Cliffs Natural Resources Dividend Increase Sends Strong Message

| About: Cliffs Natural (CLF)

Cliffs Natural Resources' (NYSE:CLF) share price has been taking a beating lately-- in large part due to a bad combination of lower iron ore pricing and higher costs, along with fears of a continued slowdown in China, which happens to be the largest consumer of steel in the world. Not a very good combination to have at all.

However, the recent statement made by management with the latest dividend hike in the amount of $0.625 per quarter, compared to the prior quarterly dividend of $0.28, sparks some interest to take a closer look at the business. After all, this was a 123% increase in the dividend being paid to shareholders and warrants some extra attention. Tack on to this, the depressed share price for CLF is producing a current yield of 5.46%.

The primary business of CLF is iron ore production, and as such, it's pretty simple to say the business is largely impacted by fluctuations in iron ore spot price. Iron ore prices are significantly lower than a year ago but have been trending up in 2012 so far. Despite the fact that the average spot price per ton for CLF was 20% lower at $144 a ton in Q1 2012 versus $180 per ton in Q1 2011, sales still increased 7%. The company has managed a 5 year revenue compound annual growth rate of 28.73% from 2006 to 2011, which is much higher than the 7% increase in the latest quarter over quarter results.

Based on company guidance for 2012, the low end revenue expectation would come out to be $6.857B and the high end would be $7.125B. The current QoQ percentage revenue gain is higher than the high end revenue expectation for full year 2012 percentage gain over 2011 at 4.87%. Figure 1 highlights company guidance for 2012.

Figure 1: 2012 Guidance Figures by Operating Segment (source Q1 2012 10-Q)

Metric

U.S. Iron Ore

Eastern Canadian Iron Ore

Asia Pacific Iron Ore

North American Coal

Total

Sales (in millions of tons)

23

12

11.4

7.2

53.6

Revenue/ton Low End Estimate

115

140

140

130

525

Revenue/ton High End Estimate

120

145

145

135

545

Low End Total Sales Estimate (Million $)

2645

1680

1596

936

6857

High End Total Sales Estimate (Million $)

2760

1740

1653

972

7125

Click to enlarge

It should be noted that the first quarter of 2011 had the highest revenue percentage increase over 2010, so we can anticipate the QoQ revenue growth for the rest of 2012 to be less than 7%.

Higher costs have been problematic for Cliffs Natural Resources this year, with an overall increase in cost of goods reaching nearly 50% for the first quarter of 2012 compared to 2011. A large part of this increase is attributable to non-recurring favorable cost savings realized in 2011 in the U.S. Iron Ore segment. A 2012 non-recurring cost involved fire related expenses in the Eastern Canada Iron Ore segment. The rest is related to a host of unfavorable trends, ranging from higher mining and labor costs to adverse foreign exchange rates in the Asia Pacific Iron Ore segment. It will be telling of Cliffs Natural Resources' executive team to see how increased costs are countered throughout what will be a difficult remainder of 2012.

Cliffs Natural Resources has shown a commitment to reward shareholders through its most recent dividend increase of 123%. Quoting CFO Laurie Brlas from the most recent earnings call, "As you know driving top quartile total shareholder return is our main subject in growing the Company." With a current yield of 5.46%, a large dividend hike, and an apparent commitment to shareholders by management to increase total return, it is prudent to look at the company from a dividend growth perspective.

CLF's 5 year dividend compound annual growth rate (OTCPK:CAGR) is 53.85% and has been accelerating with a 3 year CAGR a whopping 102.38%. A dividend increase of 123% will have that kind of impact on historical CAGRs. With a 2012 EPS estimate of $8.11 and indicated annual dividend payment of $2.50, the payout ratio is almost 31%. This is more than three times the average annual payout ratio paid since 2004. It is highly doubtful another significant increase will be forthcoming without a reversal of EPS growth in the coming years, which means strengthening iron ore spot prices and contained costs. It's reasonable to expect smaller dividend increases however. Figure 2 shows a 10 year dividend growth analysis using a 5% and 10% dividend CAGR and assuming dividends are reinvested. A single share of CLF is used as the cost basis at $45.74.

Figure 2: 10 Year Dividend Growth Analysis at 5% and 10% estimated CAGR (Reinvested Dividends)

5% CAGR

10% CAGR

QUARTER

DIVIDEND

VALUE

SHARES OWNED

YIELD ON COST

VALUE

SHARES OWNED

YIELD ON COST

Q3 2012

$0.625

$46.37

1.0137

5.47%

$46.37

1.0137

5.47%

Q4 2012

$0.625

$47.00

1.0275

5.54%

$47.00

1.0275

5.54%

Q1 2013

$0.656

$47.67

1.0423

5.90%

$47.70

1.0430

6.18%

Q2 2013

$0.656

$48.36

1.0572

5.98%

$48.42

1.0586

6.27%

Q3 2013

$0.656

$49.05

1.0724

6.07%

$49.15

1.0745

6.36%

Q4 2013

$0.656

$49.75

1.0878

6.15%

$49.89

1.0907

6.46%

Q1 2014

$0.689

$50.50

1.1042

6.55%

$50.71

1.1087

7.21%

Q2 2014

$0.689

$51.26

1.1208

6.65%

$51.55

1.1271

7.33%

Q3 2014

$0.689

$52.04

1.1377

6.75%

$52.40

1.1457

7.45%

Q4 2014

$0.689

$52.82

1.1548

6.86%

$53.27

1.1646

7.58%

Q1 2015

$0.724

$53.66

1.1731

7.31%

$54.24

1.1858

8.47%

Q2 2015

$0.724

$54.51

1.1916

7.42%

$55.23

1.2074

8.63%

Q3 2015

$0.724

$55.37

1.2105

7.54%

$56.23

1.2293

8.78%

Q4 2015

$0.724

$56.24

1.2296

7.66%

$57.25

1.2517

8.94%

Q1 2016

$0.760

$57.18

1.2501

8.17%

$58.40

1.2767

10.02%

Q2 2016

$0.760

$58.13

1.2708

8.30%

$59.57

1.3023

10.22%

Q3 2016

$0.760

$59.09

1.2919

8.44%

$60.76

1.3283

10.42%

Q4 2016

$0.760

$60.07

1.3134

8.58%

$61.97

1.3549

10.63%

Q1 2017

$0.798

$61.12

1.3363

9.16%

$63.34

1.3847

11.93%

Q2 2017

$0.798

$62.19

1.3596

9.32%

$64.73

1.4152

12.19%

Q3 2017

$0.798

$63.27

1.3833

9.48%

$66.16

1.4463

12.46%

Q4 2017

$0.798

$64.38

1.4074

9.65%

$67.61

1.4782

12.73%

Q1 2018

$0.838

$65.55

1.4332

10.31%

$69.25

1.5140

14.31%

Q2 2018

$0.838

$66.75

1.4594

10.50%

$70.92

1.5506

14.66%

Q3 2018

$0.838

$67.98

1.4862

10.69%

$72.64

1.5881

15.01%

Q4 2018

$0.838

$69.22

1.5134

10.89%

$74.40

1.6266

15.38%

Q1 2019

$0.879

$70.55

1.5425

11.64%

$76.38

1.6699

17.32%

Q2 2019

$0.879

$71.91

1.5721

11.86%

$78.42

1.7144

17.79%

Q3 2019

$0.879

$73.29

1.6024

12.09%

$80.50

1.7600

18.26%

Q4 2019

$0.879

$74.70

1.6332

12.32%

$82.65

1.8069

18.75%

Q1 2020

$0.923

$76.21

1.6661

13.19%

$85.07

1.8598

21.17%

Q2 2020

$0.923

$77.75

1.6998

13.45%

$87.56

1.9143

21.79%

Q3 2020

$0.923

$79.32

1.7341

13.73%

$90.12

1.9703

22.43%

Q4 2020

$0.923

$80.92

1.7691

14.00%

$92.76

2.0281

23.08%

Q1 2021

$0.970

$82.63

1.8066

15.00%

$95.75

2.0934

26.14%

Q2 2021

$0.970

$84.39

1.8449

15.32%

$98.84

2.1609

26.98%

Q3 2021

$0.970

$86.17

1.8840

15.64%

$102.02

2.2305

27.85%

Q4 2021

$0.970

$88.00

1.9239

15.97%

$105.31

2.3023

28.75%

Q1 2022

$1.018

$89.96

1.9668

17.13%

$109.04

2.3839

32.64%

Q2 2022

$1.018

$91.96

2.0105

17.51%

$112.91

2.4684

33.80%

Q3 2022

$1.018

$94.01

2.0553

17.90%

$116.91

2.5559

34.99%

Q4 2022

$1.018

$96.10

2.1010

18.30%

$121.05

2.6465

36.23%

Click to enlarge

From the analysis, an investor can expect significant cash return and yield on cost after 10 years. At the 5% CAGR, the investor now owns one additional share per share invested at a yield on initial cost over 18%. Results look even better at the 10% CAGR with over 1.5 additional shares being owned for every share invested and a yield on cost over 35%. Both the 5% and 10% dividend CAGRs used in the analysis produce returns over 100%. This does not even include any price appreciation experienced by CLF shares over the next 10 years.

Comparable dividend yields for Cliffs Natural Resource's North American iron ore competitors include ArcelorMittal (NYSE:MT) at 4.70%. Asian iron ore competitors include Vale S.A.(NYSE:VALE) at 6.40%, Rio Tinto (NYSE:RIO) at 4.30%, and BHP Billiton Ltd. (NYSE:BHP) at 3.60%. Coal competitors include CONSOL Energy Inc. (NYSE:CNX) at 1.80%, Arch Coal Inc. (ACI) at 1.90%, and Peabody Energy Corp. (BTU) at 1.50%, in addition to Alpha Natural Resources, Inc. (ANR) and Patriot Coal Corporation (PCX), which do not currently pay a dividend.

With a current P/E ratio of 5.63, CLF is trading near historic low valuations over the last two years given the lowest investors have been willing to pay in 2010 and 2011 was between a P/E ratio of 4 and 5.

While it may be a good entry point to open a position, a savvy investor may choose to utilize a short put option position to enter with a slight hedge. Consider an entry point of $45. A June 2012 put option at a strike price of $45 can be sold for a premium of $160, or 3.55% yield for 12 days. If the current price is deemed an appropriate entry point, you could sell an in the money June 2012 put option at a strike price of $46 for a premium of $205, or 3.82% after subtracting the in the money portion of $0.29 since the stock is trading at $45.71.

Disclosure: I am long CLF.

Additional disclosure: I may initiate a short put option position with intent to purchase CLF in the within next 72 hours.