Valuentum's  Instablog

After we predicted a dividend cut in November 2012, Cliffs Natural Resources (CLF) finally cut its dividend after posting poor results for 2012. The firm slashed its quarterly payout 76% to $0.15 per share.

Results for Cliffs were actually a bit better than consensus estimates on both the revenue and earnings side. Total revenue declined 4% year-over-year to $1.5 billion, while earnings dipped 59% year-over-year to $0.62 per share (after adjusting for a $1 billion goodwill impairment). Free cash flow for the year was incredibly weak, falling to a negative $613 million, explaining why the dividend needed to be cut. If we only took into account the payout ratio, Cliffs' adjusted earnings per share of $3.45 for 2012 would seem to give the dividend ample cushion (its prior annual dividend payout was $2.50 per share, an adjusted payout ratio of 72.5%). However, Cliffs is a perfect example of the significant and potential tragic pitfalls of using the payout ratio as a measure of dividend safety and why the Valuentum Dividend Cushion is one of the most important metrics for income investors to use to safeguard their portfolios from dividend-growth blow-ups.

<< FAQ: Where Can I Find the Valuentum Dividend Cushion Score?

Capital management at the firm seems relatively weak, as the company had to write down $1 billion related to its acquisition of Thompson Iron Mines in 2011. The company also had to raise capital by selling 9 million shares of common stock and 20 million shares of preferred stock. With the firm giving relatively positive guidance (shown below) for 2013, we're a bit shocked by this move since it has upset existing shareholders (Sources of Images: CLF).

(click to enlarge)

(click to enlarge)

The company's outlook suggests stronger profitability, as China and the US are expected to have improved industrial performance in 2013. The move to raise capital is fairly prudent, in our view, since Cliffs' balance sheet is not great, and some of the new equity will be used to reduce the company's debt balance. Also, commodity prices have been particularly volatile-to the point that it has been rumored that producers may be buying in the spot market to help control supply. The company also intends to allocate $800-$850 million for capital expenditures during the year, so even significantly improved operating cash flow may not be able to cover the increased capital investment.

We're currently taking a close look at the firm's valuation, and we expect to publish an updated report soon. We don't think the dividend will return to the previous bloated levels anytime in the near future. After the firm's steep price decline today, we continue to believe shares of Cliffs are fairly valued. We have no interest in adding the company to the portfolio of our Best Ideas Newsletter.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

As we celebrate over 2,500 hundred followers on Seeking Alpha, we thought it important to remind you how we use our stock-selection process. After all, our methodology combines a rigorous DCF valuation, relative valuation and technical and momentum assessment into one easy-to-interpret rating. And oftentimes, our readership may not know that it is that rating, the Valuentum Buying Index score (click here), that is paramount to our process -- not any one component by itself.

But first, let's get this out of the way. Firms in our Best Ideas portfolio should be considered our best ideas at any point in time. The Best Ideas portfolio can always be found on page 8 of our monthly Best Ideas Newsletter, which we only house on our website. We have commented on hundreds of companies, but only the cream of the crop make it to our portfolio, which we only disclose to members.

Furthermore, we've noticed via our statistical backtesting that the momentum factor behind our process tends to be much more pronounced (powerful) over longer periods of time. This was one of the interesting findings of our academic white paper study. And we try to replicate this dynamic with the update cycle of our reports (and the time horizon for our ideas to work out). That's why our reports are updated regularly or after material events and not daily. There's just too much noise in daily price movements. We expect our best ideas to work out over a 6-18 month time horizon -- any shorter than that is mostly luck, in our view.

So, in other words, we tend to add firms to our Best Ideas portfolio when they register a 9 or 10 on our Valuentum Buying Index and tend to remove firms from our Best Ideas portfolio when they register a 1 or 2 on our Valuentum Buying Index. However, we don't blindly and immediately add firms to our portfolio once they score a 9 or 10 (and we do not add all firms that score a 9 or 10 to our portfolio). For example, recently Google (GOOG) registered a 10 on our scale, but we remained patient and didn't add the company to our portfolio until after it reported earnings, which provided us with an even better entry point.

After adding firms to our portfolio, we may tactically trade around these positions when they have VBI ratings between 3 and 8 depending on the size of their weighting in our portfolio or the attractiveness of them relative to other opportunities. We tend to remove firms from our Best Ideas portfolio when they register a 1 or 2 on our process. Importantly, however, firms in our Best Ideas portfolio should be considered our best ideas at any point in time.

Take eBay (EBAY), as another example, the firm initially flashed a rating of 10 in late September 2011 (at $32)--click here for that excellent call--and we added it to our Best Ideas portfolio. The VBI rating changed to a 6 in December 2011 and then back to a 10 in May 2012. Because the rating never breached a 1 or 2, we did not remove the position from our portfolio. In fact, we tactically added to it. eBay is probably one of the better examples to use for illustrating the prolonged outperformance driven by undervalued stocks that are beginning to generate good momentum.

Though eBay may register a lower VBI rating in a subsequent update, we would still view it as one of our best ideas, as it is a holding in our Best Ideas portfolio (it has never flashed a 'We'd Sell' signal, 1 or 2). Obviously, there have been more straight-forward opportunities in our Best Ideas portfolio, especially in the case of EDAC Tech (EDAC), which has tripled since we added it to the portfolio (never registering below a 9 along the way). The VBI ratings on our most recent 16-page reports, downloadable directly from our website, reflect our current opinion on the company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Some of the firms mentioned in this post are included in our actively-managed portfolios.