Falling No More, Cliffs' Bonds Roar Higher

| About: Cliffs Natural (CLF)

Summary

A new supply contract is encouraging news.

The restarting of idled mines suggest demand is increasing.

The CEO appears to be making solid progress.

Cliffs Natural Resources (NYSE: CLF) has undergone a business transformation the past year or so and has returned to its historical roots of supplying iron ore and pellets to the U.S. steel industry. The health of the U.S. steel industry will play an important role in the health of Cliffs.

Cliffs bonds have rebounded from depressed levels seen earlier this year. The bond prices have staged an impressive rally since the December 30, 2015 article - Cliffs: 2016 Is Pivotal. The higher bond prices could lend support to the stock price. It is interesting that the bond prices improved after the expiration of the $200 million share repurchase plan on December 31, 2015.

Bond source: Finra

Click to enlarge

Investors or speculators that purchased discounted bonds have been well rewarded for the risk taken. A note of caution when bonds are purchased in taxable accounts, the bond premium, or discount might be amortized, per IRS rules. The change in market price appears to be treated as interest income rather than capital gain or loss.

When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount. See Discounted Debt Instruments , later.

You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount. See Partial principal payments , later in this discussion.

If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited. See Limit on interest deduction for market discount bonds , later.

On March 14, 2016, Cliffs announced that it was restarting production at the Northshore mine. This is an encouraging sign of customer demand. However, in the past, the Northshore mine has been idled and later restarted. More recently on June 9, 2016, Cliffs announced the restart of the United Taconite mine. In addition, iron ore sales guidance was increased to 18 million long ton, from 17.5 million long tons.

The more encouraging news was announced May 31, 2016, with the announcement of a new long-term supply agreement with ArcelorMittal that replaces the contracts due to expire December 2016 and January 2017. A minimum of 7 million long tons of iron ore pellets will be supplied, and could reach up to 10 million long tons, according to the press release.

The common stock price closed June 14, 2016, at $4.80 has been quite volatile recently, see chart.

CLF Chart

CLF data by YCharts

The increased volatility might be in response to the liquation of holdings by Casablanca Capital. It should be noted that investors were purchasing the stock sold by Casablanca Capital. The Casablanca Board approved the repurchase shares $200 worth of shares that resulted in falling bond and stock prices. In fact, it could be argued that the Cliffs Board creditability was reduced when it announced the $200 million share repurchase plan and then failed to purchase a single share.

The exit of Casablanca raises the question of the direction that Cliffs might undertake. Cliffs have recently redone their webpage to highlight its focus upon serving the North American steel industry and how it provides custom pellets to its customer base.

While Cliffs reported positive results on April 28, 2016, the results were driven by the gain from buying bonds at a discount to par, rather than from the sale of iron ore, which recorded a loss. It was somewhat disappointing that full year cash production cost were forecasted to run $50 to $55 a ton, compared to the $47.88 a ton that was achieved during the quarter ended March 31 st. Though, the cash production cost did fall vastly from the prior year level of $64.98.

The 10-Q contained the following language.

"On April 1, 2016, we borrowed $60.0 million and on April 28, 2016, we borrowed $45.0 million under our ABL Facility for general corporate purposes."

"On March 14, 2016, we announced we will be restarting iron ore pellet production at our Northshore operation in Minnesota by May 15, 2016. We are taking such action based on our domestic customers' demand for iron ore pellets and consistent with our previously announced production plans for the year."

Interest expense is costing Cliffs shareholders, for the quarter ended March net interest expense was $56.8 million with 181,909,771 shares outstanding. Therefore, net interest expense reduced earnings per share by 31.2 cents or $1.25 annualized.

Cliffs earnings release contained this tidbit:

"Cliffs is increasing its full-year 2016 capital expenditures expectation to $75 million from its previous expectation of $50 million. The increase is a result of the capital spend required to produce a specialized, super-flux pellet at United Taconite in order to meet a customer's pellet specification requirements."

Cliffs remains highly leveraged and relied upon a handful of major customers. There has been progress on reducing the amount of outstanding debt; unfortunately, it has not resulted in reduced interest expense. The balance sheet is expected to hamper the recovery in the stock price unless or until an equity raise is done to improve the balance sheet. Given that the Board announced a share repurchase plan with the stock in double-digits, it is now roughly $5 per share. The share repurchase plan if implemented would have greatly weakened the balance sheet.

The CEO sounded much more confident during the last conference call than in past conference calls. Given the recent announcements and recovery in the bonds and stock price, it appears that the CEO's confidence was well placed. So far, 2016 has seen encouraging news.

Conclusion:

Readers may think I am a broken record when I say that the key to the stock performance is improved bond prices. However, on a risk-reward basis, the bonds appear to offer the better value. As the bonds approach par, then the risk-reward may shift towards the common stock.

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.

Additional disclosure: Also, own Cliffs bonds.