Investor concerns for Cliffs Natural Resources (CLF) are well justified. With a slowing global economy, getting out of a company with a 60 month beta of 2.42, increasing expenses and thus decreasing profits is hard to argue against. FBR Capital Recently downgraded the stock from outperform to market perform and cut its price target from $102 to $56. But slow-downs don't last forever, and patient investors should start looking at Cliffs. When an investor can own a company below the tangible value of its assets, she is basically paying for the assets and procuring any future earnings for free (assuming low debt levels).
Cliffs Natural Resources is an international mining and natural resources company focused on iron ore, ferroalloys, and coal. The company's primary focus is iron ore but the stock has been depressed by coal concerns which will be addressed later. Operating iron ore mines in North America and two complexes in Australia, Cliffs seeks to target emerging market growth in Latin America and Asia.
Book Value vs. Tangible Book Value
Investors can be misled by book value calculations because "goodwill" and "intangible assets" are often included in the valuation. A large amount of goodwill is a red flag for overvalued assets. Tangible book value is calculated by removing goodwill and intangible assets from the book value calculation in an attempt to get the true breakup value of a company's assets, such as land (tends to appreciate), machinery (tends to depreciate), etc.
Compared to other well covered names in the metals and mining space, Cliffs Natural Resources and POSCO (PKX) represent significant values.
|Company||Price to Book||Price to Tangible Book|
|Rio Tinto (RIO)||1.56||2.3|
|U.S. Steel (X)||0.76||1.9|
Debt, Cash Position, and Dividend
How appealing a company trading near the value of its assets becomes is largely dependent on the level of debt the company holds. The larger a company's cash position is relative to its debt the better. Cliffs is extremely weak here with only $159.2 million in cash on $3.614 billion worth of of long-term debt which cuts into the valuation. For investor's wondering how the stock could fall so fast on weakness this may be a big part of the explanation. However, with a debt to equity ratio of 0.4 the company is not over-indebted so much as it has a weak cash position.
The good news for investors is that the company's low cash position is partially the result of a large dividend (now 6.48%). But large for investor's doesn't always mean large for the company as Cliffs' dividend payout ratio is a mere 9% compared to 33.8% for Vale, 10% for Pasco, 81% for Nucor, and 39% for Rio Tinto. This should allow Cliffs to grow when the global economy improves while continuing to reward shareholders.
Earnings and Profit Margin
For the last quarter ending June 30, 2012 Cliff's reported earnings of $4.45 per share vs. $6.07 a year ago. Not only does this represent lower iron ore prices, but slowing demand as inventories have risen from $475.7 million to $741 million over the same time period. Cliffs operates mines all over the world and thus faces headwinds from Europe and fears of a slowdown in China. Additionally, the recent bankruptcy of Patriot Coal (PCX) has spooked investors. Patriot said in a statement that its business outlook had been hurt by a reduction in coal use because of cheap natural gas, environmental regulation costs and the weaker international and domestic economies. Natural gas is the future and at these prices it is seriously cutting into coal companies.
Last year Cliff's derived $512 million of its $6.794 billion in revenues from its coal division. Therefore the concerns over coal stemming from the low price of natural gas and the struggles of pure coal plays like Patriot may be having a disproportionate impact on the stock. Cliffs also focuses production on metallurgical coal which is used primarily to produce steel as opposed to thermal coal which is used in power generation; this decreases the potential impact natural gas will have on the company and Cliffs is cutting production of thermal coal. The key is iron ore and while currently depressed, the metal is not facing threats from alternatives like coal is from natural gas.
The company's profit fell 37% in the second quarter on both rising costs and weak demand. The biggest concern here is the rising costs because while demand and prices will pickup, costs are less likely to be reduced by an economic upturn. The company said the higher costs where due to higher labor, maintenance, and mining expenses.
Despite higher costs the company expects prices and demand for its iron ore to remain stable for the rest of the year. If true, "stable" is better than declining and should help the company continue paying down debt and rewarding shareholders for their patience via the dividend.
Selective Industry Comparison
All values in billions ($) for the prior fiscal year.
|Company||Market Cap.||Revenue||1 Year % Revenue Growth||1 Year % EPS||Modified % Return on Capital||% Profit Margin|
Source: Standard & Poor's Compustat.
Because results are for the prior year, this chart is best viewed as a picture of what the beginnings of recovery may look like rather than a current snapshot. While Cliffs is not one of the largest players, it is one of the largest in North America and has shown more of a propensity for higher revenue growth than its peers. The company has also been able to operate with higher margins than many others in the space. In other words, the chart shows where investors can expect Cliffs to be positioned when prices rise and demand comes back relative to its peers. That is what really matters to the long investor and the company appears well positioned which makes it attractive at tangible book value. The debt fears will be mitigated if management's prediction that prices will stabilize in the second half comes to fruition.
Obviously investors should do a lot more homework before establishing a long position, but such a low valuation should always be a catalyst for taking a closer look. It is rare to see a large U.S. company with such a low valuation and with relatively low debt levels (debt to capital 0.4). When a company is trading below tangible book value there is no better time to establish a long position if investors take a closer look and find the future prospects of the company intriguing.
|S&P Core EPS ($)||17.25||9.61||5.33||4.76||4.48||1.85||7.47||11.59|
Source: Standard & Poor's Compustat.
Global economic headwinds remain a threat to most industries but hit growth industries like metals and mining particularly hard both depressing prices and reducing demand. Whether or not an investor decides to take a long position in Cliffs should be determined by the underlying asset valuation (great) and how she feels about the macro picture (unknown) because of the high level of debt to cash the company carries. That said, when the global economic pictures improves both prices and demand will rise and Cliffs Natural Resources will be well positioned to reap the benefits. A shareholder who establishes a long position at these levels should as well and with a 6.48% yield that shareholder will be well-paid to wait.