The stock price of Cleveland, Ohio-based iron ore producer Cliffs Natural Resources (CLF) has risen over 50% since the end of the second quarter, briefly touching $26.05 on August 12, before pulling back slightly and trading more or less sideways for the past month to close Friday at $21.98. The stock is still down significantly YTD, but this recent rally has investors asking if the bottom is in and if Cliffs can continue this rise from the ashes to regain at least some of its former luster.
So what's going on; what's moving the needle and why? More importantly for investors, is this a sustainable move and the beginning of a rebound in the stock or just a sucker bet?
The company reported second quarter revenue of $1.48 billion and earnings of $0.82/share that exceeded analyst expectations of $1.44 billion and $.60/share respectively. Most of the upside was driven by higher margins from the Asia Pacific Iron Ore and North American Coal business. Turning to the balance sheet, Cliffs reported $263.3 million in cash and equivalents versus $159.2 million in Q2-2012. Debt also decreased from $3.61 billion in Q2-2012 to $3.32 billion in this most recent quarter.
This was a substantial beat to be sure, and the second solid quarterly report for the company since it recorded a $1.6 billion loss and slashed its quarterly dividend by 76% in the final quarter of 2012. Encouraging as these last two quarters have been however, they are hardly a trend. Before I invest a dime of my own money, I want to know what's changed since late last year and if I can expect this change to continue.
Earnings Impacted by Lower Iron Ore Prices
A closer look reveals that the recent turn of fortunes for Cliffs is largely the result of a rocky but generally rising price of iron ore, a main component in the production of steel. Ore traded below $100/ton in October of 2012, rebounding to over $150/ton in Q1-13 before briefly retreating to under $120/ton at the end of Q2-13. Currently ore is trading at just under $140/ton (see chart below)
The price of iron ore is THE key metric for Cliffs as, according to the most recent company 10Q (found here ), the company's cost to produce a ton of ore is between $67-$72/ton. By way of comparison, some of the larger players in the space such as BHP Billiton (BHP), Vale SA (VALE), and Rio Tinto (RIO) can reportedly produce that same ton for under $50.
As iron ore prices drop or rise, margins are impacted accordingly. The simple fact is that Cliffs needs ore prices to remain at or above $140/ton in order to thrive and expand. At $120/ton the company is marginally profitable and at $100/ton or less, management is shuttering expansion projects, cutting dividends, and probably watching the stock price crater. This reality was made crystal clear by Cliffs CEO, Joseph Carrabba, at the Steel Success Strategies Conference earlier this summer when he was asked what effect ore prices might have on the Bloom Lake project. His answer:
"At $90 the project doesn't go, which is the consensus right now. At $110-$120, the project goes. And believe me, the line is that fine when it comes down to the criticality of that project."
So it's pretty simple: for the most part, as goes the price of iron ore, so goes Cliffs. Unfortunately for investors in CLF, right now iron ore prices are fairly high and there are no bullish catalysts on the near term horizon that could take it much higher.
China is the Key
Simply put, demand for steel in China is what determines the price of iron ore these days. Chinese steel mills currently gobble up 2 out of every 3 tons of iron ore that is produced globally. To meet this demand, mining companies have invested heavily to expand their operations in the region.
As a result, there is a co-dependent relationship between the iron ore suppliers and their Chinese customers. On the one hand, China needs to import iron ore to feed its mills and continue supplying the country's need for finished steel. In turn, mining outfits like Cliffs and others need the demand from those mills to remain high in order to support their expanded capacities in the region. But here's the rub; due to production inefficiencies in their steel mills, the Chinese need the cost of iron ore to remain around $120/ton or lower to keep the cost of finished steel from becoming prohibitively expensive to produce. This fact was underscored recently when Wang Jiahua, executive vice-president of the China Mining Association, warned his counterparts in Australia that elevated iron ore prices are not sustainable. Indeed as recently as earlier this year, when ore prices rose above $120/ton, many of the less efficient Chinese mills simply idled their operations, which reduced the demand and price of ore back (albeit briefly) to a sub $120/ton level.
Why then have ore prices remained strong throughout the summer? In fact, the recent strength in ore prices is not unexpected. In a February interview with Bloomberg news, UBS Mining Analyst Tom Price predicted summer prices in the $130-$160/ton range on seasonal supply/demand constraints. It should be noted Price also predicted that demand for ore would begin to weaken in September and, with extra capacity from Australia coming on line at the same time, he thinks rates could briefly dip to as low as $70/ton. Indeed a recent article published by Reuters reveals that the price for iron ore may start to decline this week with one trader quoted as saying
"We expect more supply availability from the big miners and that could drag iron ore prices lower. Chinese demand is stable but there's just far more material available in the market".
Even if most analysts don't see spot ore being cut as drastically as Mr. Price, most agree that ore prices will be moderating in the coming months. CLSA commodity strategist Ian Roper sees iron ore averaging $115/ton in the second half of the year, while Standard Bank analyst Melinda Moore has forecast $113/ton and $108/ton for the third and fourth quarters, respectively.
As mentioned above, larger regional players like BHP Billiton, Vale and Rio Tinto are still comfortably profitable at the $120/ton level, while Cliffs is marginal.
The Bottom Line
Cliffs needs a global bull market to drive the price of ore above the $140/ton level and keep it there. Secular trends are pushing the price of ore up in the short term but as with any commodity, it's near impossible to predict short-term pricing in iron ore. However, with $120/ton being China's marginal cost of production, it seems rational to peg that as the longer term price target for ore. These metrics just don't favor a higher cost producer like Cliffs. There is value in the business to be sure, but after this most recent bounce, I think it's fully reflected in the stock at these prices.