Earnings Call Transcript - CLF Q2 2021

Operator, Operator

Good morning, ladies and gentlemen. My name is Diego, and I am your conference facilitator today. I would like to welcome everyone to Cleveland-Cliffs Second Quarter 2021 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. The company reminds you that certain comments made on today's call will include predictive statements that are intended to be made as forward-looking within the safe harbor protections for the Private Securities Litigation Reform Act of 1995. Although the company believes that its forward-looking statements are based on reasonable assumptions, such statements are subject to risks and uncertainties that could cause actual results to differ materially. Important factors that could cause results to differ materially are set forth in reports on Forms 10-K and 10-Q and news releases filed with the SEC, which are available on the company website. Today's conference call is also available, and being broadcast at clevelandcliffs.com. At the conclusion of the call, it will be archived and on the website and available for replay. The company also discusses 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 Cliffs, Executive Vice President and Chief Financial Officer, Keith Koci.

Keith Koci, CFO

Thanks, Diego, and good morning everyone. Our second quarter numbers for revenue, net income, and EBITDA were all quarterly records. They clearly demonstrate our operational and commercial success in integrating the two acquisitions into Cleveland-Cliffs, as well as a sustainable steel environment supported by strong and resilient demand for our products. This being said, our Q2 record numbers: revenue of $5 billion; net income of $795 million; and adjusted EBITDA of $1.4 billion should not be our all-time records for long. With the lagged and fixed pricing mechanisms we have in place with our customers, we have enough visibility to be confident that these records should be broken again here in the third quarter. Drilling down specifically on our adjusted EBITDA, the $1.4 billion performance represented a 165% increase over the past quarter, primarily due to increased steel pricing, fixed-price contract improvements, favorable product mix, and higher volumes. Unlike most of the American steel industry, we have been relatively well shielded from inflationary forces thus far due to our self-sufficiency in raw materials, namely pellets and HBI. More specifically, our overall cost per ton barely moved compared to the first quarter. In the steelmaking segment, we sold 4.2 million net tons of steel products, which included 33% hot-rolled, 17% cold rolled, and 30% coated with the remaining 20% consisting of stainless, electrical, plate, slab, and rail. Due to the lighter automotive demand pool related to the chip shortage, we were able to sell more tons of higher-margin material into the spot market. Direct automotive shipments were about 1.2 million tons during the quarter, about 300,000 tons less than what we anticipated back in March. This contributed to an inventory build of about $300 million during Q2, which along with rising receivables due to rising prices, produced another working capital build during the second quarter. Our free cash flow generation will certainly be further increased in the third quarter. We expect to generate $1.4 billion in cash from our expected $1.8 billion in adjusted EBITDA for the third quarter. These numbers result from continued rise in prices on our HRC linked contracts and spot sales, offset by higher employee-related costs and the planned outage at our largest blast furnace Indiana Harbor Number 7. Furthermore, we are increasing our full year adjusted EBITDA guidance to $5.5 billion. Our free cash flow expectation still includes minimal federal cash tax disbursement as a result of our NOL position. Given our immense profitability so far this year, we have been able to effectively utilize our sizable NOL balance, and we'll continue to utilize it for the rest of the year. With these NOLs rapidly being used, we expect to become a federal cash taxpayer again at some point either later this year or early next year. Our main priority with this free cash flow continues to be the pay down of debt. The level of free cash flow we are expecting has created a generational opportunity to completely de-risk our balance sheet, and we are taking full advantage. In the second quarter, we made open market bond repurchases and completely redeemed the remaining $400 million of our 2025 unsecured notes, the only bond we had that was callable this year. Our debt-to-cap ratio is currently at a nine-year low, and we have already repaid another $455 million in debt during just the first 20 days of July. As the year progresses and into next year, we will be rapidly and methodically reducing our debt balance, and we expect to reach net debt zero sometime next year. With that, I'll turn it to Lourenco.

Lourenco Goncalves, CEO

Thank you, Keith, and good morning to everyone. The best way to understand the new Cleveland-Cliffs is by comparing Q2 results with Q1. Our revenue line increased by $1 billion, and our cost of goods sold increased by just $100 million. The seamless and complete integration of both AK Steel and ArcelorMittal USA into Cleveland-Cliffs has generated a new and very efficient business model geared toward value creation. Demand for steel is very strong across all sectors, and strong demand supports strong prices. Q4 2020 was supposed to be the peak for steel prices, then Q1 2021, and then again in Q2. Well, we are in Q3, and the reality is demand is relentless. Most of our customers are experiencing record profits and learning that higher prices are good for pretty much everyone in the supply chain. Actually, some of the customers who were complaining earlier this year about rising steel prices then turned around and decided to accept the reality. They cut deals with Cleveland-Cliffs at that time and are now just plain happy. Others probably will be unhappy for a long time. Also, as new electric arc furnace capacity continues to be brought to operation in the United States and abroad, the notion that prime scrap is precious metal will be better understood. Iron ore fundamentals are strong as well, keeping the price of pig iron imported by the mini mills elevated and also pushing up the pricing of steel offered by foreign sources. Russia is restricting exports of ferrous materials including pig iron, of which they are the largest exporter to the United States. China continues to say that they want to cut emissions, which they can do by either cutting steel production to reduce sinter usage or using more scrap or both. With all that, the trend on the price of prime scrap is also upward. Separately, investments towards decarbonization will need ROI, return on investment, unless you operate in Europe, in Japan, or in Canada. Steel companies in these countries and continent are being awarded general subsidies and free money like grants. Canadian and European steel producers are so happy to advertise as they get their gifts and handouts from their respective governments. That's another compelling reason why imports need to be held in check as other countries take advantage of a totally uneven playing field with their much worse environmental performance than ours in major government subsidies that we don't get here in the United States. China is not our only problem; our so-called friends are bad too. While all of our relevant Q2 figures represent company record revenue, net income, adjusted EBITDA, I would add we haven't reached our full potential yet. Due to previously agreed upon sales contracts so far this year, we have sold a significant chunk of our volume well below price levels that would make us comfortable. Our most important commercial priority through the end of this year will be to improve these contracts. We know the real value we provide to the clients, including but not limited to our ability to manage complex, just-in-time requirements in several different highly specified products. We also know the unique technological capabilities that we have and the limitations of others in the steel industry that cannot match what we do, particularly at the massive scale that we do. Simply stated, it's time to be awarded a better return on our capital invested to serve these clients and we are well underway to achieve that. Being the largest supplier of steel by a lot to the automotive industry, we are obviously affected by the supply chain issues they have experienced, all related to things other than steel. Nevertheless, our Q2 results were actually better than our guidance among other reasons because we were able to take advantage of the reduced demand from these customers and managed to divert automotive volume to spot buyers or to other contract clients willing to pay market-level prices. When stated like that, it sounds simple. But reorganizing both the melt schedules and deliveries of these materials was a challenge that our team did a great job overcoming during the quarter. Even with all the difficulties in finding available rail cars, trucks, and truck drivers during the quarter, we were still able in Q2 to increase our shipment volume in comparison to Q1. One thing that should not be holding up anything any longer is COVID-19. Brilliant scientists have developed not one, but several truly groundbreaking vaccines that would stop the virus in its tracks and any current variants. But we need enough people taking the vaccines. With the safety of our workforce always a top priority, earlier this month, we instituted a company-wide vaccination bonus program that offers a cash bonus of $1,500 to each vaccinated employee if the level of vaccination at their working sites achieves 75%. If the level of vaccination at the site achieves 85%, the cash bonus paid to each employee of the site doubles to $3,000. Upon announcement of the program, we saw an immediate uptick in vaccination rates. Some of the locations are already at the first threshold with two locations already at a second threshold of 85%. Protection from the virus is just as important as any other safety mandates we have in any of our locations, and we are willing to spend real money to ensure each of our facilities reach herd immunity. In order to meet current market demand, our assets need to be well-staffed and well-maintained. This process involves pre-planned maintenance outages, including the one taking place at Indiana Harbor later in this quarter from September 1 to October 15. Indiana Harbor 7 is the largest blast furnace in North America and for reference produced 33% more hot metal per day than our two blast furnaces at Cleveland works combined. The outage includes repair to two BOF converters in the steel shop and a partial reline in several upgrades to the blast furnace. Some of these upgrades are related to our ongoing work towards decarbonization such as further enhancements to our ability to use massive amounts of both HPI SP stock and natural gas as supplemental reduction at Indiana Harbor Number 7 blast furnace. Another success story of the past quarter is our Toledo direct reduction plant. We reached our nominal capacity within six months of start-up. And thus far in July, we are producing at a 2.1 million tons annualized rate well above nameplate of 1.9 million tons per year. Our timing could not be better. Prime scrap is scarce. And every day the price of scrap goes up, our cost savings from HBI becomes more significant. On top of that, we have actually used the vast majority of our internally consumed HBI in our blast furnaces enhancing hot metal output and allowing us to capture additional margin on incremental steel tonnage produced and sold to clients. Along with the productivity benefits this action alone reduced our implied carbon emissions by 163,000 tons during the quarter. Direct reduction and degrade scraps are critical to the future evolution of a clean and environmentally friendly steel industry. Cleveland-Cliffs sees decarbonization as part of our license to continue to exist. As you can see in our recently published sustainability report, we are well on our way to achieving our targets through the combination of natural gas usage, HBI production, and internal usage and carbon capture. There's a lot of talk about hydrogen as a reduction in Europe with little recognition that we already use hydrogen in the United States through the use of natural gas. Natural gas composition is 95% CH4 methane and 4% C2H6 ethane. Natural gas is used in our blast furnaces as a partial replacement for coke. That means we emit good old H2O when we reduce our iron ore. And CO2 ambitions are cut by more than half when compared to reduction exclusively by coke or coke plus PCI. Also, our direct reduction plant uses 100% of natural gas as a reduction. The total amount of natural gas we currently use in our eight blast furnaces and in our direct reduction plant, eliminates the need for 1.5 million tons of coke per year, the equivalent of two coke batteries. And we continue to explore and increase the use of natural gas throughout the entire footprint. Hydrogen is promising; actually, our direct reduction plant was designed and built to be able to use up to 70% hydrogen. But in order to make hydrogen a viable reduction method, serious cost improvements and breakthrough technical developments are still needed. Europe does not have abundant natural gas other than in Russia. So they have embraced the hydrogen route even with the current uncertainty surrounding the economical use of hydrogen. That might not take them anywhere as far as emissions control, but is actually a great shortcut for free money and more subsidies from government to companies. And we all know how these things end. Replacing blast furnaces with EAF is not a solution either. There are technical reasons. No major steelmaking nation runs entirely on EAFs. When producing flat-rolled steels, EAFs need a significant amount of virgin material like pig iron, prime scrap, DRI, HBI, and even oxygen injection just to try to mimic the blast furnace BOF route. In reality, even here in the United States soon to achieve 75% participation of EAFs, we may be near a peak, particularly, if further investments in direct reduction are not made. Just don't count on Cleveland-Cliffs for that. This ship has sailed when we acquired ArcelorMittal USA and AK Steel and successfully integrated both into a single unit company named Cleveland-Cliffs. At this point, we are very comfortable using our degrade pellets to exclusively supply our plant in Toledo, and our blast furnace great pellets to supply our own blast furnaces. To wrap-up, Cleveland-Cliffs is doing well, actually very well. As of today, our leverage is already below one-time EBITDA, and we expect to be at net debt zero sometime next year. With that, I'll turn it over to Diego for the Q&A. Diego, please.

Operator, Operator

Thank you. And at this time, we will be conducting our question-and-answer session. Our first question comes from Phil Gibbs with KeyBanc Capital Markets. Please state your question.

Phil Gibbs, Analyst

Hey, good morning.

Lourenco Goncalves, CEO

Good morning, Phil.

Phil Gibbs, Analyst

Lourenco, I had a question just on the automotive piece of the equation. I think the revenues declined there a little bit, and you mentioned some chip issues impacting production. How is that evolving as you look into the back half of the year? The automotive supply chain has been kind of tough to read from our vantage point.

Lourenco Goncalves, CEO

I agree. You can only work with the information available, and the details being shared are not very good. Here at Cleveland-Cliffs, we are no longer depending on our clients for insights; some clients provide better information than others, but generally, we are focusing on our own evaluations of how they will manage their just-in-time inventory. From an external perspective, they tend to be overly optimistic while actually hedging their positions in case they receive what they need and then require the steel. Our primary commitment is to our shareholders, and we cannot overlook that responsibility. That's why we shifted a significant amount of tons in Q2 from automotive to other clients, which turned out to be beneficial for us. This kind of maneuvering is something we can achieve by effectively managing our fully integrated and synergistic company like the new Cleveland-Cliffs. In my view, conditions will improve; they will not worsen. Lessons must be learned from current situations, and issues like the microchip shortage reflect that the supply chain is fragile and overly complex. I expect that moving forward, the automotive OEMs will enhance their supply chain management, focusing more on practical aspects like being near their suppliers and recognizing the importance of short-term solutions rather than depending on ports. Therefore, I am quite optimistic about improvement ahead.

Phil Gibbs, Analyst

Okay Lourenco. And then as we look at the third quarter, I know you've got some scheduled maintenance. Is that from an incremental standpoint versus the second quarter kind of a transitory cost headwind for you all as you have more maintenance in there, or is that really not a factor?

Lourenco Goncalves, CEO

It's minor. It's minor. And at the end of the day what matters is that all numbers that we gave as guidance, they are already embedding all these things. So, we are talking about $1.8 billion EBITDA in Q3, and Keith Koci just released our full year guidance of $5.5 billion for 2021. So, that implies another $1.8 billion EBITDA in Q4. So, all these two numbers Q3 Q4 EBITDA of $1.8 billion are a setting stone at this point the way we normally do our assessment and all these cost fluctuations are taken into consideration. The important thing is that a lot of the reliability that the clients are seeing right now and the way we supply from our big footprint is already a consequence of how we approach maintenance. We are taking very good care of the assets that we acquired, and we are playing extremely well with production planning and making sure that we are prepared for all the planned outages. For example, this one in the Indiana Harbor No 7 with a 45-day duration, we of course, already built a lot of slab inventory. And a lot of what you see in cash flow is related to that cash flow in Q2 because we had to prepare for this outage. Otherwise the client would not be taken care of. So, our holistic approach to the footprint, our technical and matter-of-fact approach on how to deal with the assets is a big change. I think it's a very welcome change to this industry since we acquired the assets that we did last year.

Phil Gibbs, Analyst

Thanks. And if I could ask just a follow-up just on the guidance that you guys have provided the $5.5 billion. There's some puts and takes. What's the expectation for hot rolled for the rest of the year in that equation? Thanks guys.

Lourenco Goncalves, CEO

We are using the available data from the commodity forecasts of the major banks and sticking with our previous assessment. There is nothing particularly negative or overwhelmingly positive about it. We are simply relying on the same forecast that you and other research analysts probably use, based on the forward curve of commodities from the leading providers.

Phil Gibbs, Analyst

Thanks, Lourenco. I appreciate it.

Lourenco Goncalves, CEO

All right. Thank you, Phil.

Operator, Operator

And our next question comes from Lucas Pipes with B. Riley Securities. Please go ahead with your question.

Lucas Pipes, Analyst

Hey, good morning everybody, and congratulations on another really strong quarter and a very positive outlook from my perspective.

Lourenco Goncalves, CEO

Thanks Lucas.

Lucas Pipes, Analyst

Lourenco, I wanted to touch a little bit on the net debt target of zero. It makes all the sense in the world to me. But maybe the market could benefit from getting an explanation from just what is the strategic rationale for a net debt zero target? Thank you very much for your perspective.

Lourenco Goncalves, CEO

Lucas, first of all, having zero net debt in a cyclical industry shouldn't come as a surprise. I've been in this business for forty years and have experienced everything from the good to the bad and surprising. One undeniable fact is that we are in a strong position regarding our balance sheet. This puts us in a much better spot to navigate downturns if they happen. While I don’t foresee any downturns, it's important to be prepared, especially since we didn’t see COVID coming. Our reaction during that time was evident with the two acquisitions we made. We also don’t ignore reality; I had to adapt operations by reducing output and shutting down the blast furnace, and construction in Toledo had to stop due to safety concerns. Realistically, achieving zero net debt is a positive goal, and we have the opportunity to reach it. That’s why it is our target. However, we remain open to other possibilities. For instance, given the recent stock price performance, I am now considering fully redeeming the ArcelorMittal preferred shares for cash—something I haven't previously thought about. I understand the market is skeptical about certain things, but I know we're set to receive $1.4 billion in cash in Q3 and another $1.8 billion in Q4. This cash will allow us to act and could be beneficial for ArcelorMittal. While I’m not committing to this action, I am contemplating redeeming the preferred shares in cash. So, while zero net debt is a goal, it's not our sole focus; it’s just a reasonable objective for a company that has acted sensibly. Apologies for the lengthy response.

Lucas Pipes, Analyst

No. That's very, very helpful. And I appreciate that perspective very much. My second question, Lourenco, is in regards to the fixed price contracts. You touched on those in the remarks and in the release this morning. And I wonder, just in terms of contract structure, what is on the table here? Could we be seeing some index pricing with some of your auto customers later this year? Is that a possibility, or how would you describe these negotiations at this point? Thank you very much.

Lourenco Goncalves, CEO

Lucas, I think you appreciate that I'm not going to say publicly or any outside conversation about how we are actually negotiating with the clients. That's off limits. So we are not going to talk about that. I would just say that, people still talk about synergies and things like that. If there's one synergy that people can deny that we accomplish are commercial synergies. So we are now a much stronger commercial animal than either of the three companies that were behind the new Cleveland-Cliffs have ever been. We are in good shape. And we are doing everything we need to do to the business, to the shareholders, to the balance sheet and to the debt holders. So at the end of the day, everybody will be happy, including the clients. I'm not saying that all clients would be happy. I'm prepared to dump a client if I need to. That's another thing that in the past I am 100% sure that AK Steel never considered, because they believed that if they did, ArcelorMittal would certainly go there and grab the business and vice versa. That opportunity is gone. And I'll leave it at that.

Lucas Pipes, Analyst

Lourenco, thank you very much and continue. Best of luck.

Lourenco Goncalves, CEO

Thank you.

Operator, Operator

Thank you. Our next question comes from Tristan Gresser with Exane BNP Paribas. Please go ahead with your question.

Tristan Gresser, Analyst

Yes. Hi. Good morning. Thank you for taking my question. Maybe first a quick one on the outlook for maybe working capital in H2. Obviously, you had a big deal in Q2 as you mentioned to prepare for the outage. What should we expect for H2? Maybe more neutral release given the outage? And also, if you can touch on if anything has changed regarding CapEx for next year as well. Thank you.

Keith Koci, CFO

Yes. Sure, Tristan. So the working capital, the two big factors are receivables and inventory. Receivables will really just be dependent on pricing. So whatever pricing assumption is used for the rest of the year is the way the receivables will go, because volumes are likely to remain similar to where they are now. So probably, it depends. Prices go up, receivables will go up, and if prices were to move down, we don't expect that. But if they were then the receivables will come down. So but more than likely, you're just looking at flat for the rest of the year on receivables. Inventory same thing; it's going to depend on if and when the automakers can pull – pull the additional demand to catch for the chip shortage. We do have a small inventory build for them ready to go. So if they can pull, we can probably release a couple of hundred million out of inventory, if the chip shortage goes into next year then that might sit and go into next year. So it's – again, it's going to depend on how our customers produce here in the second half, as far as CapEx, we would – we haven't developed our 2022 CapEx forecast yet. At this point for modeling purposes, we would assume just to use a similar number to what we are heading to this year. We're heading to about a $650 million number this year. So at this point, that's probably a good number as well to use for 2022. But we'll be updating that number as we continue our analysis and our budget process for 2022. And we'll make an update in the coming quarters.

Tristan Gresser, Analyst

All right. Thank you. If I may follow-up regarding your environmental targets to reduce emission, I think minus 25% by 2030. You talked about the interesting use of natural gas, but also I think energy efficiency, carbon capture, and storage. Between all those options is there really one that stands out that would enable you to achieve most of the gains in terms of CO2 reduction? And also, when you look at this time frame is there any CapEx gross CapEx associated with those efforts? And lastly, I think the US government is also kind of preparing to help the industry to decarbonize. Do you expect to receive some kind of formal help or financing as well? Thank you.

Lourenco Goncalves, CEO

I'm sorry. Expect to achieve what? Say it one more time.

Tristan Gresser, Analyst

Your carbon emission reduction 25% by 2030.

Lourenco Goncalves, CEO

Yeah. We are totally confident that we are getting there. And we also will continue to refine these numbers toward targets for 2035, 2040, 2050. We're going to get there. But I don't feel like at this point, there is any need other than for press release purposes to be stating that we will be carbon neutral by 2050 because nobody knows at this point. That's it. Every single company that committed with that are just telling what people would like to hear. My 2030 number is real, as real as my net debt zero target, as real as my $9 billion in revenues year-to-date, as real as my EBITDA year-to-date. That is a number that nobody could have imagined six months ago. That's how we do things. We are in the United States, Tristan. You guys in Europe, you guys talk a good game. But the best contribution that Europe can really give to the decarbonization of the world is not in subsidizing losers and mavericks that come with proposals, just to keep people employed. So Europe sucks from the environmental standpoint. So we are real here in the United States. We have the best footprint. We have the best carbon compliance in the entire world. Europe is light years behind. Japan is light years behind. Korea is light years behind. And China doesn't even make it to the picture yet. That's the reality. People will start to see that in the very near future. Did that answer your question?

Tristan Gresser, Analyst

Yes. Kind of. Just one quick follow-up.

Lourenco Goncalves, CEO

But what part did you not understand? I'll tell you that the plants that are talking a good game should be shut down by now. Spain this folks. You are in Europe, right? You're out of London?

Tristan Gresser, Analyst

Yes, yes.

Lourenco Goncalves, CEO

Yes. So you know what I'm talking about. You know. You know better than anyone on the call. But you get the same. So keep doing. Be my guest.

Tristan Gresser, Analyst

So one follow-up I had was just on the elements you can leverage to decarbonize. And you talk about natural gas, and I think it's really interesting. But for your targets, do you – would you say that natural gas will be, I don't know, more than 50% of all the reductions you can realize or carbon capture and storage is also a part to play in energy efficiency as well? Just trying to figure out the different elements in that target. Thank you.

Lourenco Goncalves, CEO

Yes. Natural gas is hydrogen at the end of the day. Look at the proportion of carbon and hydrogen in the CH4 and CH286. Think about the chemical reaction to reduce iron ore in a blast furnace or in a direct reduction reactor, when you use coke alone produces CO as a reduction or reform the natural gas when you produce a lot of H2 and a little bit of CO that will be transformed in CO2 only in minor proportion. So natural gas is the way to decarbonize the steel industry, the only technologically dominated way at this point. Everybody else that's talking about anything is just technologically speculating. That's the story we are doing right here. When people are talking about I put $1 billion in a plant that nobody believed that would be a game changer. So much of a game changer that made us able to change the landscape of the American steel industry by consolidating the two best mills in the integrated route and supplying them with HBI. HBI, that was never considered a feedstock for blast furnaces other than a weak attempt to buy it that I don't know if it plays out or not because nobody hears about – because of the problem that I have just mentioned to you about the European steel. So – but look it takes time for people to see things. I am a patient guy. I never fight to take. So I'm always ready to take advantage of the weakness of investors. They give me money to take it. I'll leave it at that, Tristan. All right. Thanks. Appreciate it. Diego, who is next?

Operator, Operator

Thank you. And our next question comes from Matthew Fields with Bank of America. Please go ahead.

Matthew Fields, Analyst

Hey, Lourenco. Hi, Keith. A couple of questions on the cash flow balance sheet side of the house. Clarification on that $455 million of debt retired in July. Is that mostly ABL? Is that some additional market repurchases of bonds? And then how do you anticipate using that kind of free cash flow that you're telegraphing for debt reduction on ABL versus open market repurchases? None of the bonds are callable until 2022. So, I just wanted to get a sense of the trajectory there for the rest of the year.

Keith Koci, CFO

Yes, Matt. So far, the entire $455 million has gone to the ABL this quarter. We will consider open market repurchases when possible, but our main focus will be on the ABL where most of the funds will be allocated. However, we will take advantage of opportunities in the open market when they arise.

Matthew Fields, Analyst

Okay, great. That's very helpful. Thank you. And then second on the MC&A preferred stake. You don't have to do anything until December 2022. I guess you have a free option on deciding what to do then before that starts paying dividends. But now that you're considering paying it in cash, I guess at $20 a share roughly that's $1.1 billion, $1.2 billion proceeds if I'm correct. Does that affect the net debt zero target in 2022 if that's now considered to be paid in cash versus retired with equity?

Lourenco Goncalves, CEO

Based on our current projections, if we choose to pay down the entire tranche of preferred shares in Q3, it would push our net debt zero achievement back by one quarter. We previously stated that we would reach net debt zero within 2022, and that remains unchanged, though it may now be delayed by one quarter. Instead of achieving this by Q3, it will now be in Q4. It still falls within 2022, which is the bottom line at this point. However, opting to pay the preferred now and using the $1.1 billion mentioned is not ideal, because if we don't proceed with it, we might be looking at a $2.2 billion payment in the future. If you truly believe we will continue to trade at this absurdly low price, feel free to think that way. However, you're aware that this isn't the current situation, right? You're with Bank of America, correct?

Matthew Fields, Analyst

Well, I know not to fight Lourenco on the tape. So, thanks for the clarity on that. And it's just a stunning kind of to see where the company is now versus a few years ago. So, thanks very much for the questions. Appreciate it and good luck in the rest of the year.

Lourenco Goncalves, CEO

I appreciate that very much the support. And you are in the bonds, and it's always great to have a good partner within Bank of America. Thanks Matt.

Operator, Operator

Thank you. Our next question comes from Karl Blunden with Goldman Sachs. Please state your question.

Karl Blunden, Analyst

Hi, good morning. Thank you for your time. I wanted to follow up on the net debt zero position you expect to achieve in 2022. This gives you a lot of options, and you've mentioned a few of them. At what point do you think about speeding up your decarbonization investments or possibly reducing pension liabilities?

Lourenco Goncalves, CEO

Let's start with the accelerating decarbonization. We continue to work with a plan that was put in place in 2017. I don't know where you're coming from, but we are the only ones who have already implemented actions instead of just talking about them. You understand that we are using 54% of our internal usage of HBI in the blast furnace, right? When you put more HBI inside the blast furnace, you are adding more pre-reduced iron. If it's pre-reduced, you require less reduction, which means you are emitting less carbon. Consequently, you are generating less CO. This is happening as we speak. Additionally, I mentioned that one of the guidelines for the Indiana Harbor 7 outage starting September 1st is to enhance our ability to use more HBI and more natural gas over the next two years. This will reduce scope and fuel usage. It seems like you feel we are not doing enough for decarbonization.

Karl Blunden, Analyst

No. I think you guys are a leader on the HBI at least as far as blast furnaces are concerned. But at some point, you might have an opportunity to make another big investment either EAF or additional HBI capacity?

Lourenco Goncalves, CEO

In order to invest in HBI capacity, I need to be short in HBI. I'm not shorting HBI just yet. So I'm still pretty much in line. By the end of this year, I will have zero HBI to sell to the market because internal consumption will be pretty much equivalent to my two-point something million tons production a year. So they are going to be even in terms of our internal consumption. So at that point we might consider. As far as investing in EAF, they're going to need to have to invest in HBI because if you follow my line of thought there's a scrap shortage in the making, particularly for highly specified products that was kind of ignored by others. That's another thing that I can't prove right now. You're going to have to bear with me. So one more year, two more years to be crystal clear. But that's the history of my life. And I'm not surprised that you are not there with me just yet. And another thing last but not least, we are very comfortable with the footprint that we have. We are generating a lot less yield than any other integrated steel mill in the entire world right now as we speak. I'm talking about Nippon Steel, JFE, and we are going to continue to reduce the CO2 generation and we're going to implement carbon capture. No, there's not planning to go EAF. I'm not going to tell you what you'd like to hear. And Goldman Sachs needs to move on from these concepts that are wrong.

Karl Blunden, Analyst

No. I got you. I mean you guys are doing a lot of different areas. I'm just thinking about different…

Lourenco Goncalves, CEO

I'm sure you did not get.

Karl Blunden, Analyst

…uses of cash.

Lourenco Goncalves, CEO

But you will get in six months, one year, two years, you and Goldman Sachs.

Karl Blunden, Analyst

No. A lot of that makes sense. In terms of what you're using cash for you discussed the preferred. Is there any intended use or potential use of cash for pension obligations some of the acquired obligations for example?

Lourenco Goncalves, CEO

Yeah. Keith will take that.

Keith Koci, CFO

Right now, our balance sheet includes the pension and the OPEB. The pension obligations are currently decreasing, and our asset returns are exceeding all other pension costs. We anticipate pension funding requirements to be below $20 million annually moving forward, essentially making it negligible. Regarding retiree health and OPEB, the cash funding needed is under $200 million a year, which we consider manageable for a company of our size. We believe we can meet these obligations over the next 40 to 50 years without the need for pre-funding, as it would not be the most effective use of our capital.

Karl Blunden, Analyst

That's helpful. I guess the one quick follow-up is on I haven't seen a gross debt target. It sounds like you could continue being flexible there. And you wouldn't really want to put that out there because I think it would commit you to taking out bonds at given points in time. But is there anything you can share around gross debt?

Lourenco Goncalves, CEO

Yes. You already answered your own question yes.

Karl Blunden, Analyst

All right. Thanks.

Lourenco Goncalves, CEO

Who’s next?

Operator, Operator

Our next question comes from Lucas Pipes with B. Riley Securities. Please go ahead with your question.

Lucas Pipes, Analyst

Thank you for following up, Lourenco and team. This is a somewhat broader question, but if you take the guidance for the second half and double it to annualize, then based on your net debt target, it results in 1.5 times EV to EBITDA. This clearly suggests that the market anticipates a rapid decline in steel prices. Lourenco, could you provide your insights on how the steel markets in North America differ from others, and how this may compare to other commodities that have already fallen? Thank you for your thoughts.

Lourenco Goncalves, CEO

I am not sure what other commodities you might be thinking of, but if you're referring to items like copper, then the differences are significant. It simply doesn’t apply in this context. Additionally, it's important to recognize that much of what is labeled as a commodity in our sector is actually very specialized material that cannot be easily substituted. This is often misunderstood in the market. A relevant point from our merger with AK ArcelorMittal USA last year highlights this, as we find ourselves in negotiating positions where we have considerable leverage. We are not working with generic products; rather, we handle highly specified components that can significantly impact development. I'm not claiming we will leverage this advantage, but it is a notable reality. There is a significant difference between commodities like pork belly and specialized advanced high-strain steels designed for specific applications. Furthermore, it's one thing to discuss the capability of a facility or company to scale up production, but managing a supply chain with roughly 5 million tons of complex parts per year to ensure timely, quality metal flow into assembly lines is a colossal undertaking. This is compounded by the fact that every few years, we have to overhaul everything to keep up with new models. We are currently planning for developments slated for 2025, 2026, and 2027. This is a continuously evolving challenge. If someone asks why this hasn't been achieved before, I honestly don't know, as I always believed it was possible. Since we took action last year, I see every day that it is feasible, and we are making progress. However, the real results will speak for themselves. Therefore, I am ready for any possible outcome in the market. If it works well, great; if not, I will still strive to do what is best for my shareholders and bondholders, as well as for my clients based on the market conditions.

Lucas Pipes, Analyst

Very, very helpful. Lourenco, I really appreciate that additional color, and continue best of luck.

Lourenco Goncalves, CEO

Thanks, Lucas.

Operator, Operator

Thank you. Our next question comes from Sean Wondrack with Deutsche Bank. Please go ahead.

Sean Wondrack, Analyst

Hey, guys. And really nice job quarter again.

Lourenco Goncalves, CEO

Hey, Sean.

Sean Wondrack, Analyst

First question just when you take a look at the 9, 7 in secured notes you have outstanding are there any other means other than open market purchases, where you could redeem that tranche below the make whole price at this point in time?

Keith Koci, CFO

Yeah. Sean, they're callable next year. So the call periods opens up I think in the first quarter of next year. So between now and then not a whole lot of options on that tranche.

Sean Wondrack, Analyst

Got you. Okay. Thank you. Appreciate that. And then just with the massive debt reduction that's ongoing right now. I know, this is probably a hard question to answer. But is there a rough idea what the potential interest savings could be there? I mean, I think you paid a pretty considerable amount of interest last year. And obviously, that's going to come down at time.

Keith Koci, CFO

Yeah. I mean, it depends on where we go. So the ABL is obviously our lowest-cost debt. So as we pay down the ABL, we're saving about 2% on that. And then as we – we took down the 25s in the second quarter and that was – those were 5.75%. So it depends on the order, and how we do it. But yeah, you're going to see a sizable reduction. It will show up more kind of starting early next year than it will this year. But yeah, there will be a sizable reduction in our cash interest costs starting in –

Lourenco Goncalves, CEO

Yeah. But look to say at this point, that we are paying an enormous amount in interest expense it's not really reflecting the reality of the numbers. Look, we are talking about a company that will have revenues in the $20 billion level. So we have one trust that, I don't like. And that's the trust that we put in place at the peak of the pandemic. And that one is not callable. And that one is the biggest candidate for me to bite the bullet and pay the make whole. Everything else we'll manage, because all other tranches are priced in perfection. Remember, we are pricing at BB level when we were B minus. We are now pricing at a BBB level when we're a BB. And we have no plans to issue. And we know that there's an issue that right now will be very cheap. So, no, we are in good shape. Our debt is not a problem right now. Our debt is good.

Sean Wondrack, Analyst

Right. No. That makes a lot of sense and that kind of helps us frame on the gross debt side. That you want to keep some of this capital outstanding because it's low cost which makes sense.

Keith Koci, CFO

Yeah.

Sean Wondrack, Analyst

Just my last question, if I may in the M&A market. We saw Nucor made a small downstream acquisition I think yesterday. Another one of your competitors recently mentioned the potential for a pickup in the M&A market. Obviously, you got way ahead of the curve with your transactions last year and that's shown up in the P&L. But can you just maybe provide some thoughts on after you get through your debt reduction goal? Sort of what your capital allocation priorities are there?

Lourenco Goncalves, CEO

Our redemption of the ArcelorMittal preferred is the first step, and I'm pleased to see other companies engaging in mergers and acquisitions, even if they aren't at the level we have been. Smaller developments are positive as well. We will only discuss our own plans once they are finalized, so we don't have any updates at this moment, Sean.

Sean Wondrack, Analyst

Okay. Thank you very much for answering my questions.

Lourenco Goncalves, CEO

Thank you. Thank you.

Operator, Operator

Thank you. There are no further questions at this time. I'll turn it back to management for closing remarks.

Lourenco Goncalves, CEO

Thank you very much. I appreciate the interest and we will keep in touch. Bye now.

Operator, Operator

This concludes today's conference. All parties may disconnect. Have a great day.