Seeking Alpha
Value, contrarian, long-term horizon
Profile| Send Message|
( followers)  

Cliffs Natural Resources (CLF) was down again on Tuesday, January 21st, mostly due to the report from Goldman Sachs indicating that, in their opinion, "the sunset of the Iron Age starts in 2014." As a result they changed their projected price for Iron Ore to about $108 for 2014 and a projected decline of $80 for 2015. Naturally, the price of CLF's stock dropped quite quickly with The Street marking CLF as a roof leaker. Just a week ago, Jim Cramer had spoken of CLF in his 6 stocks in 60 seconds, indicating that the stock might be a good buy if its restructuring plan had worked. Cramer's assessment was simply a reiteration of the Deutsche Bank upgrade which had occurred earlier that day (January 14th).

Others within the research/analysis business are not quite so negative with respect to the future demand for Iron Ore. Macquarie estimates that the price of Iron Ore will be around $115 to $120 by year's end. They also seem to indicate that the early 2014 issues currently being experienced with respect to Iron Ore and the Asia-Pacific market will dissipate by the end of the year.

So what should an investor in Cliffs do? We have conflicting perspectives on the future demand for Iron Ore and steel in general. Macquarie thinks that Iron Ore will not do quite as terrible as Goldman Sachs which evidently thinks that the Steel industry is completely finished. Deutsche Bank which does its analysis based on the merits of the company itself, and not simply the spot price of Iron Ore, seems to think that Cliffs is ready to succeed and has marked it as a 'buy.'

Why would Deutsche Bank think this?

First we will take a brief look at why Goldman Sachs seems to think that we are in the twilight years for Iron Ore. We will then consider the Deutsche Bank upgrade and the investor guidance given by Cliffs on January 7th.

A) So Nobody Wants Iron Ore Anymore?

Goldman Sachs has stated that China's decreased demand for Steel is the central reason for their bearish sentiment on the price of Iron Ore. Goldman Sachs indicates that over the last 20 years the usage of steel in China has increased at a rate that is not sustainable.

[China's] current rates of steel consumption are already high; in terms of steel stock per capita they are equivalent to the average household purchasing a new car every 8 months without disposing of its older ones.

With the rate of steel consumption in China slowing down, the production of steel will decrease, and this ought to drive the price of Iron Ore down.

What is not addressed by the Goldman Sachs analysis, is that China's production of Steel was never strictly tied to China's own consumption of Steel. China has been exporting cheap steel for many years to other countries throughout the world, which has often caused difficulties for countries such as the US where cities such as Pittsburgh suffered for years as a result. The real issue with respect to China's steel is the trade tariffs that were put in place by many countries to prevent the dumping of steel. India and the United States are two such countries that have trade tariffs in place with respect to steel in order to prevent China's dumping.

So it's not that we have suddenly reached a point in civilization where Steel has gone the way of the dinosaur, as the Goldman Sachs analysis would seem to suggest; but rather, we must simply wait for other developing countries to increase their production capacity for steel or for developed countries to relax the trade tariffs currently in place.

The other component to our analysis with respect to Iron Ore, is that the price of Iron Ore is not driven solely by China's demand for steel. While the demand for steel in China has fallen roughly 7% steel is actually expected to increase at least within the United States for 2014 according to Zacks and also according to the World Steel Association. The expectation that worldwide Steel production will increase is probably at the heart of Macquarie's estimate of $115 to $120 per ton of Iron Ore.

B) So Why Does Deutsche Bank Think Cliffs Is A Buy?

Deutsche Bank projected that the target price for CLF should be roughly $27.00. Deutsche Bank's increase in CLF's rating is mostly associated with a careful analysis of the recently released guidance that Cliffs released on January 7th. Deutsche Bank is also mostly concerned with how Cliffs operates as a company and not simply the spot price on Iron Ore.

There were two major items noted within the upgrade by Deutsche Bank:

1. The scale of its North American Operations:

Cliffs is North America's largest producer of iron ore pellets accounting for ~45% of the region's supply (rest are steel mill-owned) and sells its production mainly to integrated steel companies in North America.

2. Management change and recent cost reductions:

We rate Cliffs as Buy on valuation and strategic outlook given significant senior management change and cost reductions.

1. It is important to understand with respect to Cliffs, that it maintains a decent profit margin within the United States for Iron Ore. It's cost per ton is roughly $65 - $70. The United States is also the major market for Cliffs.

With respect to our China issues, during 2012 there were 11 mega tons of Iron Ore exported from Cliffs mines in Australia over to China.

See the map below for a visual on the international operations of Cliffs:

(click to enlarge)

International Operations For Cliffs Natural Resources

And as a percentage of revenue here is the Global Market Exposure. 2012 numbers are used from the most recent investor guidance presentation by Cliffs. 2013 numbers will be released on February 14th.

Based on this historical data, Cliffs offers a rather optimistic perspective for their sales guidance:

(click to enlarge)

To put this 2014 Sales Guidance into perspective, Cliffs expects their release of 2013 numbers to show that U.S. Iron Ore was at 21 Million Tons, while their Asia Pacific Iron Ore was at 11 Million Tons. So, Cliffs essentially expects no increase due to their Asia Pacific Operations but a modest increase due to their U.S. Operations.

However due to a decline in demand for China's steel, and due to high inventory levels in China of Iron Ore, it would appear that Cliffs should probably expect more of a decline in Asia Pacific than only 1 ton. While I do not believe that Cliffs sales in the Asia Pacific region will fall too short of this guidance, as the situation will inevitably improve in China, I do believe that a "per the course" type of guidance is somewhat overly optimistic for that region.

2. With respect to the positives in expenditure reduction and management change, analysts at Deutsche Bank are referring to slide 9 within the guidance given to investors by Cliffs on January 7th.

(click to enlarge)

As you can see from the image above, the profit margin has been steadily increasing every quarter and hopefully this trend will continue with the new CEO Gary Halverson. Most mines within the United States have high profit margins with low cost of goods sold, however the Canadian operations are a somewhat different story. While still profitable, the Canadian operations have a cost per ton for Iron Ore of roughly $100 - $105. In contrast, United States and Australian operations have a cost of roughly $65 - $70. Hopefully the new CEO will be able to get the Canadian operations to perform at a more profitable level. The other take-away from this slide was the decrease in SG&A expenses, which is a big positive.

Conclusion:

Deutsche Bank upgraded Cliffs on sound reasoning based off of the Investor Guidance offered on January 7th. This analysis was conducted based on the merits of the company's operations and not solely on the spot price of Iron Ore. It would appear that having exposure to China's Iron Ore markets is an important factor for future success even if it does not help the company very much at the moment. However Cliffs is uniquely positioned to capitalize on its position as a provider of Iron Ore within the United States. This is a position that is unparalleled by other significant miners of Iron Ore. It is quite possible that other Iron Ore miners will have greater trouble than Cliffs due to the difficulty in China. Cliffs is therefore the better bet for Iron Ore mining and will most likely benefit from this unique position during 2014 and 2015.

The question now is not whether Cliffs is a solid company for investment; but rather, how low will the price of Cliffs stock go based on the current issues and negative projections for Iron Ore? With the release of Goldman Sachs pessimistic analysis we can expect Cliffs to continue falling for a little while longer, but most likely we will see positive movement in the stock before the end of 2014.

Source: Cliffs Natural Resources - How Far Will It Fall?