On July 16 I published a bullish article about Cliffs Natural Resources (CLF) here. In the article I argued that the company is undervalued due to several over-exacerbated negative headwinds. Three months have passed, the stock price climbed by as high as 50% and now is 25% above the price when I wrote the article. During the recent three month period there are several updates on this industry and this company itself. In this article I want to revisit several arguments that I made previously and explain why I am still bullish on CLF.
In my July article I argued that CLF is undervalued because of the following arguments:
- China's economic slowdown is exaggerated by the media and sell side analysts.
- High cost miners (mostly are in China) will have to cut production if the iron ore price drops further. And China's iron ore inventory level is low compared with last year's level.
- CLF has taken steps to clean up its balance sheet.
- CLF has taken steps to control its cost.
- CLF extended its contract with Essar to at least 2024, which alleviated concerns over the future of CLF's US operations.
- The stock is oversold and its valuation is very attractive.
We will examine some of above points in the following section. But first let's recap the stock performance and some technical signals. The below chart shows the daily chart of CLF in the past year. The stock has recovered substantially since it hit the multi-year low of $15.6 in early July. The stock has also broken its downtrend line (see the blue dashed line in the chart) and now is sitting above its 200 DMA line (see the red line in the chart). The chart shows that the stock price has strong support at the $20-21 level, and the July low of $15.6 seems to be the long term bottom.
(click to enlarge)
Global Economy Update
CLF's performance is highly linked to the global economy. During the last three months there was much good news out of China, the US and Europe. Several leading indicators that were pointing to weaker global growth in the first half have now rebounded. The most relevant indicator for the mining industry is the manufacturing PMI. It has turned above 50 in both China and Europe, and it continued to rise in the US. The following chart of global manufacturing PMI shows that the global economy recovery starts to gain its momentum.
In the US, the economy continued its slow but steady recovery after the financial crisis. Both the auto and housing markets remained in uptrends despite some short term volatility that was caused by the government shut down and debt ceiling debate. The newly appointed Fed chairman Janet Yellen shares many similar dovish views as current chairman Bernanke, and she is expected to provide any necessary monetary support for the US economy to continue to grow.
In the Eurozone, although the unemployment rate is still high, there were some clear signs that the economy is coming out of recession and starting to grow. The latest Eurozone manufacturing PMI was 51.1 and the service PMI was 52.1 (a new 27-month high). Eurozone business activity and manufacturing activity were both at 2-years highs. If there are no new surprises from those peripheral countries, Europe's economic recovery is expected to accelerate in late 2013 or early 2014.
In China, whose economy has the largest impact on the iron ore market, Q3 GDP growth rose to 7.8% compared with 7.5% in Q2. Both the manufacturing and service PMI (including both the official number and the private HSBC number) returned to above 50 and continued to improve in the third quarter. Although the overall manufacturing activity has slowed compared with the last two years, the steel-intensive segments continued to grow strongly thanks to strong auto production and the infrastructure investment. In addition, the housing market began to pick up after a slow spring. Newly started construction has increased 16.7% y/y ending in July, and sales by developers have increased more than 20% y/y ending in August. China's Communist Party will hold a key meeting in November on future economic policy. President Xi and Premier Li will discuss their economic reform plans and how they will support a slowing economy. Because many local firms were waiting for more clarity on the future economic policy, I expect economic activity to accelerate further after these policies are announced at the November meeting.
In the first nine months of 2013, the iron ore market has displayed its volatile nature with the prices ranging from $115 to $155/mt. Back to early 2013, the market was very bearish about future iron ore prices due to concerns over new supplies and the Chinese economy's hard landing. The inventory level stayed at very low levels at the beginning of the year because people were waiting for the price to drop later in the year. However, the price has been more resilient than many market participants and sell-side analysts have expected. Therefore, any new supplies were easily absorbed by the strong demand from China. Currently, the inventory level was still low compared with the level from last year, and considering people need to start building their inventories, the short term iron ore price should have strong support at the current $130/mt level.
Deep Analysis on Global Iron Ore Supply and Price Projection
Rio Tinto (RIO) and Vale (VALE), the two largest iron ore producers, recently confirmed that their new iron ore mine projects are on track to be finished and both will significantly increase their iron ore production in the next few years. The market consensus is that the supply will increase by 10-15% each year in the next 2-3 years before it returns to flat. And the sell side analysts' iron ore price projection seems to reflect this extra new supply. The consensus estimates for iron ore price is $115 in 2014 and $105 in 2015, which are respectively 15% and 25% lower than today's price. However, the following reasons make me feel more optimistic about the future iron ore price than most sell side analysts.
Reason 1: sell side analysts are too bearish about the global demand
The market consensus of future demand growth for iron ore lies between 2-5%, which is significantly lower than the average growth of 10% in the last 5 years. As I discussed previously in this article, there are more reasons to be optimistic about the global economy than to be pessimistic. The global economy is picking up. Europe just came out of a recession. Japan's economy seemed to be improving after its government injected massive stimulus packages. The auto and housing markets in China continue their strong growth and show no signs of slowdown. And the current iron ore inventory level is lower than historical levels. All these factors indicate that a 5-10% demand growth is realistic in the next few years, which will help absorb any new supplies that come into the market.
Reason 2: new supplies may not arrive on time, as the market currently expects
Building new mines means significant capital investments and great execution. Since late last year, cost cutting became the focus for most miners due to the deteriorating business conditions. If the iron ore price falls further from the current level, some miners (especially the smaller ones) may have to delay or cancel their new projects to conserve their capital. For large diversified miners like Rio Tinto, they also have the incentive to manage the speed of new supplies to maintain their margins. Rio is expected to increase its iron ore production by 100 million tons by 2015, and their decisions have a direct impact on the global iron ore market. Below is a quote from Rio Tinto CEO Sam Walsh in their Q2 earnings call. And it confirms that Rio has the ability and willingness to manage their new supplies based on market conditions and demands.
"Yes, firstly in relation to iron ore market and 360. There are more than two options in relation to 360, there is an option of moving ahead full steam, there is an option of not doing it of course, but there are other options in the middle as I've tried to describe in relation to productivity improvements, incremental mining, existing improvements and bringing on new mines. So I mean there we have got the ability of developing 360 in a range of ways lot of flexibility."
"There has been a lot of controversy, in fact there's a lot of 'instant experts' on iron ore and iron ore prices and so on in relation to trade-offs of volume and price, and there have been some people who were worried that in our analysis we don't take into account our existing iron ore portfolio when we look at the additional tones that we are bringing on. Well, let me assure you all we look at the total picture, we look at the total valuation of the business in terms of the trade-off between price and volume. But importantly what will drive that expansion will be what the market demands physically need. Let me just go back to say, look, we are going to be very rational and logical about this in ensuring that we are actually delivering value to shareholders and not just proceeding with something because it's on the books. It will be a well thought through process."
Reason 3: lower iron ore price will force high cost miners to shut down their businesses
When the iron ore prices hit $115/mt early this year, there was news reporting that several high cost miners (mostly in China) shut down their operations because they were losing money. Below is a chart that shows global iron ore miners' cost curve. Around 10-15% of production currently has a cost higher than $110/mt. If the price drops close to $110/mt level, I expect most of these mines will have to be shutdown, which provides a strong price floor for the entire market.
Based on the above three reasons, I think the market's projection for future iron ore prices is too conservative and only represents the bear case. There is a high probability that the iron ore price will be higher than $115/mt in 2014 and $105/mt in 2015, and that will push CLF's share price to a higher level than today's price.
Q3 Earnings Outlook
CLF reported strong earnings that beat expectations in Q1 and Q2 this year. I expect them to report another strong quarter because of the strong demand for iron ore and the high iron prices in Q3. In fact, sell side analysts started to upgrade their forecasts on CLF in the last few weeks (see below table).
Consensus Revenue Estimate
Consensus EPS Estimate
It will be interesting to see how the stock price reacts to the earnings. I think the market will pay more attention to the following factors:
- The progress on appointing a new CEO
- The progress on cost control on eastern Canadian mines
- Any indication regarding their decision on Bloomlake phase II project
Summary and Investment Reasons
Below are a summary of reasons why I am bullish on CLF:
- The mining industry has stabilized and its outlook has improved due to the macroeconomic improvements globally (China, US, Europe).
- There will be significant new supplies coming to the market in the next few years. However, the majority of these supplies have been priced into CLF's current stock price. And if the iron ore price deteriorates in the future, it is likely that some of the new and current supplies will be delayed or cut, which should provide support to iron ore prices.
- CLF's balance sheet is continuing to improve, generating improved cash flow and profits.
- The focus is still on CLF's Bloom Lake mine and its progress on cutting cost in eastern Canada. The next few months are critical. In the case that the progress at Bloom Lake mine is worse than expected, there is a risk that CLF has to revise its plan or even permanently shut down the mine to save cash.
- I believe that CLF is still undervalued because the market is too bearish regarding the future demand and supply of iron ore. In the short-term, the high short interest on the stock may provide some short-squeeze opportunities. In the long term, I believe the company's intrinsic value is higher than today's stock price. I maintain my previous one year price target ($27) and am bullish on the stock.