Why Splitting Cliffs Natural Resources Isn't The Best Idea

Feb.19.14 | About: Cliffs Natural (CLF)

By Stuart Burns

To split or not to split?

An article this week in Iron Investing News on efforts by minority shareholder Casablanca Capital to have Cliffs Natural Resources Inc. (NYSE:CLF) spin off its overseas operations underlines the disparity between the iron ore markets in North America and the base metals markets.

With no futures market and large domestic natural resources, the North American iron ore market exists as something of a microcosm within the rest of the world.

Casablanca Capital is trying to force the Cliffs board to spin off its Bloom Lake mine in Quebec and the company's Asia Pacific-based assets to "realize true value." Cliffs' board is staunchly resisting any such move, arguing that the company is stronger for having a spread of risks and rewards rather than focusing just on the fortunes of one market, the U.S. Great Lakes area, where the firm has its domestic assets.

Casablanca's reasoning, the article explains, is that Cliffs' international and domestic iron ore businesses have "very different risk/reward profiles." Specifically, the company's Asia Pacific assets are "directly exposed to the competitive 'seaborne' iron ore market, and the large Bloom Lake project is still in the development stage," while the company's U.S. iron ore assets "benefit from unique supply and demand characteristics and barriers to entry in the Great Lakes, generate strong cash flow and enjoy long-term contracts, which provide volume and price visibility."

In other words, the U.S. operations are not exposed to the Chinese steel industry and the swings and fortunes that market exerts on the seaborne global iron ore price.

Whether Casablanca Capital has a point depends on your time frame - the short-term gain of spinning off assets and redistributing the returns to shareholders would be negated over time by the exposed position a shrunken Cliffs Natural Resources would find itself in; as the article points out, the firm would become a takeover target for a company like ArcelorMittal (NYSE:MT).

But the point is, with lower energy prices and a less volatile, largely captive iron ore supply market, the U.S. steel industry has advantages going forward that few (if any) in the world can match. Stable iron ore supply and pricing combined with the low cost of energy in the U.S. will help counter higher regulatory costs for steelmakers during the balance of this decade and provide a more profitable future for both miner and steelmaker.

A Split Cliffs a Better Prospect Than Combined One?

Probably not. Much of the investment in Bloom Lake seems to have already been made or accounted for; why sell the asset now, especially if the North American steel industry stands to benefit from unique advantages going forward?

As to its Asian assets (for which read: Koolyanobbing in Western Australia), those have limited upside from a price perspective, but with more resources reported to be in the area, it could have long-term potential, provided Australia doesn't kill the goose that lays its golden eggs with more taxation.

Global iron ore prices are more likely to ease lower than rise over the next five years, but any sales price would reflect that view, so a sale would only make sense if ore grades were declining and/or Cliffs had unsustainable levels of debt to pay down. The firm has been on a buying spree over the last decade, but has managed to pay down its debt quite effectively during that time.

Still, it does carry some $3 billion of debt. If Casablanca Capital has its eye on returns from sold assets to pay down debt, that would be one thing, but simply to redistribute to shareholders or buy back stock would be an extremely short-term move.

Disclosure: No positions