking about the various growth options that we have going forward, if I can disclose a little more color, little more detail. The answer is no. None of those are ripe for disclosure right now. You're going to have to take my word, they exist and we’re studying, that's all I can tell you right now.

[Phil Gibbs, KeyBanc Markets]

Okay. And then what will it take to I guess make a decision one way or another on Empire? I think you were looking at a feasibility study as the last call.

[Lourenco Goncalves, CEO]

The feasibility study has been concluded. The only thing that it takes would be to secure a long term take or pay guaranteed contract at a minimum price with a client. That would lock the IRR of Empire to our benefit. In the past, not too long ago, I was accepting, even if some blast furnace would come and pony up with some equity. And I would give a minority position to these blast furnaces to participate in the restart of Empire.

Well, at this point, I changed my mind. No equity. At this point, if someone wants the pellets that we can produce, we would be able to produce at Empire 3.2 million, 3.3 million tons a year very easily after removing a few layers of overburden, they will have to commit with a long term take or pay contract to assure their long term survival and to assure that you would get a phenomenal IRR out of Empire. Other than that, the taconite they have in the Upper Peninsula in Michigan will stay on the ground.

[Phil Gibbs, KeyBanc Markets]

It's very helpful. And if I could ask just one more strategic question. Lot of the iron alternative projects over the last few years have not gone as planned from a profit perspective or a cost perspective or from a reliability perspective, so if you could give us some perspective or comfort around why your startup will be different and what gives you the confidence that the assets will deliver what you believe they will, thanks.

[Lourenco Goncalves, CEO]

Can I mention the projects that we’re talking about, because these all first.

[Phil Gibbs, KeyBanc Markets]

Let's just say the other HBI or DRI equivalent projects that have happened in the last five years?

[Lourenco Goncalves, CEO]

Well, there's a huge, big, huge, enormous difference between our projects and other projects. You're probably talking about best opinion, right? You got to say it, you got to be courageous. Are those the ones you are comparing to?

[Phil Gibbs, KeyBanc Markets]

Those might be the ones. Yes.

[Lourenco Goncalves, CEO]

So, I will assume they are. You are just not courageous enough to say that we're bashing just opinion, but that's okay with me. So the biggest difference between our projects and the -- not the biggest, but the one clear difference between our project and the local project [indiscernible] is that we supply, we produce and supply our own feedstock, and almost genius feedstock, high quality feedstock is key for a reactor, no matter if it's a blast furnace, if it is a DR – a direct reduction reactor to operate its booth. That's the very first thing.

Well, our feedstock will be produced at Northshore, our pellet plant, coming from pellet, our mine, we have been supplying this, producing this feedstock, improving the quality of this year great pellets day in and day out. We supplied a lot to Nucor in Trinidad and they loved the pellets, the pellets performed extremely well at Nucor in Trinidad. By the way, they have no problems in Trinidad to speak off. We are not either the sole supplier, we're not even the major supplier, we're just one supplier, but they run extremely well when they have good feedstock.

On the other hand, we hear information that for periods of time, best opine in Corpus Christi Texas was feeding their mid racks plant that's very similar to ours with [indiscernible] not even blast furnace pellet that would be an enormous downgrades over DR grade pellets, which DR grade pellets generate BR grade or downgrade and compares with a single source pellet from a reliable producer of pellets like Cleveland-Cliffs.

So you go one step down when you are buying DR grade pellets from the entire market because at the very least, even if you get good stuff, you're going to get good stuff from different sources and the good stuff from one supplier is different from the good stuff from the other supplier, which is different from the good stuff from the third supplier, but then you go one step down, when you can find DR grade pellet and by the way, it has been happening a lot in the marketplace to Samarco, let alone now, with Samarco and [indiscernible] so they can find the upgrade. So the next step, blast furnace pellet, the next step down is [indiscernible] not too long ago. So do get the idea, the idea, so we are going to supply single source Northshore, our pellets, the pellets that we have been improving and I thank Nucor for allowing me to develop a very good DR great pellet. When we develop together with Nucor in Trinidad.

[Phil Gibbs, KeyBanc Markets]

Sounds like the continuity of supply and the proximity to your mind is really what is a nice

comfort factor.

[Lourenco Goncalves, CEO]

Proximity has nothing to do with, I haven't said a word about proximity. I was talking about standard deviation. Remember when we were in school statistics, narrow standard deviation makes the process to go smooth. So on top of narrow standard deviation, I just said today in my prepared remarks that our DR grade pellets will have 67.2% iron content and 2% silica. So they are not low silica content, they are 2%. And, the iron content is not high, it’s 67.2. So we know exactly what we're doing as far as feedstock. That's why the blast furnaces that use our pellets, they get addicted to our pellets.

That's why the DR, the direct reduction operators that get our pellets, they get addicted to our pellets. The problem is that we like that too. And we're going to give total preference to ourselves. So we're not going to start up our first HBI plant and give it a try. We are going to start up the new benchmark for HBI facilities in the world, Midrex is learning. And as we start to operate, they will learn a lot more, as long as I allow them to learn. I don't know that if they will qualify at that time to continue to learn. But so far, so good. They will learn a lot as soon as we start. Very humble assessment of our first HBI client, as you can see.

[Operator]

The next question comes from [indiscernible] from Jefferies.

[Unidentified Analyst]

Maybe just from a debt perspective, if we could get a sense for your updated thoughts on what you think the debt target is. Obviously, you're set up to have a pretty strong year here. But just over the long run, what do you think the appropriate level of debt is for the company at this point?

[Lourenco Goncalves, CEO]

Matt, look, you know I have always been working with the 1 billion notional target for us in terms of net debt. We got that a couple of years ago, when we got to 1.3. But we spent 300 million to acquire our minority position from US Steel, our minority position at Empire from Arcelormittal. So we spent $300 million to do that. So we got to the 1 billion. So even though we have these notional targets of 1 billion net debt, we are always looking to do what we have to do in order to enhance the value of the company, in order to protect in the real sense, the shareholders of the company.

And that's why we decided to spend money, buying back stock. If we had not expand so far $171 million in net debt since the inception of the buyback programs, we would have another $171 million cash in the bank to say, look, we are now, our net debt is now $171 million less than it is as of today, April 25, 2019. So we deal in a real world, we deal with realities. So the notional target for net debt continues to be 1 billion, but it's not something that I will lose sleep off, if I do the right things for this company and continue to protect the shareholders and I'm not talking about guys that keep their stock for a couple months or a couple of days, I'm talking about guys that are shareholders like me, that put their money in this company and forget about. And actually, these are the shareholders that should buy Cliffs’ stock.

This is not a stock for people that go in and out. There's a lot more convenient vehicles for these folks. We are for the ones that understand the dynamics of a business that is long term, that understands that there's only so much of environmental path that the Chinese can get and nobody would question what they are doing. So the day will come that these NGOs and these environmental folks will have to put up or shut up. I mean, they will have to criticize the Chinese or they'll have to confess where these guys get their money from. I bet that this money is coming from sources that are not really great sources. So the Chinese, the environmental, the long term viability of the US steel industry, the high quality of revenues that we have, the long term plan, the strategies that keeps playing out the way we plan. So these are the things, 1 billion notional.

[Unidentified Analyst]

Okay. And just one quick follow up, I guess, more of a housekeeping item, the working capital build, you always sort of use some cash in the first quarter, is a little bigger this quarter, any insight as to whether you get all of that back over the course of the year, just trying to get a sense for the magnitude of the free cash flow. So just any color on working capital would be helpful.

[Lourenco Goncalves, CEO]

Yeah, this year is more of the same. The outflow in Q1 is related to inventory build. Inventory will be recorded mainly in Q3 and Q4. Receivables and payables are dictated by timing. We proceeded to do what we continue to do in this company and the weather change the cash flow of this business at this point. With HBI, this will change, but that’s the design of this company at this point.

I'll take one more question if you have, Denise. Otherwise, it's about time to wrap up. Do we have any questions in the queue?

[Operator]

Yes. Your last question comes from Piyush Sood with Morgan Stanley.

[Piyush Sood, Morgan Stanley]

Quick housekeeping question for me. So about 0.5 million tons of intercompany sales to HBI this year, since there won't be third party, we’ll take it out to EBITDA, just wanted to understand that if the shipment is too half rated, or is it primarily in 4Q? And second, how should we think about the same dynamic next year, where you may look to build some inventory of pellet at the HBI side before you start off third party sales of HBI?

[Lourenco Goncalves, CEO]

You’ve given a lot in one question. So let me see if I was able to memorize everything. The amount of tons that we are going to move to Toledo will be 500,000 tons for this year. And what was the other one about?

[Keith Koci, CFO]

And that'll be in the third quarter this year.

[Lourenco Goncalves, CEO]

Thanks, Keith. What else, Piyush. You gave them too much.

[Piyush Sood, Morgan Stanley]

Sorry, so third quarter this year and what about the extras, maybe some inventory build in next year at the HBI site for DRI, sorry, some pellets coming out from Northshore. So should we expect something similar magnitude in maybe 1Q or 2Q?

[Lourenco Goncalves, CEO]

Yeah, we will continue to direct pellets to Toledo, but that will be on an ongoing basis after we built this brand of 500,000 tons, we feel like we're in good shape, because we're going to start to operate to do the first to commission, the plant and then to do program runs and then hot runs. So and then by mid-year, we will be in operational level. So then it will be an ongoing thing. So this is the biggest thing right now in 2019, 500,000 tons allocated to build the startup inventory.

[Lourenco Goncalves, CEO]

All right. Thank you very much and we will continue our dialog. Don't forget is the new normal. Iron ore and pellets are in shortage. This will not be fixed soon. Headlines will not save your money. What saves your money is good execution, a good plan and good execution. Let's invest together and make money together. You guys have a great two months. We will talk in two months or three. Thank you. Bye.

[Operator]

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