Why Is Cliffs Using Its Precious Cash To Buy Back Shares?

Aug.26.14 | About: Cliffs Natural (CLF)

Summary

Cliffs Natural Resources recently announced its intention to buy back as much as $200M of its own shares.

In light of a heavy debt load, declining revenues and a negative cash flow position, this is a curious time to be authorizing a $200M stock buyback.

If iron ore prices begin to recover, this could ultimately prove to be a smart move, but there's significant downside risk and it feels like a gamble.

The stock buyback could foreshadow a cut in the dividend, as Cliffs may be choosing to redirect its available cash.

Cliffs could be counting on asset sales to fund the stock buyback, but finding buyers for its assets could ultimately prove difficult.

Did I hear this latest bit of Cliffs (NYSE:CLF) news correctly? The board has decided to approve a $200M share buyback program? Is this the same company that is carrying roughly $3.5B in debt, but only has about $360M in cash on hand? Is this the same company whose revenues have declined 26% quarter-over-quarter? Is this the same company that went cash flow-negative in the most recent quarter? This is the company that decided it's time to buy back its own shares?

Obviously, there's an optimistic view and a pessimistic view that comes with a move like this. The board obviously feels that there is some value to be had in such a move and there's an argument to be made in favor of a stock buyback. The stock price is at the lowest level it's been at in years. Buying shares in the current environment is essentially buying at a deep discount. It's a strategy that worked for Bank of America (NYSE:BAC) recently as it was weighing the choice of buying back discounted shares or raising the dividend. It ended up buying back its own low-priced shares (but ultimately ended up raising the dividend too). It's a legitimate strategy as long as there's a rebound in the future. With Cliffs, that's not necessarily a certainty.

It's also worth asking where the money is going to come from for this. Casablanca, prior to taking over the board, left little uncertainty in its desire to divest Cliffs of underperforming and non-core assets. They want to rid themselves of the Bloom Lake facility as quickly as possible, and the money could come from that sale, but nothing is imminent on that front, and potential buyers could be scarce.

One of my initial thoughts is that this move could be portending a dividend cut. Cliffs spends about $100M a year in dividend payments to shareholders. The 4% yield on the stock is nice for investors, but it's also a number that's pushing the limits of sustainability. If the board decides that there's more value in a stock repurchase, it could essentially swap one for the other.

But is a stock buyback a wise decision at all at this point? The company is saddled with a huge amount of debt, and it would seem that any available cash would be better used on that. Even if the cash isn't used to address debt, a company that is bleeding cash and experiencing declining revenues with no immediate relief in sight should be hanging on to its cash to get through the current rough period. Cliffs continues to cut back on capital expenditures to save money, but there comes a point where you simply can't cut back any more. If iron ore prices haven't started recovering by then, it could be tough staying afloat.

Conclusion

The new Cliffs board has been resolute in its desire to return value to shareholders, and this announcement falls in line with that goal. And it's worth noting that Cliffs would have up until the end of 2015 to make the buyback, so it's not like it's going to be dropping the cash tomorrow. But this strikes me as a move made by the board to demonstrate its ability to increase shareholder value at the expense of longer-term planning.

Given the current iron ore environment, it would seem a wiser choice to either hang on to cash or pay off debt. If Cliffs completes the share buyback and iron ore prices start rising again, this will look like a smart move. But at this point, it's a bit of a gamble. And if the board is wrong, it could mean serious consequences.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.