When Goldman Sachs came out with their list of most shorted stocks this year, I was not surprised to see Cliffs Natural Resources (CLF) in second place with a 36% short interest. I think that the downside was summed up by Credit Suisse's report, in which they came out with a $10 price target:
Our cost curve analysis suggests that on a 2-3 year view CLF's Canadian and APAC assets are likely to be displaced off the top end of the cost curve. The core US business is not our seaborne cost curve but will generate 16-23% EBITDA margins through the cycle (putting it in the third quartile), not the 40-50% that we've seen the past few years, and on this basis CLF's operational earnings are $200-300mn p.a., which on the historic 5x multiple is worth $1.5 - 2.0bn. We see this as insufficient to service the company's $3.1bn net debt position.
Without higher iron-ore prices, it will be harder for Cliffs Natural to remain profitable. In Cliffs Natural conference call they estimated $137/t iron-ore cost (current price $138/t and down 11% from last year), while Morgan Stanley estimates iron-ore to fall to $117/t in 2014. Once more, Cliff Natural can face even more challenges:
1) Because of China slowdown, iron-ore imports are expected to drop, through the exact amount and when remains uncertain. Exports to Asia already dropped to $327m versus $361.3m a year ago, while the slowdown has only just begun.
2) Because of a stronger USD$, imports from other countries are likely to increase while domestic production will likely decrease.
With all of the negatives, why is anyone even considering to buy Cliff Natural stock? It's simple - it's a value play!
In the most recent quarter (Q2 2013) shareholder equity increased to $5,631,200,000 from $4,632,700,000 last year. At first glance, it looks like Cliffs Natural Resources is worth much more than its $3.5 Billion market cap. I would like to go into the numbers, and how Cliffs Natural Resources can unlock cash and value.
The scariest thing with Cliff Natural resources is its risk of default: it has more than $3.3 Billion in long term debt, with less than $1.7 Billion in current assets. I would like to create a plan for Cliffs to repay its liabilities of $6,811,100,000.
Cliffs Estimated Earnings
|(in USD$)||This Year||Next Year||2-3 Years|
For my estimates, lets say they generate another $200 Million this year, and $200 Million for the next 3 years (using Yahoo Finance and Credit Suisse). Now, let's look at their debt position:
Their total debt is $3.32 Billion, down from $3.96 on December 31, 2012. Their lease obligations look like:
The complete picture looks like this:
Cliffs Natural resources has been able to repay more than $1 Billion in liabilities since December 31, 2013 (6 months) without losing asset value. It seems unlikely that they could do this in the future as their sales and profit are declining (as analysts predict), so I would like to create a worse-case scenario. Using the revenue guidance above, I would like to go through their future obligations and assets.
Estimated Long-term Liabilities per Year (in Millions)
*Includes all lease obligations from 2018 and after (106.1 Million)
These numbers include scheduled maturities of lease obligations and debt (bonds). It comes out to just $3.275 Billion of the $6.8 Billion. Cliff Natural Resources has more than $1.3 Billion left on their revolving line of credit (they have used $440 Million of $1.75 Billion).
If they were to use the $1.15 ($150 Million left) Billion to repay all their current liabilities they could survive long enough to mount a true turnaround. At the current point in time, they have $1.665 Billion in current assets (if they liquidate at book value). Take into consideration the net income estimates (roughly $200 Million for the rest of this year and the next few), and we can calculate future expenditures. If they repay their liabilities as the table above (through 2017), they would have repaid $286.4 Million in liabilities while obtaining a net gain of $713.6 Million, leaving them with $2.378 Billion in current assets in 2017.
If they continued to earn $200 Million a year through 2021, they could stay afloat obtaining $600 Million while paying $2.2 Billion in liabilities. If we took a look at their financial position in 2022 it could look a lot like this:
|Current Assets||$778 Million|
|Debt (Bonds)||$790.3 Million|
|Revolving Credit||$1.15 Billion|
|Deferred Income Taxes||$1.1 Billion|
|Other Liabilities||$1.342 Billion|
In roughly a decade, Cliffs Natural Resources can reduce their liabilities in nearly half to $3.6 Billion. While it would require them to take on debt and use many of their current assets, they still have the most important aspect of their balance sheet: Property, Plant, and Equipment.
Cliffs has roughly $11.19 Billion in Property, Plant, and Equipment on its balance sheet, accounting for $2 Billion in future DD&A. Cliffs includes depreciation and depletion under costs of goods sold, which means it is already taken out before the operational income. The $7.8 Billion is what Cliffs values their minerals and land at (it costs them roughly $6 - $18 a ton in DD&A), and they went through more than $280 Million in 6 months.
When DD&A is taken into account, in 2022 Cliffs Natural Resources could have roughly $11.9676 Billion in assets, with approximately $4.3823 Billion in liabilities, leaving them with approximately $7.58 Billion in shareholder equity (current market cap is $3.45 Billion, representing roughly 120% upside).
There is a lot that could happen in roughly a decade, and Cliffs Natural is still drowning in debt. The $3.3 Billion is the face value of the debt, and does not reflect the fair value of $3.565 Billion. Once more, revenue is in steep decline as iron-ore prices are falling. They are paying more than $40 Million in interest a quarter (while also paying roughly $13 Million in dividends), taking cash right away from their balance sheet.
The bull case would be Cliff's ability to turn around the company before their debt begins to mature in 2018. With analysts downgrading the stock, and a huge short interest, the bears may be looking over some of Cliff's strengths.
I think that options would be a good way to play Cliffs Natural Resources. Then next 2 - 4 quarters will give us a better picture of their debt and equity position, allowing us a clearer picture of their future.
For those who have the guts, buying the stock might be a good plan too. In my calculations, I used just $200 Million a year in net profit, while they earned roughly $130 Million in Q2 alone. If you think that management can turn Cliffs around in the next five years, it could unlock tremendous value in the coming years. While some analysts think that Cliffs could lose money next year, others think that they can earn upwards of $400 Million - but no matter who you ask, they are in decline.
Cliffs needs management to dig them out of debt in the coming years, before all of Cliff's potential is washed away. If management can unlock its potential, the shares can climb more than 100% and reach their past levels. If not, they can continue to sink into decline. Management has been given 5 years before the debt begins to mature.
This can be one of the greatest turnarounds in history, but there are still obstacles in its way. Cliffs Natural Resources is in a hole, but they have a shovel to dig themselves out.