Cliffs Natural Resources: What Options Are Left To Turn The Ship?

| About: Cliffs Natural (CLF)

Summary

Cliffs Natural Resources will report its Q4 earnings on January 27.

I think that AK Steel's and U.S. Steel's report will be equally important for Cliffs' shares.

I discuss whether the company has any options left besides cutting costs further.

Cisco Systems

Cliffs Natural Resources (NYSE: CLF) will report its fourth-quarter earnings on January 27. The company, whose stock continues to trade under $2, will have a chance to convince investors that it remains on the right path in this difficult environment.

So far, the overall market environment has prevailed, and Cliffs' actions did not help its shares. Here' what will be important for Cliffs' shares dynamics in the company's fourth-quarter report and the reports of related companies.

Read United Steel and AK Steel's reports

Cliffs' current strategy is to focus on the domestic market. The company has already done everything that it could have possibly done to achieve this result. Cliffs sold Bloom Lake mine and sold its coal assets.

I covered these events in articles "Cliffs Natural Resources: The Historic Example Of Value Destruction" and "Cliffs Natural Resources Exits Coal Business". There is no possibility to sell aging Australian iron ore mines in the current price environment, so they will stay with the company until the end of their useful mine lives.

The problem with this plan is that the domestic steel market is also under pressure. Cheap imports in combination with cheap oil seriously disrupted Cliffs' turnaround plans. In this light, steel producers' results and outlooks may be even more important than Cliffs' own results.

Both companies will present their fourth-quarter reports before Cliffs (AK Steel (NYSE: AKS) will report on January 26 before the market open and United Steel (NYSE: X) will report on January 26 after the market close).

AK Steel has recently reported a $30 increase in its base prices for all carbon flat-rolled steel products. I am not excessively optimistic about this news, and I will wait for confirmation that the market has really found a bottom.

Australian mines

In Cliffs' current setup, the goal of the Australian mines is to be at least EBITDA-neutral. Australian mines reached this goal in the first three quarters of 2015. The Australian dollar was trading in a range in the last three months of 2015, so one can expect that Cliffs' costs have at least been neutral compared to the third-quarter numbers.

However, looking into the future, it would have been better if Cliffs could squeeze a dollar or two more out of its $34.72 third-quarter cash cost. I remain very cautious about the impact of Vale's (NYSE: VALE) S11D project on iron ore prices. I touched this topic in an article "Vale: No Dividend In 2016", so I won't repeat myself here.

As a side note, notice that Vale's port problems failed to provide meaningful upside to iron ore prices. I view this as a confirmation that S11D's shadow is putting pressure on the market. I may be wrong, and this behavior of iron ore prices could just be related to the overall pressure on commodities at the beginning of this year.

U.S. mines - what's next?

As I mentioned at the beginning of this article, Cliffs has already done what it promised - sold Canadian operations and coal assets and cut costs. The remaining question is what is the current plan for U.S. mines? I'm skeptical of Essar endeavor, so I think that Cliffs still has some pricing power in the pellet's market, but to what extent?

Time goes by, and contracts will ultimately roll over. I think that we are somewhat near a bottom in the steel market, but will this translate into normal contracts going forward?

The sales outlook is also very important. Last year's sales volume outlook was cut to 17.5 million tons for U.S. mines. Clearly, this does not look great, and it's not a big surprise that Cliffs' shares struggle to return above $2.

Debt, equity buybacks

Given the current pricing levels, it's high time to discuss whether Cliffs has some options in terms of buying cheap debt or shares. In my view, the possibility of such actions will greatly depend on the company's U.S. sales outlook. I believe that if the sales outlook for 2016 is not increased compared to 2017, there is no sense in spending any amount of money on any kind of a buyback.

As for me, I'm skeptical about equity buyback. My view is that Cliffs' third-quarter cash on the balance sheet, $270 million, is near bottom in terms of a comfortable amount of cash. In this light, I think that building cash with the help of coal sales and not spending it on an equity buyback is a wise thing to do.

One could argue that the stock is trading at very low levels, but I think that the survival of the company is much more important than any short-term upside that might arise from a buyback. Long-term, if Cliffs survives current market downturn, its shares will rise significantly.

As for debt repurchases, Cliffs has previously done this and I expect that the company will continue to take advantage of favorable opportunities when they present themselves.

Bottom line

I don't think that Cliffs' fourth-quarter report will contain news that could dramatically impact the price of the company's shares. The company is still not in a critical juncture yet and has some time to figure out what to do next if the steel market does not improve.

I don't think there's any hope that the iron ore market will improve this year due to the detrimental impact of S11D. At the same time, I'm almost certain that Cliffs' CEO will once again mention Vale, Rio Tinto (NYSE: RIO) and BHP Billiton (NYSE: BHP) and blame them for careless moves that cost everyone in the industry a ton of money. I share this view, but I don't think that anything will change on this front in the short-term.

Thus, Cliffs' ability to support current capital structure depends on the success of its U.S. pellet business. Judging by the stock price, the market is quite skeptical about Cliffs' long-term prospects. There is no panic, but shares continue to trade below $2. I see no reason to enter or exit positions in Cliffs prior to the earnings report, and hope to hear a plan for the U.S. iron ore segment for this year and beyond.

Disclosure: I am/we are long CLF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.