Cliffs Natural Resources: The Rally Will Not Last

| About: Cliffs Natural (CLF)

Summary

CLF shares have made an impressive recovery this year on the back of better iron ore pricing and a debt-exchange offer, but investors should not get carried away.

Despite the debt exchange, CLF’s interest expense will increase this year and force it to burn more cash, while its net debt to EBITDA will still remain high at 11x.

Investors should not expect the iron ore rally to continue as Chinese steel mills are being forced to cut production in order to bring down oversupply and minimize losses.

Seaborne iron ore surplus this year will be 46 million tons, indicating that the industry will remain oversupplied and weigh on pricing, creating a headwind for CLF.

I find it surprising to see that iron ore miner Cliffs Natural Resources (NYSE:CLF) has bounced back in 2016, appreciating almost 15% so far this year. In fact, the stock has continued rising even after it posted woeful fourth-quarter results a month ago and slipped deeper into the red. One of the reasons why Cliffs has appreciated of late is the recent recovery in iron ore prices, while the fact that the company has taken steps to manage the debt via an exchange offer has also been a growth driver.

But, in my opinion, it won't be a good idea to expect Cliffs Natural Resources to sustain this recent momentum as iron ore prices could fall going forward, while the debt exchange offer will not have a huge impact on its financials from a long-term perspective. Let's see why.

The debt is still huge

Liquidity is a serious concern for Cliffs. The company had a net debt of $2.4 billion at the end of the last-reported quarter, which is huge considering that it has a market capitalization of less than $300 million. Although the company has improved its debt situation somewhat from $2.6 billion at the end of 2014 and $2.5 billion at the end of the preceding quarter, the remaining debt will have a huge impact on its cash flow profile and will not bring about any improvement to its financials.

I'm saying this because last quarter, Cliffs paid out $60 million in interest expenses, but it generated only $60.5 million of free cash flow. To put things in perspective, Cliffs' interest expense increased 25% year-over-year as it issued new secured notes. For the full year, Cliffs' interest expense came in at $231.5 million, up from $185.2 million in the prior-year period. Now, things are about to get worse this year as the interest expense is expected to climb to $240 million despite the debt-exchange.

Moreover, the debt-exchange offer won't be of any help to Cliffs Natural Resources. Last month, the company had announced a bond exchange which will utilize its new 8% 1.5 lien senior secured notes that are worth $710 million and due in 2020. A successful bond exchange could help Cliffs save around $40 million in yearly interest expense, according to Deutsche Bank. But, the fact remains that the coupons on the company's bonds are on the higher side and won't do much to bring down the debt profile and liquidity concerns will still exist. As reported on Seeking Alpha:

"A fully-successful exchange could reduce CLF's debt by $925M and generate ~$40M/year in savings, but the company's net debt to EBITDA still would be ~11x, Beristain calculates; also, he does not expect a fully subscribed exchange offer, believing the offering will be less than 50% subscribed."

Thus, unless the company further leverages its working capital or the iron ore prices turn favourable, the company might not have enough cash in hand to reduce its debt by any meaningful amount. However, expecting a sustained period of turnaround in iron ore pricing is not a good idea.

Iron-ore outlook

The iron-ore market is highly oversupplied and it will continue to remain oversupplied due to weakness in Chinese consumption. The reason is that China has started to consume less and less of iron-ore and the major players have kept increasing their production despite the price decline.

Now, China accounts for about 40% of the global demand for steel and about half of global steel production. Since China's economy has been suffering for the past year and economic growth has slowed down, Chinese steel mills have decided to cut down production. In fact, inventory levels at Chinese ports are rising at an alarming pace fast and in the past couple of months they have shot up above 100 million tons.

Moreover, the decline in steel prices due to overcapacity has led to huge losses in the Chinese steel industry. For instance, last year, "large and medium-sized steel mills suffered losses of 53.1 billion yuan ($8.18 billion) in the first eleven months of 2015." This year, it could be worse as exports from China are slowing down. The country had resorted to export more iron ore in order to counter the decline in consumption in the domestic market, but in January, China's iron ore exports dropped 7%.

This is a result of trade complaints filed by several countries against cheap Chinese steel, restricting avenues for the country to sell its steel. As a result, more Chinese steelmakers will cut down production as the country had 400 million tons of excess steel capacity last year.

Additionally, the Chinese government is targeting steel production cuts in the range of 100 million to 150 million tons going forward to curb pollution. This is because most Chinese steel producers use sinter as feedstock in their plants, making them environmentally unfriendly. As a result of these factors, it is expected that seaborne iron ore surplus this year will be just under 46 million tons, indicating that the industry will remain oversupplied.

Conclusion

Hence, it is not a good idea to expect iron ore prices to turn around given the conditions prevalent in the industry. This makes Cliffs Natural Resources a risky bet considering its debt and interest burden. So, according to me, it will be prudent for investors to avoid Cliffs Natural Resources and not get carried away by the recent rally.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.