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Summary

In this article I analyze Cliffs Natural Resources (CLF), an iron ore and coal mining company. I will show that investors overreacted to several negative headwinds around mining companies and Cliffs. After conducting a thorough financial statement analysis, I conclude that Cliffs' stock valuation is very attractive and has the potential to double within 12 months.

Company Profile

Cliffs Natural Resources Inc. (Cliffs) is an international mining and natural resources company. Cliffs is based on Cleveland, USA, and is the largest producer of iron ore pellets in North America with approximately 25.5 million tons of annual capacity (approximately 44.2% of the North American pellet market) serving integrated steel producers in the U.S. and Canada as well as the seaborne market to Europe and Asia. Cliffs also participates in the coal markets through its five metallurgical coal mines and one thermal coal mine in West Virginia and Alabama. Outside of North America, Cliffs has iron ore interests in Australia through its Koolyanobbing mining complex. Table 1 is a summary of ten mine subsidiaries that Cliffs operates.

Name

Location

Ownership Interest

Operation

Northshore

Minnesota

100%

Iron ore

United Taconite

Minnesota

100%

Iron ore

Wabush

Canada

100%

Iron ore

Bloom Lake

Canada

75%

Iron ore

Tilden

Michigan

85%

Iron ore

Empire

Michigan

79%

Iron ore

Koolyanobbing

Western Australia

100%

Iron ore

Pinnacle

West Virginia

100%

Coal

Oak Grove

Alabama

100%

Coal

CLCC

West Virginia

100%

Coal

Table 1. Summary of Cliffs' Mine Subsidiaries. (Data Source: sec filing form 10-Q)

Cliffs' main revenue comes from iron ore (72% of 2012 revenue) and coal (18% of 2012 revenue). And North America is the dominant earnings source with 76% of revenue coming from North American operation. Table 2 summarizes Cliffs' revenues from regional product sales.

Revenues from product sales and services

Three Months Ended March 31,

2013

2012

U.S. Iron Ore

$410.1

36%

$441.7

36%

Canadian Iron Ore

$245.3

22%

$220.7

18%

Asia Iron Ore

$270.8

24%

$359.8

30%

North American Coal

$214.3

18%

$189.9

16%

Total

$1,140.5

100%

$1,212,1

100%

Table 2. Summary of Cliffs' Regional Sales. (Data Source: sec filing form 10-Q)

Investment Thesis

Cliffs' revenues, earnings and cash flow generation are highly leveraged to iron ore and coal prices, which are partly driven by the global steel production levels, the growth rate of which slowed materially in 2012 and 2013. Several negative factors added pressure to Cliffs' common share price, which hit a multi-year low of $15.5 on June 26, 2013. Figure 1 draws Cliffs' one year stock price with the 50 days moving average.

(click to enlarge)

Figure 1. Cliffs' One Year Stock Price. (Data Source: Yahoo Finance)

Those negative factors that impacted Cliffs' stock price are:

  1. A slower than expected China economy growth rate would lower the demand for commodities including iron ore and coal
  2. There are oversupplies in both iron ore and coal markets, and new mines are expected to add more supplies in the next two years
  3. Strong U.S. dollar is negative to all commodities.
  4. Cliffs is not well-diversified like its major competitors such as BHP Billiton (BHP), Rio Tinto (RIO) and Vale (VALE). Also, since it doesn't enjoy economies of scale like those larger companies do, its cost of production is higher than industry's average. Tumbling iron ore prices thus affect Cliffs more than the other larger, more diversified players.
  5. Cliffs' management made bad decisions on acquiring Consolidated Thompson in 2011 for $4.4Bn. The purchase happened at the peak of the commodity market, and it significantly increased Cliffs' leverage and limited its liquidity flexibility.
  6. There are concerns that Cliffs would have to further delay its ramp up of Bloom Lake mine project, resulting in decreased volumes and increased costs. A failure to control the cost at Eastern Canadian mines may eventually force the company to step back from international operations.

Despite all these negative headwinds, I think the current valuations of Cliffs' common shares are very attractive and recommend value investors to start accumulating Cliffs' stock in steps. My valuation models indicate that Cliff's common share's fair value is between $22 and $27, which is more than 40% above June 26th closing price. And if either the iron ore market recovers or Cliffs can more efficiently lower its cost at its Eastern Canadian mines, the stock price can easily pass $30 in the next 12 months. My investment thesis is based on the following arguments:

  1. The China slowdown story has been exacerbated. It is no doubt that China is experiencing its economy transition and may not be able to maintain its 8% plus economy growth in the future, and a growth rate between 6.5-7.5% is more reasonable. But even at 6.5% annual GDP growth rate, it is still expanding at two times U.S. growth rate and is more than enough to support the current depressing commodity prices. The newly elected Chinese government is pushing hard for urbanization, which will actually increase the demand for steel and other commodities. Therefore, I expect the demand for iron ore and coal will stabilize this year and start to recover.
  2. The current iron ore price is not economic for many small miners and will speed up the consolidation in the industry. According to Reuters, half of China's iron ore mines are unprofitable at the price of $100/T. These miners typically have small size and high leverage. If the price continues to fall, these miners will either go bankrupt or be bought out by bigger players, and the bigger miners will cut production and CAPEX to control their costs. Figure 2 shows that the iron ore inventory at various Chinese sea ports has dropped from 93 million tons at the end of September 2012 to the current 70 million tons. The continued shrinking of inventories plus the cut of production will ease the oversupply problem and improve the pricing power of miners.

(click to enlarge)

Figure 2. Iron Ore Inventory at China Sea Ports. (Data Source: Bloomberg)

  1. Cliffs' management has taken various measures to improve its balance sheet and liquidity. In early 2013, it decreased dividend by 76% to preserve cash, and raised $1Bn in common shares and preferred stocks to repay outstanding debt. Although these actions caused Cliffs' stock price to tumble more than 50% this year, it significantly improves its balance sheet and minimizes its default risk in the next five years. As of Q1 2013, Cliffs has $560mm cash and receivables. Its current ratio improved from Q42012's 1.2 to Q12013's 1.7, and interest coverage ratio improved from 1.3 to 3.4. Cliffs' investment grade rating was recently confirmed by both Moody's and S&P. Furthermore, there is no debt maturing until 2017, and the company has a $1.75Bn revolving credit line from lenders.
  2. Cliffs' management has taken various actions to improve its operating efficiency and decrease its production costs. Its operating expenses (Selling, General and Administration expense) decreased from Q4 2012's $159mm to Q1 2013's $70mm. And Cliffs continues to make progress on the Bloom Lake mine's production stability and development. If the Bloom Lake phase II production can be completed as expected by 2014, it would significantly decrease the cost of current production and help to improve their profit margin.
  3. On June 13, 2013 Cliffs announced an extension of its pellet sales contract with Essar Steel Algoma from 2016 to 2024. The contract extension not only adds stable cash flow to Cliffs' earnings until 2024, but also indicates that industry players are bullish on the iron ore market in the next ten years.
  4. The stock is oversold and the current valuation for Cliffs is very attractive. The analysts' average estimate for EPS is $2.36, $1.78, $2.18 in 2013, 2014 and 2015. The current price indicates a 5.7x 2015E EV/EBITDA2, versus mining peers at 6.2x and five years historical average at 7.7x. Based on my valuation model, the fair value for Cliffs' stock is $22-$27, which is more than 40% higher than the June 26th closing price.

Industry Analysis

Cliffs' revenues, earnings and cash flow generation are highly leveraged to iron ore prices, which in turn are driven by global steel production levels. In this section I analyze the demand and supply of steel/iron ore, and make my iron ore price predictions for the next three years.

Global Demand Remains Subdued in Short Term

There are various challenges that will hold up a sustainable global demand for steel in the short term. Challenges include the sovereign debt crisis in Europe, the slowing GDP growth in China and other emerging countries, and the earlier than expected QE tapering in U.S. The latest manufacturing purchasing manager index for Europe is 48.8, indicating their economy is in recession. China's PMI is slowing down to 50.1, barely above the 50 boundary line. And U.S.'s 50.8 PMI indicates a very mild economy recovery. Figure 3 shows the U.S., China and European historical purchasing manager index (PMI) values since 2008.

(click to enlarge)

Figure 3. U.S., China and European Manufacturing Purchasing Manager Index. (Data Source: Bloomberg)

U.S. Demand Driven by Housing and Automobile Recovery

In U.S. the demand for steel is picking up due to the recovery in housing and automobile markets. Figure 4 shows the U.S. housing and automobile sales data, both have recovered significantly since 2009. According to the World Steel Association, U.S. demand for apparent steel increased 8.4% in 2012, and is expected to increase another 2.9% and 3% in 2013 and 2014 respectively. Although there are various uncertainties such as continuing fiscal concerns and the earlier than expected ending of QE, I expect the demand for steel in U.S. will continue to grow at a steady pace.

(click to enlarge)

Figure 4. U.S. Housing and Automotive Sales (Data Source: Bloomberg)

Oversupply Issue Starts to Ease

In the previous section Figure 2 shows the iron ore inventory data collected from various Chinese sea ports. Since the end of 2012, the inventory starts to drop from 95 million tons to 71 million tons as of the end of June. Lowering inventory levels will mitigate the effect of decreasing demand and may ease the pressure on the iron ore prices. On the other hand, since many small iron ore miners are operating at a loss at current $110-120 price levels, I expect more supply cuts that will further relieve the oversupply concern.

Iron Ore Price Forecast

Based on the above analysis, I forecast the iron ore price to be $125/mt in 2013E, $115/mt in 2014E and $120/mt in 2015E, which are close to Wall Street's consensus. Table 3 lists analysts' forecasts for iron ore prices for the next two years.

Firm

Analysts

As Of

2013E

2014E

Toronto-Dominion Bank/Toronto

B. Melek

06/05/13

130

135

Itau Unibanco Holding SA

I. Goldfajn

06/05/13

114

108

Bank of America Merrill Lynch

M. Widmer

05/28/13

108

110

Deutsche Bank AG

D. Brebner

05/17/13

110

114

Intesa Sanpaolo SpA

D. Corsini

05/06/13

115

National Australia Bank Ltd

J. Glenn

04/10/13

115

100

Westpac Banking Corp

J. Smirk

04/08/13

110

110

Credit Suisse Group AG

R. Deverell

04/03/13

110

100

Australia & New Zealand Banking Group Lt

M. Pervan

02/08/13

142

130

Standard Chartered Bank

J. Zhu

01/17/13

140

125

Average

119.4

114.7

Table 3. Analyst's Iron Ore Price Forecast (Data Source: Bloomberg)

Financial Statement Analysis

Income Statement and Earnings Forecast

Income Sheet as of:

FY11A

FY12A

FY13E

FY14E

FY15E

Total Revenue

6,563.90

5,872.70

5,579.07

5,300.11

5,565.12

- Cost Of Goods Sold

3,953.00

4,700.60

4,291.59

4,240.09

4,280.86

Gross Profit

2,610.90

1,172.10

1,287.48

1,060.02

1,284.26

- Operating Expenses

260.90

431.00

387.90

368.51

386.93

Operating Income

2,350.00

741.10

899.58

691.52

897.33

- Non-operating Expenses

122.00

597.80

200

200

200

- Unusual Items

27.80

1,049.90

- Income Tax Expense

407.70

255.90

224.89

172.88

224.33

Earnings from Continues Operations

1,792.50

(1,162.50)

474.68

318.64

473.00

- Extraord. Item & Account. Change

(20.10)

(35.90)

- Minority Int. in Earnings

193.50

(227.20)

Net Income

1,619.10

(899.40)

474.68

318.64

473.00

- Extra Items

44.98

908.84

Net Income excludes Extra Items

1,664.08

9.44

474.68

318.64

473.00

- Pref. Dividends

-

-

40

40

40

Net Income to Common Equities excludes Extra Items

1,664.08

9.44

434.68

278.64

433.00

Table 4. Income Statement and Earnings Forecast for Cliffs. (Data Source: Bloomberg)

Table 4 shows the income statement and my three-year earnings prediction for Cliffs. My forecast assumes the iron ore and coal market will continue to be challenging and the revenues at Cliffs will decline by 5% each in 2013 and 2014, and recover in 2015. I also assume that Cliffs' management will continue to deleverage and improve its operating efficiency, which will maintain the ratio of operating expense to revenue at a similar level as in 2012.

Balance sheet analysis

Balance Sheet as of:

3/31/2013

3/31/2012

Cash And Equivalents

287.20

122.30

Short Term Investments

-

-

Total Cash & ST Investments

287.20

122.30

Accounts & Notes Receivable

272.30

247.20

Total Receivables

272.30

247.20

Inventories

1,530.20

924.70

Prepaid Exp.

-

-

Restricted Cash

-

-

Other Current Assets

364.30

293.10

Total Current Assets

2,454.00

1,587.30

Net Property, Plant & Equipment

11,236.30

10,766.70

Long-term Investments

-

-

Deferred Charges, LT

137.30

511.70

Other Long-Term Assets

624.40

2,027.60

Total Assets

14,452.00

14,893.30

LIABILITIES

Accrued Exp.

470.50

380.60

Short-term Borrowings

-

87.20

Accounts Payable

299.90

394.50

Curr. Income Taxes Payable

81.50

238.00

Other Current Liabilities

249.50

284.30

Total Current Liabilities

1,101.40

1,384.60

Long-Term Debt

3,433.00

3,583.80

Unearned Revenue, Non-Current

-

-

Other Non-Current Liabilities

2,428.50

2,491.00

Total Liabilities

6,962.90

7,459.40

Total Pref. Equity

731.30

-

Total Common Equity

6,127.70

7,433.90

Total Equity

6,859.00

7,433.90

Total Liabilities And Equity

13,821.90

14,893.30

Table 5. Balance Sheet of Cliffs. (Data Source: Bloomberg)

Table 5 shows Cliffs' balance sheet that ended March 31, 2013 and March 31, 2012. Like many other mining companies, Cliffs has a high leverage, especially after its purchase of Consolidated Thompson in 2011. However, the management has recognized current challenging operating environment and started to improve its balance sheet and liquidity. This February, Cliffs raised just under $1 billion in common shares and new 7% Series A Mandatory Convertible Preferred Stock. Net proceeds were used to repay outstanding balances ($847 million at December 31, 2012) under its term loan due May 2016 and for additional liquidity. Furthermore, the company decided to lower its quarterly dividends from $0.63 to $0.15. The combination of above actions significantly improved Cliffs' balance sheet, preserved its cash balances, and maintained its investment grade ratings. Although the debt balances are still higher than 2011 levels due to the acquisition of Consolidated Thompson, Cliffs' balance sheet is well positioned for any further deterioration in the mining industry.

Valuations

I applied both discounted cash flow and relative valuation models to calculate the fair value of Cliffs' common shares. The discounted cash flow model calculated a target price of $22, and relative valuation model calculated a target price of $26.6.

A. Discounted Cash Flow Model:

My discounted cashflow model calculated a target price of $22 for Cliffs' common shares. Table 6 lists the base case assumptions for discounted cash flow analysis. I assumed a 9.7% weighted average cost of capital (OTC:WACC), which is calculated in table 7. I assumed a 12% marginal tax rate, which is based on the average of the last five years' tax rate. Furthermore I assumed a 1.5% growth rate, which equals the inflation rate.

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

Sales yoy growth

(5%)

(5%)

5%

10%

20%

20%

20%

20%

20%

20%

EBIT Margin

10%

5%

5%

10%

20%

20%

20%

20%

20%

20%

CAPEX growth

20%

10%

-

-

5%

10%

20%

20%

20%

20%

Table 6. Assumptions for Discounted Cashflow Analysis

Weighted Average Cost of Capital

1) EQUITY

2) DEBT

WEIGHT

57.5%

42.5%

COST

15.2%

2.3%

Weight x Cost

8.7%

1.0%

WACC

9.7%

COST OF DEBT

x Pre-Tax Cost ST Debt

0.4%

x Pre-Tax Cost LT Debt

2.7%

+ ST Debt

94

+ LT Debt

3,961

Total Debt

4,055

ST Debt to Total Debt

2.3%

Pre-Tax Cost of ST Debt x ST Debt to Total Debt

0.0%

LT Debt to Total Debt

97.7%

Pre-Tax Cost of LT Debt x LT Debt to Total Debt

2.6%

x Total Pre-Tax Cost of Debt

2.6%

Effective Tax Rate

12.0%

(1 - Effective Tax Rate)

88.0%

Cost of Debt

2.3%

COST OF EQUITY

x Country Premium

7.6%

Beta (SPX)

1.64

+ Equity Risk Premium

12.5%

Risk Free Rate

2.7%

Cost of Equity

15.2%

Table 7. Calculation of Weighted Average Cost of Capital (WACC)

I also conducted a sensitivity analysis to show how the calculated stock price responds to changes of assumptions of WACC and growth rate. These results, which are described in Table 8, show that the downside risk is limited at $15 if the WACC increased to 11.7% from current 9.7%, which means either the risk premium of Cliffs' stock or the cost of its debt will significantly increase from current levels. Because Cliffs' management is focused on improving its balance sheet and controlling the non-operating expenses, I expect the cost of debt will decrease over the time. And since the current risk premium is already at multiple years high, I predict that the WACC is not likely to exceed the 10% level. On the other hand, if the growth rate exceeds 1.5%, which is a very conservative assumption, the stock price can go above $30.

Fair Value

Growth Rate

2.0%

2.5%

3.0%

3.5%

WACC

1.5%

2.0%

2.5%

3.0%

3.5%

9.70%

$22

$24

$27

$29

$33

10.20%

$20

$22

$24

$26

$29

10.70%

$18

$20

$22

$24

$26

11.20%

$16

$18

$19

$21

$23

11.70%

$15

$16

$17

$19

$21

Table 8. Sensitivity Analysis of Discounted Cashflow Model

B. Relative Valuation Model:

Table 9 and Figure 5 show the historical EV/EBITDA ratio for Cliffs and its competitors. The current EV/EBITDA ratio is 6x, lower than Cliffs' 5 years average of 7.7x and mining industry's 5 years average of 7.6x. Based on previous section's earning forecast, I apply a 2015E EBITDA of $1.3Bn, and I assign a 2015E 7x EV/EBITDA ratio to reach the target price of $26.6. If I apply the 5 years average of 7.7x EV/EBITDA ratio, then I get a target price of $32.5.

(click to enlarge)

Figure 5. Historical EV/EBITDA Ratios for Cliffs. (Data Source: Bloomberg)

2008

2009

2010

2011

2012

CLF

2.7

13.1

6.7

4.7

8.2

Console Energy Inc

6.7

8.9

12.0

6.8

11.3

Peabody Energy Corp

4.8

10.4

10.5

6.9

7.0

Alpha Natural Resources

2.4

12.1

9.3

8.2

5.0

BHP Billiton Ltd

8.4

8.7

7.5

6.7

5.3

Ferrexpo Plc

1.0

16.3

6.8

3.2

7.2

RIO Tinto Ltd

3.7

13.2

8.2

5.1

9.1

VALE SA-PREF

5.3

20.0

7.0

4.2

7.9

Teck Resources Ltd

5.9

8.3

8.4

4.5

6.8

Vedanta Resources Plc

5.1

4.0

9.9

6.1

6.8

Industry Average = 7.6

4.6

11.5

8.63

5.64

7.46

Table 9. Historical EV/EBITDA Ratios for Cliffs and Its Competitors. (Data Source: Bloomberg)

C. Risk to Price Target

The key risks to my price target for Cliffs include:

  1. Weaker than expected growth of the global economy would likely lead to reduced demand for steel products and the raw materials that Cliffs supplies. A Chinese economy hard landing, a return of Euro zone debt crisis, a slower than expected U.S. housing market recovery could all lead to a significant drag to global economy growth.
  2. Selling prices for much of Cliffs' supplies are partially linked to prices determined on international markets. If the selling prices for iron ore and coal continue to fall, Cliffs' growth and profitability could fail to meet my predictions.
  3. If Cliffs fails to control its production costs, especially at its Canadian operations, it will add pressure to its profitability and in the worst case may force the company to pull back from international operations. Based on the latest Cliffs' earnings presentation, its cash cost per ton at Bloom Lake mines is $90, and it is targeting to lower this cost to $65 once it finishes the phase II project. There is much uncertainty towards this project and the path to successfully lower the cost to Cliffs' target.
  4. Cliffs' North American iron ore and coal divisions' revenues are highly dependent on a few customers. ArcelorMittal, Algoma and Severstal together accounted for 62% of Cliffs' U.S. iron ore revenues in 2012. A loss of sales to any of these existing customers could have a substantial adverse impact on the company's revenues and profitability.
  5. Any natural disasters that will impact the production at any of Cliffs' mines.
  6. Any further Canadian or Australian dollar strength.
Source: Cliffs Natural Resources Has Limited Downside And Can Double In 12 Months