For better or worse, we judge the future success of a company on its past performance. A company growing revenue at a fast clip will get a premium valuation, or a company with a management team that consistently overpromises and underdelivers will sell for cheap. Some of the most difficult companies to value are those that have changed. All too often, they are judged as the companies they were rather than the ones they are and what they could be. It just so happens, though, that stocks like this are where you can find great buying opportunities, as Wall Street is not yet wise to changes that have happened.
Two stocks that look as though they are still being judged based on their former selves despite being fundamentally different are iron ore producer Cleveland Cliffs (NYSE: CLF) and renewable-power yieldco TerraForm Power (NASDAQ: TERP). Here's why investors might be scared off by their respective histories but why you should ignore the past and take a look at these stocks today.
Same product, different company
The commodity boom that happened from the mid-2000s to the beginning of this decade was simultaneously the best and worst thing to happen to Cleveland-Cliffs. It was great because iron ore prices were incredibly high as people panicked about the ability to meet China's seemingly insatiable appetite for commodities. In 2011, the company recorded its best-ever year and was generating more than $1 billion in free cash flow.
The trouble was that all that panic about future supply and all that excess cash turned its management team into a bunch of drunken sailors on leave. Cleveland-Cliffs went on an acquisition binge highlighted by a near-$5 billion purchase of Consolidated Thompson at what was the top of the market. Within 24 months of this acquisition, commodity prices started to slip, and the company was already taking billion-dollar writedowns. To make things worse, management had liberally used debt to finance these acquisitions, so it was sitting on a huge debt pile backed by an asset base with deteriorating value. It was, to be dramatic, a ticking bankruptcy time bomb.
In 2014, activist investors took over the board and installed the current CEO, Lourenco Goncalves. It may not have been noticed at the time, but this was the moment that things started to turn around. Goncalves immediately started shedding billions in unprofitable or noncore assets and wanted to focus primarily on the company's productive U.S. iron ore business. Through a drastic portfolio reconfiguration, significant operating cost cuts, and some well-timed financial moves, the company is now back to generating steady earnings and has a much more manageable balance sheet. In fact, Goncalves thinks enough progress has been made lowering its debt obligations that the company is ramping up spending for new mines in the U.S. and adding new upgrading facilities to meet the changing needs of the steel market. There is even talk of reinstating a dividend.
Investors shouldn't forget that Cleveland-Cliffs is in a cyclical industry and that the ups and downs of iron ore prices will have a significant impact on the bottom line. However, this is no longer a company that looks ill prepared for the ups and downs of the market. With shares trading at a P/E ratio of 6.8 times, investors should look hard at this incredible turnaround story.
Cleaning house with a new manager in place
Speaking of mismanaged assets, TerraForm Power is another example of a company that was in desperate need of better management and received it when Brookfield Asset Management took a controlling stake in it. TerraForm's previous parent organization, SunEdison, had a nasty habit of selling assets to TerraForm at unfavorable rates and loaded up the yieldco with debt to finance those payments. Without yieldcos that could buy assets and take on SunEdison's debt, the parent company succumbed to Chapter 11 bankruptcy.
The thing was, the assets TerraForm Power held were actually quite attractive. They were all relatively new solar installations with power purchase agreements in place for more than a decade, ensuring steady revenue. So, as part of the bankruptcy restructuring, Brookfield Asset Management did what it does best and swooped in to acquire distressed assets at deep discounts. It then set about fixing many of the operational and financial issues it had under SunEdison to shape it in the mold of several of its other partnerships that have been great wealth generators for its investors over time.
The most compelling thing about Brookfield's plan to fix and grow this business is that it can get a whole lot of per-share growth just from improving on what is already there. Management estimates that it can grow cash available for distribution per share by $0.14 to $0.19 -- a 16% to 22% improvement -- just from lowering operating and overhead expenses as well as refinancing with Brookfield's better access to capital. This goes to show the potential sitting on TerraForm's books waiting to be unlocked.
Yieldcos haven't all turned out to be the great investment vehicles many thought they would be, and it has likely kept many investors away from TerraForm Power's stock. With Brookfield calling the shots, though, there is a much greater chance that TerraForm will live up to its promise of being an investment that can deliver a high yield and growing payout for many years to come.
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