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Edited Transcript of CLF earnings conference call or presentation 25-Apr-19 1:00pm GMT

Q1 2019 Cleveland-Cliffs Inc Earnings Call

CLEVELAND Apr 26, 2019 (Thomson StreetEvents) -- Edited Transcript of Cleveland-Cliffs Inc earnings conference call or presentation Thursday, April 25, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* C. Lourenco Goncalves

Cleveland-Cliffs Inc. - Chairman, President & CEO

* Keith A. Koci

Cleveland-Cliffs Inc. - Executive VP & CFO

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Conference Call Participants

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* Curtis Rogers Woodworth

Crédit Suisse AG, Research Division - Director & Senior Analyst

* Matthew Vittorioso

Jefferies LLC, Research Division - Analyst

* Matthew Wyatt Fields

BofA Merrill Lynch, Research Division - Director

* Philip Ross Gibbs

KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst

* Piyush Sood

Morgan Stanley, Research Division - Research Associate

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Presentation

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Operator [1]

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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. (Operator Instructions) The company reminds you that certain comments made on today's call will include predictive statements that are intended to be made as forward-looking within the Safe Harbor 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 clevelandcliffs.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'd like to introduce Lourenco Goncalves, Chairman, President, and Chief Executive Officer.

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

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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 in Metals USA. He was Director of budgeting in 2003. At the time, we listed 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 IPO-ed Metals USA in 2010 and listed the company on the New York Stock Exchange. And he was my most valuable player when we sold Metals USA to another publicly traded company Reliance Steel & Aluminum in 2013. Keith 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 1 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 will turn it over to Keith Koci for the financial overview portion of this call. Keith?

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

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Thank you, Lourenco, and good morning to all of you listening in on today's call. After about 2.5 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 netback 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 Northshore 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 $667 -- $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 1/3 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 1/3 of the entire year.

Similar to last year, our first quarter cash cost 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 the full year cash cost to trend closer to the higher end of our cost 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 forecast. 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 noncash ARO accretion.

This amount will be slightly, but not materially, higher over the next 2 quarters. On the cash flow front, as customary, during the first quarter, we build 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 Northshore DR upgrade project.

Next year, total expected CapEx should be down 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 0-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 4 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.

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

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Thanks, Keith. Throughout my nearly 5-year tenure as CEO of Cleveland-Cliffs, I have always tried to be several steps ahead of the pack, plotting out our strategy maneuvers 2 or 3 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 bonds, allowed us to buy back a lot of our bonds cents 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 shortening our bonds at that time. They provided us with a fantastic shortcut, pun intended, to save this company.

The cheap bonds we are 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 these so-called investors were not shortening our bonds. I call these folks good shorts.

Second example, we predicted 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. That was a time also known as the Australian-Brazilian championship of stupidity. Their 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 towards 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 time when the pellet premium was not even an object of discussion.

Well, since its 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 these 2 -- these 3 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. Flash forward 2 years, and after several announcements from trustworthy EAF steel mills of new projects and 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 1, we'll 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 EAF's come online, we will be already selling a proven products that the mills 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 Cliff's CEO has been to explain time and again why this is not a cost-driven business. When I first arrived at Cliffs 5 years ago, there was no appreciation for the fact that the pellets we produce 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 us 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 raced 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, tailings 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 multiyear 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 tens of millions of metric tons. Furthermore, as tailings dams 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 in closing criminal liability related to the loss of life of hundreds of Brazilian citizens 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 these 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 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 date. I do not fight the date. I take what the market gives us. 4 years ago, we had had 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 this improved EBITDA forecast and even considering that this year will be our peak 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 share we paid to our employees in royalties. While steel pricing has declined from its peak, the hunger for our pellets has not and the steel mills 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 use to increase the price they charge for steel in the United States, and by doing so, avoid a profit squeeze that would otherwise happen to them caused by more expensive pit stops.

While we are discussing market dynamics, I would also like to address the latest themes 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 4 years, and the ones making these predictions have been embarrassingly wrong every single year. It's a long history of excuses and moving the goal posts to another year later. With domestic steel, it will be the same.

The evolution of the United States into 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 these 2 industries 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 a 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 a number of traditional barriers against unfair trade, including antidumping and countervailing duties, we also have tariffs and quotas. 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 will lose and destroy 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 U.S. or an importer that has to pay a tax to keep the price at a reasonable level. Even if these 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 plays into all this. With all of this new capacity coming online from the EAF side, we're going to have many more buyers fighting over the same amount of scrap and metallics.

These fundamentals for raw materials are strong enough to support a decent level for domestic steel prices. With all 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 ton shortage of pellets in the Great Lakes. By that time, our HBI number 1 plant will be consuming at its full pellet supply need of 2.8 million long tons, leaving 1 or 2 blast furnaces shorthanded and unable to run. There is no good solution for these blast furnaces. Importing pellets from outside our markets 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 an ability to expand production to fill this shortfall. I brought up the possibility of an Empire mine restart, which would 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 Taconite reserves will remain on the ground. The HBI number 1 plant, we will be demanding that through 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 shifting market dynamics from blast furnace to EAF is something we saw coming long ago. And that's why owning 100% of our HBI number 1 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. Erection of the steel tower 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 4 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 purer than our standard pellets and are tailor-made for the direct reduction process in our HBI number 1 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 steelmaking, and we all appreciate very much their 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 is 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, exactly here in the United States, where Cleveland-Cliffs supplied the merchant market for pellets and no steel mills buy center feed finds, 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 these shortages at least for a few years. Going forward, that's the New Normal. Welcome to the New Normal. With that, I will turn it over to Denise for the questions.

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Questions and Answers

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Operator [1]

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

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Matthew Wyatt Fields, BofA Merrill Lynch, Research Division - Director [2]

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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 I 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.

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

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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 pellets 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 still the biggest. And Vale was leading the negotiations of the pellet premium. The individuals at Vale that were leading the negotiations of the pellet premium spent a lot of time moving their goalpost 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 were 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 will finish what they never finished. That's the status of things. So it's coming. Let Vale be focused again.

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Matthew Wyatt Fields, BofA Merrill Lynch, Research Division - Director [4]

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Okay. 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 a 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 up, kind of, a valued customer, kind of, ongoing in your portfolio?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [5]

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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 treated us with the same level of respect. We heard a lot of that in the -- 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 would probably be very different. So this being said, the outcome was the outcome that had to happen. They had a massive need of pellets, through contracts that were expiring, and we were an able supplier to continue to supply them with no disruptions. With Vale's new pellet content, the Mustang pellet, we invested money at the United. And life is good, we still have 8 years to go. So if you are implying that ArcelorMittal might be at risk of losing their pellet supply I would like to remind you that we still have 8 years of a good contract going for both of us. The contract is binding on both sides. So they have their supply guarantees. We have our resources allocated for them, so there is nothing to be concerned about. That's the history lesson, what did I miss?

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Matthew Wyatt Fields, BofA Merrill Lynch, Research Division - Director [6]

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I was talking about a different supplier who has a contract that's near-term expiration that (inaudible).

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [7]

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With whom?

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Matthew Wyatt Fields, BofA Merrill Lynch, Research Division - Director [8]

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With AK Steel in 2023. If they're -- it appear towards (inaudible)

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [9]

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Yes, yes. 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 3 main contract situations that will have its time by 2020. And other than Algoma that's pretty much a make-or-break. But the other two, it's a portion that's not really the major portion. So I don't see any big uses for AK Steel for that matter. I -- 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 that answer your question or I'm still dodging your question? I don't like to be dodging your question.

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Matthew Wyatt Fields, BofA Merrill Lynch, Research Division - Director [10]

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No, no, no. That's a great answer.

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Operator [11]

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(Operator Instructions) Your next question comes from Curt Woodworth with Crédit Suisse.

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Curtis Rogers Woodworth, Crédit Suisse AG, Research Division - Director & Senior Analyst [12]

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Lourenco, I wanted to get your take on the announcement from the union agreement with Bedrock, which as you know, is 50% owner to acquire -- or not acquire, but to restart the Pointe-Noire pellet plant, 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.

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

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Yes. 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 Pointe-Noire pellet plant back to operation. They will need to spend a lot of money over there. It was a lot more money than I was willing to spend in order to keep that thing operating. But you know Pointe-Noire 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 of the Great Lakes, making for a voyage that is pretty complicated. You have to come down the river to get the pellets here inside the lakes. With all this being said, I don't sell to Stelco. So for me, it's not a problem. The ones that supply Stelco should be thinking about it, not me. I'm just giving 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?

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Curtis Rogers Woodworth, Crédit Suisse AG, Research Division - Director & Senior Analyst [14]

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Yes. No, no, no, that's helpful. And then just a follow-up on...

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [15]

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But I could give you the color of the roof. The color of the roof there is brown with holes. So they need to start putting a new roof over there because it has been raining and snowing inside that pellet place for a long, long time. That's the extra color I can give to you.

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Curtis Rogers Woodworth, Crédit Suisse AG, Research Division - Director & Senior Analyst [16]

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Yes, 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?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [17]

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Look, we are not going to talk about a second HBI plant until we have the first HBI plant 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 a second HBI plant, it's buying back my stock. It's obvious, that if the market continues to deny value to our equity in the market in the stock exchange every day, I'm going to continue to buy back stock. And the domestic U.S. market will starve before metallics. They will beg for me to build a second HBI plant, and the second HBI plant is not going to happen because again, it's an exercise of optionality and allocation of capital. Our second best use of capital right now would be paying down debt. And we prove 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 the stock is -- are at par. They're not. Buying back stock is a lot more rewarding for the company right now than buying back bonds. HBI is next, but 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 delivering DR-grade pellets to Toledo. But we are not in a hurry to build HBI number 2.

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Curtis Rogers Woodworth, Crédit Suisse AG, Research Division - Director & Senior Analyst [18]

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Your next question comes from Phil Gibbs with KeyBanc Markets.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [19]

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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.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [20]

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Yes. HBI is DRI recapped. So calling it DRI. If you call my HBI, DRI, my HBI will tell you, yes, it's true, how can I help you? So DRI and HBI are the same guy. But anyway, you're talking about the various growth options that we have going forward if I can disclose a little more color, a little bit more detail. The answer is no. None of those are right for disclosure right now. You're going to have to take my word. They exist in your study. That's all I can tell right now.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [21]

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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, at the last call.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [22]

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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 the 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 furnaces would come and pony up with some equity. But -- 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't 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 we would get a phenomenal IRR out of Empire. Other than that, the Taconite we have with the Upper Peninsula in Michigan will stay underground.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [23]

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It's very helpful. And if I could ask just one more strategic question. A 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?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [24]

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Can you mention the project that you are talking about? Because this is our first. So...

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [25]

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Let's just say the other HBI or DRI equivalent projects that have happened in the last 5 years, leave it to that.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [26]

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Well, there's a huge -- big, huge, enormous difference between our project and other projects. You're probably talking about Voestalpine and Nucor, right? You've got to say it, you've got to be courageous. Is that -- are those the ones you are comparing to?

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [27]

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Those might be the ones, yes.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [28]

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Might be the ones. So I will assume they are. You're just not courageous enough to say that we're bashing Voestalpine and Nucor, but that's okay with me. So the biggest difference between our project and the -- not the biggest, but the one clear difference between our project and the Nucor project, the Voestalpine project is that we supply -- we produce and supply our own feedstock and homogeneous 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 smoothly. That's the very first thing. Well, our feedstock will be produced at Northshore, our pellet plant coming from [David], our mine. We have been supplying this and producing this feedstock, improving the quality of this DR-grade pellets day in and day out. We supply a lot to Nucor in Trinidad, and they love the pellets. The pellets perform extremely well at Nucor in Trinidad. By the way, they have no problems in Trinidad, to speak of. We're not even their 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 the information that for periods of time, Voestalpine in Corpus Christi, Texas was feeding their Midrex plants that's very similar to ours, with lump ore. Not even blast furnace pellet that would be an enormous downgrade over DR-grade pellets, which DR-grade pellets generic would be already a downgrade in comparison 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 and you can't find DR-grade pellets. And by the way, it has been happening a lot in the marketplace since Samarco, let alone now, with Samarco's involvement in Córrego do Feijão. So they can't find DR-grade pellets. So the next step down is blast furnace pellet, then the next step down is lump ore. Well, Voestalpine was using lump ore not too long ago. So you do get the idea. So we're going to supply a single-source, Northshore, our pellets. The pellets that we have improving, and I thank Nucor for allowing me to develop a very good DR-grade pellet when we develop together with Nucor in Trinidad. That's been accomplished.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [29]

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No. It sounds like -- sounds like the continuity of supply and the proximity to your mind is really what is a nice comfort factor.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [30]

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Proximity has nothing to do with it. I haven't said a word about proximity. I was talking about standard deviation. Remember when you were in school statistics. Narrow standard deviation makes the process to go smooth. So -- and on top of narrow standard deviation, I just said today in my prepared remarks that our DR-grade pellets, we have 67.2% iron content and 2% silica. So they are not no 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're going to start up the new benchmark for HBI facilities in the world. Midrex is learning from us. 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 plant as you can see.

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Operator [31]

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Your last question -- your next question comes from Matt Vittorioso with Jefferies.

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Matthew Vittorioso, Jefferies LLC, Research Division - Analyst [32]

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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?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [33]

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Matt, look, you know I have always been working with $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 billion but we spent $300 million to acquire our minority position at Tilden from U.S. Steel, our minority position at Empire from ArcelorMittal and the land in [Blackrock.] So we spent pretty much $300 million to do that. So we got to the $1 billion. So even though we have this notional target of $1 billion net debt, we are always open 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 spent so far $171 million in net debt since the inception of the buyback program, we would have another $171 million cash in the bank. So to say look we -- our net debt is now $171 million less than it is as of today, April 25, 2019. So we deal in the 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 would lose sleep of, and if I do the right things for this company and continue to protect the shareholders, and I'm not talking about guys that keep the stock for a couple of 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. We -- this is not a stock for people that or those people that go in and out, there's a lot more convenient vehicle for these folks. We are for the ones that understand the dynamics of a business that is long-term that understands that there is only so much of environmental path that the Chinese can get and nobody would question what they're doing. So the day will come back 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 will have to compare 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 U.S. steel industry, the high quality of revenues that we have, the long-term plan, the strategy that keeps playing out the way we planned. So these are the things, $1 billion notional.

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Matthew Vittorioso, Jefferies LLC, Research Division - Analyst [34]

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Got it. 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 it 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.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [35]

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Yes. This year is more of the same. The outflow in Q1 is related to inventory build and inventory will be recorded mainly in Q3 and Q4. Receivables and payables are dictated by timing. We continue to do what we continue to do in this company and the weather changed 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?

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Operator [36]

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

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Piyush Sood, Morgan Stanley, Research Division - Research Associate [37]

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Quick housekeeping question for me. So about 0.5 million tons of inter-company sales to HBI this year, since there won't be third-party we'll take them out to EBITDA. Just wanted to understand that if that shipment is 2-half weighted 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?

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [38]

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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're going to move to Toledo will be 500,000 tons for this year. And what was the other one about the...

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Keith A. Koci, Cleveland-Cliffs Inc. - Executive VP & CFO [39]

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And that will be in the third quarter this year.

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [40]

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Thanks, Keith. What else Piyush? You gave me too much.

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Piyush Sood, Morgan Stanley, Research Division - Research Associate [41]

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

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C. Lourenco Goncalves, Cleveland-Cliffs Inc. - Chairman, President & CEO [42]

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Yes. We'll continue to direct pellets to Toledo but that will be on an ongoing basis. After we build this front of 500,000 tons, we feel like we're in good shape because we're going to start to operate to do that -- first to commission the plant and then to do cold runs and then hot runs. And then by midyear, we'll be at an 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 start-up inventory.

All right. Thank you very much, and we will continue our dialogue. Don't forget it's the new normal. Iron ore and pellets are in shortage. This will not be fixed soon. Headlines will not save your money but save your money is good execution, a good plan and good execution. Let's invest together and make money together. You guys have a great 2 months. We will talk in 2 months or 3. Thank you. Bye.

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Operator [43]

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