Cliffs Natural Resources: Classic Value Trap

Oct.11.12 | About: Cliffs Natural (CLF)

The easiest way to invest is looking at the recent past. Trends and mirages often come and go, but it is easy to think a stock that was a top performer just a couple years ago could regain its high in the next several years.

Cliffs Natural Resources (NYSE:CLF) and many leading iron ore and metallurgical coal stocks have sold-off hard over the past year as growth in China has begun to slow dramatically. China was growing at over 8% when the real estate and construction industries of this nation were booming just a couple years ago, but the slowdown in China has accelerated significantly in the last year.


Cliffs Natural Resources lost over 50% of its value over the last year, and leading iron ore and metallurgical coal producers such as Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP), have also sold-off hard.

Cliffs Natural Resources is a nearly $5.8 billion dollar company that gets just over 20% of its revenues from the seaborne market; the company's primary business is iron ore production. Cliffs Natural Resources has long-term contracts and sells on spot price. The company has become increasingly levered to the seaborne iron ore market through management recent acquisitions, and gets nearly 25% of its revenues from the seaborne iron ore market. The company's largest operations are in North America, but most iron ore prices are heavily influenced by Asian demand.

Cliffs Natural Resources has operating margins of nearly 27%, a return on equity of 21%, levered cash flow of nearly $1.5 billion, and free cash flow of nearly $271 million. The company also has over $4 billion in debt and less than $200 million in cash. Cliff's Natural Resources quarterly revenue growth is negative 10%, and the company's quarterly earnings growth is nearly negative 37%. The stock trades at nearly 4x trailing earnings and 6x forward earnings estimates.

Cliffs Natural Resources is heavily levered to Chinese demand, and the company's fixed contracts are obviously based on recent spot prices. China comprises nearly 70% of the seaborne market, and the nation's nearly $500 billion stimulus in 2010 caused a massive boom in the emerging country's real estate and construction sectors. China's real estate and construction industry is grossly overbuilt today, and iron ore prices have dropped over 50% in the last year. Buyer defaults have been widespread, and leading economic indicators in China clearly show contraction.

Many traders have argued that the significant recent fall in iron ore prices and new $156 billion dollar stimulus from the Chinese government are reasons to buy stocks in the mining sector that have sold-off hard over the last year. The problem is that these stocks have no long-term catalyst. Chinese GDP is over $7 trillion, and the country spent and financed more real estate and infrastructure projects in two years than most countries do in a decade. The recently announced stimulus program is fairly small, and the country won't change leaders until next year.

The recent cash flow and earnings of companies in the iron ore and mining sectors is very misleading, and iron ore prices have historically been much lower than this commodity trades at today. Iron Ore prices currently are at around $117 a metric tonne, down from over $200 a metric tonne in 2010, but iron ore prices were below $70 a metric tonne just 7 years ago.

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Iron Ore prices have fallen nearly 50% from 2008 and 2010 highs, but iron ore prices are still 40% higher than prices were in 2005 and 2009. Many companies such as Fortescue, Rio Tinto, and BHP Billiton, ramped up production when iron ore prices peaked in 2010, and much of that production is coming on-line today. Iron ore production also generally occurs in stable countries such as Australia and Brazil, and many of the labor disputes and issues of political stability affecting leading copper companies such as Freeport-McMoRan (NYSE:FCX) are not concerns.

If iron ore prices stabilize but fail to rally over the next couple years, iron ore and metallurgical coal companies will likely continue to struggle. The iron ore market is over-supplied and Chinese real estate and construction industries are overbuilt. Chinese steel companies are also increasingly using scrap steel as well. If Cliffs Natural Resources continues to see spot prices fall, the company will face ratings downgrades. Cliff Natural Resources could sell assets, cut capital expenditures, or raise capital, but if management has to raise capital when iron ore markets are weak, the company will likely pay a premium. The company's mining projects are also multi-year projects.

Cliffs Natural Resources has less than $200 million in free cash flow and over $4 billion in long-term debt, and the company's cost of capital will rise and iron ore prices fall. China has announced new stimulus efforts, but iron ore prices have rallied only modestly, and steel markets also remain weak in the U.S., Europe, and most emerging markets. Iron ore prices may be near a bottom, but the fundamentals of this market remain weak.

Disclosure: I 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.