Volatile iron ore prices have been tough on shares of Cliffs Natural Resources (CLF). Shares are down approximately 64% since January 1, 2012. However, over the past two years Cliffs has been preparing itself for an extended period of volatile iron ore prices. During this period shareholders have been punished with an inevitable dividend cut and a collapse of the share price.
At the current price of ~$24 per share, I believe Cliffs Natural Resources represents an asymmetric risk/reward opportunity with the reward outweighing the risk going forward. The risks appear to be priced in, and I believe the downside is limited for shares of CLF. If iron ore prices do not suffer as bad as expected next year, I believe shares of CLF will trade at $40 (66% upside from $24).
Overview of Operations
Cliffs Natural Resources is a worldwide iron ore and coal producer. Cliffs operates iron ore mines in Minnesota, Michigan, Quebec, and Australia. Its coal mining operations are located in West Virginia and Alabama, and they produce primarily metallurgical grade coal. Cliffs' refers to its business segments as: U.S. Iron Ore, Eastern Canadian Iron Ore, Asia Pacific Iron Ore, and North American Coal.
Throughout the past two years Cliffs management has made strategic moves to position the company for continued volatile iron ore prices. These moves have included the following: dividend reduction, suspension of Ontario chromite project, halting production at Wabush plant, sales of non-core assets, equity public offering, and debt reduction. These decisions by management indicate a willingness to make short term sacrifices to ensure long term viability of the company.
Improved Balance Sheet
From the period ending December 31, 2012 to the period ending September 30, 2013, Cliffs has improved its cash position from $195.2 million to $298.8 million, reduced current debt from $94.1 million to $7.9 million, and reduced long term debt from $3,960.7 million to $3,319.6 million (16%).
By the end of 2013 Cliffs is expected to be fully divested of its 30% stake in the Amapo iron ore mine in Brazil. Cliffs and the majority owner, Anglo American, will sell the entire stake to Zamin. Unfortunately, the value of Cliffs' ownership in Amapo has been impaired by $67.6 million due to a landslide that resulted in a loss of lives and substantial property damage. Cliffs' Amapo ownership is now valued at $29.4 million. However, this divestiture will increase to the current cash position by 10%.
In February 2013 Cliffs used proceeds from a public equity offering to pay off its Term Loan debt obligation valued at $847.1 million. This loan matured in 2016, and paying off this debt extended Cliffs weighted average debt maturity from 2022 to 2024. This substantially reduced debt as well as eliminated Cliffs' only major near-term debt obligation. The following chart provides Cliffs' debt obligations going forward:
source: CLF Q3 10-Q Page 36
During the past two years Cliffs has increased utilization of its revolving credit facility. As of September 30, Cliffs had used $380.7 million of an available $1.75 billion line of credit. This increase has neutralized some of the debt reductions from paying off the Term Loan.
Excluding intangibles and goodwill, Cliffs' tangible net asset value is $27.33 per share (as of September 30, 2013). At current prices (~$24 per share) Cliffs should be considered on sale. Over the past 10 years CLF has traded at an average price/book ratio of 1.5.
Analyst earnings estimates for 2014 vary from $1.10 to $2.83 per share. This broad range reflects the broad range of analyst ratings from Strong Sell to Strong Buy for CLF. In 2013 analysts had a tough time predicting earnings just as most analyst had a difficult time predicting future iron ore prices.
Analysts from Citigroup, Goldman Sachs, and others are predicting a decline in iron ore prices in 2014. The cause will be attributed to decreased Chinese demand and overproduction of iron ore. They contend that the recent rally in iron ore has been due to a short-squeeze rally rather than improving fundamentals. Other entities, such as the Bureau of Resources and Energy Economics in Australia, are actually raising price estimates for 2014. The Bureau is predicting average prices of $119 per ton in 2014.
It's worth noting that 52% of Cliffs revenues year to date are from its U.S. Iron Ore segment. Iron ore mined in Minnesota and Michigan is sold primarily to domestic steel manufacturers. Even though iron ore prices hinge on Chinese demand, Cliffs will be helped by continued economic recovery in the U.S. On page 80 of the third quarter 10-Q, Cliffs states: "In 2014, we expect to sell approximately 22-23 million tons from our U.S. Iron Ore business. This is primarily attributable to increased customer demand from North American steelmaking customers."
Assuming the low earnings estimate for 2014 of $1.10 per share, the dividend coverage ratio will be 54.5%. Reduced capital spending, reduced debt, and reduced operating cost should help Cliffs remain profitable in 2014 if iron ore prices decline. Cliffs improved cash position will provide a cushion as well for volatile iron ore prices.
At the time of this writing, short interest in CLF stands at 31.41%. This is down from 38% short interest earlier in the year. Notable names have been short the iron ore sector including Jim Chanos and David Einhorn. Chanos has recently stated, "I would say anybody that's in the business of mining iron ore right now where supply is about to come on in late 2013 and 2014 whether demand holds up or not it's going to be a difficult market for those people."
It's difficult, however, to understand what makes CLF such a compelling short at this time. Cliffs Natural Resources is not going to $0 per share unless there is a global economic meltdown. Cliffs is trading at a discount to tangible book value, pays a well covered dividend, and is expected to achieve positive earnings in 2014. Cliffs will still be around if 2014 is a tough year.
The fears surrounding the near term future of iron ore prices appear to be sufficiently priced into shares of Cliffs Natural Resources. The concerns are legitimate, but the downside is limited when a company with solid fundamentals trades at a 25% discount to book value. The concerns about softening iron ore demand and oversupply going into next year are legitimate. However, if 2014 is not as bad as expected, I believe CLF will trade at $40 per share (1.25 price/book, less than 10-year average of 1.5, and P/E of 14 assuming high EPS estimate of 2.83).