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Cliffs Natural Resources (CLF) is set to announce its third quarter earnings on Wednesday, October 24. We are expecting the company to post a decline in net income on a year-over-year basis. Iron ore prices have declined significantly from levels seen a year ago. We expect that falling prices of heavyweight iron ore will drag down the company's overall margins. Rising energy, labor and other input costs will also put pressure on margins.

North America is showing signs of a nascent recovery with demand from automobile and housing sectors beginning to rise. Demand from Asia-Pacific remains relatively sluggish. If the Chinese government does provide a boost to infrastructure spending, it would result in a higher demand for iron ore, which in turn would provide a boost to prices. Any positive effect, however, is unlikely to be felt in the remaining part of 2012. With its solid asset base and favorable industry factors, Cliffs is well-placed to succeed in the long term.

Cliffs is the largest producer of iron ore pellets in North America and a major supplier of direct-shipping lump and fines iron ore out of Australia. It is also a significant producer of metallurgical coal. It operates iron ore and coal mines in North America and two iron ore mining complexes in Western Australia. In addition, Cliffs has a major chromite project, in the feasibility stage of development, located in Ontario, Canada.

As a result of economic conditions in the Eurozone and a slowdown in demand from China, iron ore is trading at significantly lower prices in the international markets than in the corresponding quarter last year. Accordingly, we expect revenues and profits to take a heavy hit in the third quarter.

Cliffs saw three consecutive quarters of revenue increase before suffering a year-over-year decrease last quarter. Revenues fell 10% in the second quarter and rose 6.9%in the first quarter, 16.7% in the fourth quarter of the last fiscal year and 59.2% in the third quarter of the last fiscal year. The company has seen its profit decline in each of the last three quarters. Net income fell 36.7% in the second quarter, 11.2% in the first quarter and 49.5% in the fourth quarter of the last fiscal year.

Outlook For The Rest Of 2012

We have lowered 2012 shipment expectations from the North American iron ore business due to lower production expected from Bloom Lake Mine. However, the company's shipments may still show marginal growth on the back of an improved U.S. economy. North American iron ore constitutes 67% of our price estimate for the company. Healthy automotive sales and a recovery in the housing construction market in North America will drive the need for iron ore demand.

We have increased sales from the Asia Pacific iron ore operations as the company is eying the Asia-Pacific region to tap into the continued strong demand compared with the stagnant outlook in North America. However, we have lowered average realized prices primarily due to an unfavorable change in product mix.

Solid Assets

Cliffs has some high-quality assets which are expected to drive its growth in the long term. At its Bloom Lake Mine in Canada, the company can increase production up to 22 million tonnes from the present figure of 7.2 million tonnes. The mine has a well-established infrastructure, there are attractive development opportunities at Lamelee and Peppler Lake in the vicinity, and the production from here can access Asian markets like those of China easily. Cliffs also has other iron ore mines like Empire and Tilden Mines, Hibbing Taconite, and the Northshore Mine.

The company has a world-class chromite asset in the form of Black Thor in Canada. It is expected to produce 600,000 tonnes of ferrochrome once production begins in 2016. The company will be spending close to $3.3 billion on this project as capital expenditure.

Long-Term Outlook

Cliffs sees economic growth in developing countries as the driving force for its future business. The company is eyeing the Asia-Pacific region to tap into continued strong demand. In 2012, the company expects to sell nearly half of its 45+ million tonnes of expected global iron ore sales to seaborne customers in the Asia Pacific region, with the remainder expected to be sold to North American customers. However, sustained weak iron ore prices could dampen the mood.

Barriers to entry in mining are rising due to increasing costs and technological challenges associated with bringing new supplies to the market. This places incumbent players like Cliffs in an advantageous position. With an established track-record and a strong balance sheet, Cliffs will find it easier to tap into scarce capital from the markets in order to invest in future production sources. (Investor Presentation, Cliffs Website)

Our primary concern stems from the fact that the North American iron ore and coal divisions' revenues are highly dependent on a few customers. ArcelorMittal, Algoma and Severstal together constitute about 35% of Cliffs' total revenues. A loss of sales to any of these existing customers could have a substantial adverse impact on the company's revenues and profitability.

Our price estimate for Cliffs Natural Resources is $48, which is nearly 6% ahead of the current price of the company's stock.

Disclosure: No positions.

Source: Cliffs Earnings Preview: Low Iron Ore Prices To Weigh On Results