Cliffs Natural Resources (CLF) was up over 8% at the end of Thursday, February 6th, which is the first significant increase since Casablanca Capital announced their 5.2% stake in the company on January 28th. While there was an initial surge in the stock price on January 28th after the announcement by Casablanca, this surge quickly subsided with the market responding very little. In a rather strange twist, the spot price for Iron Ore reached its lowest price since July 8th, 2013 on Wednesday of this week. This low point in the price of Iron Ore at $122.40 was largely driven by a decline in demand for steel produced by China. So how low will the price of Iron Ore go, and how does Casablanca Capital plan to circumvent these issues?
Morgan Stanley Analysis & The Bloom Lake Project:
A week before the Casablanca announcement, Morgan Stanley issued their analysis of Cliffs Natural Resources. Morgan Stanley viewed CLF unfavorably and mostly analyzed CLF based on the Bloom Lake project. Morgan Stanley estimated that it would be difficult for CLF to find a partner for the Bloom Lake Project based on their projected price for Iron Ore.
We examine 5 scenarios: 1) Cliffs moves forward with Phase II, with a new partner helping to fund capex; 2) Phase II proceeds without a new partner; 3) all Bloom Lake operations are halted; 4) Cliffs continues to operate only Phase I; 5) Cliffs seeks bankruptcy protection for the Canadian subsidiary, which we view as highly unlikely.
The downgrade mostly revolved around the likelihood of deriving profit from the Bloom Lake Project which they found unlikely due to their own projected future prices for Iron Ore as they indicated here:
On our math, a new partner would have to believe LT iron ore prices will average >$120/t and steady-state costs fall to <$70/t, versus our sample group's iron ore and cost views of $95/t and $70/t.
Because their poll of the average investor showed the majority as thinking a future partner would be easy to find, Morgan Stanley determined that the current price of CLF had not considered the difficulties of the Bloom Lake project adequately, and lowered their price target on the stock as a result.
There are a few things to consider with respect to this type of analysis:
A) The projected outcome of Bloom Lake by Morgan Stanley analysts is largely dependent on the projected future price of Iron Ore. While there are certainly analysts whom are currently projecting the future price to be at $95 per ton, there are still analysts such as Macquarie whom peg the future price at between $115 and $120. Here is a nice chart put together by the Metal Expert Consultants group:
For those interested in this you should take a look at the link above. The consensus of 31 major investment banks wasn't spot on last year, but they weren't too bad either. If the consensus is correct, then the $95 price per ton that is used for Morgan Stanley's calculations with respect to Bloom Lake, might not be accurate.
C) Some of the concerns with respect to lower prices for Iron Ore are driven by more production coming online within the next several years. While it is inevitable that more capacity will be found and brought into production, these fears may not be as well defined as some analysts think.
Here are two examples:
Guinea's president raised the heat on Vale SA and BSG Resources Ltd. over one of Africa's biggest mining contracts, saying a $2.5 billion partnership between the companies was illegal.
This difficulty for Vale SA will also cause less Iron Ore to be on the market within the near future or until the governmental issue is resolved.
2 - In the Asia Pacific region the Sino Project is not going as originally planned for the China based entity, Citic Pacific Mining.
In a recent press conference given by the president of Citic Pacific Mining and summarized by The South China Morning Post we were given some insight into how this operation has been grinding to a halt:
Palmer, who sold the rights to the ore to Citic Pacific, has sued it for what he says are hundreds of millions of dollars owed in royalties and tried to block Citic's port access.
So we can see that once again, the progress in mining Iron Ore around the world has not been terribly easy, which is a good thing for the price of Iron Ore and for Cliffs.
Casablanca Capital And The Proposed Plan for CLF:
Casablanca Capital revealed on Tuesday, January 28th, that they had a 5.2% stake in CLF as well as a proposed plan for the future of Cliffs. According to a filing, the share purchases began in Mid-November and had an average price of around $25 per share. In the simplest terms, Casablanca believes that the Bloom Lake Project is terrible for Cliffs and believes that the company should be split into two, with all international operations under one company and all United States based operations under a separate company.
Will this work for Cliffs? Moody's quickly responded, indicating that "any Cliffs Natural split could be junk rated." It would also seem that while the market initially had a positive reaction to this news, it quickly subsided with little change in the stock price.
But why would Casablanca want to have this proposed split take effect? Mostly because removing the issue of Bloom Lake would be quite beneficial for the company. But also, because the Iron Ore market within the United States, which is based on the production of United States Steel, is more insulated from outside imports then one might initially expect.
Some advantages to a United States Based company are as follows:
A) Within the United States 45% of Iron Ore is supplied by Cliffs, which easily makes it the largest supplier within the country. The freight costs for Cliffs are relatively small compared to foreign competitors with respect to U.S. based purchasers.
B) Due to many trade tariffs in place to protect United States based steel we can remain assured that the price of China's Steel as well as the decline in demand for China's Steel does not have a direct impact on the United States based steel companies.
Here are a few examples:
Many of these imports have violated U.S. or Canadian trade laws. Under these laws, duties can be imposed against dumped products, which are products sold at a price that is below that producer's sales price in its home market or at a price that is lower than its cost of production. Countervailing duties [or CVD] can be imposed against products that benefited from foreign government financial assistance for the production, manufacture, or exportation of the product. For many years, U. S. Steel, other producers, customers and the USW have sought the imposition of duties and in many cases have been successful. Such duties are generally subject to review every five years and we actively participate in such review proceedings. As in the past, U. S. Steel continues to monitor unfairly traded imports and is prepared to seek appropriate remedies against such imports.
And US Steel goes on to indicate the extent to which their CVD's apply to China's steel imports:
In response to a decision by the U.S. Court of Appeals for the Federal Circuit, legislation was enacted in the first quarter of 2012 clarifying its intent that the United States' CVD law applies to non-market economy (NME) countries, such as China. The legislation will apply to future sunset reviews of 25 current CVD orders against NME imports of steel products (24 on Chinese products, 1 on Vietnamese products) as well as any new matters.
2 - In addition to this, AK Steel Holdings (AKS) had a statement issued on December 3rd, 2013 indicating that they had a preliminary ruling turn in their favor with respect to steel imports from China.
U.S. International Trade Commission (ITC) has made a unanimous preliminary determination that non-oriented electrical steel (NOES) produced in several foreign countries is causing injury to AK Steel. The preliminary injury determination means that cases against NOES producers in six countries will proceed.
These are just some examples of how trade protections help United States based steel companies, and consequently, help Cliffs Natural Resources if it were only a United States based entity.
Earlier in this article I indicated that the demand for Steel in China has been declining. This also follows the recent appraisal of the situation by Goldman Sachs. It is only natural to expect an increase in imports from foreign countries, and provided this does not have a serious impact on domestic production, a United States based Cliffs should be adequately guarded against this danger.
Casablanca might manage to persuade Cliffs to split, and this could certainly be a good thing for Cliffs especially for the resultant United States based company. If the price of Iron Ore per ton continues to go down and reach the levels that Morgan Stanley analysts seem to indicate of $95 per ton, then certainly spinning off the Bloom Lake Project would be a good solution. By doing this Cliffs would manage to mitigate some of the risk associated with a falling price for Iron Ore.
However the Bloom Lake project may not be quite as terrible as analysts assume since the consensus on the future price for Iron Ore (as shown in the chart above) tends to indicate that the future price may not be $95. If the price for Iron Ore manages to remain around $115 then the profitability of the Bloom Lake Project will drastically improve. Therefore even if Cliffs does not split, we are probably looking at a solid investment for the future.
The price increase on Thursday of 8.2% is therefore warranted, despite the recent decrease in the price of Iron Ore per ton.