Cliffs Natural Resources (NYSE:CLF) has had a tough time this year. Iron ore prices have fallen as the combination of increased Australian production adding to supply and a weakening Chinese economy weighs on demand. Since Cliffs Natural Resources derives more than 80% of its revenues from iron ore, the deteriorating iron ore conditions have painfully squeezed the company. For its second-quarter earnings, Cliffs lost an adjusted $8 million and saw revenues fall by 26% year over year. It reported operating cash flow of negative $124 million, and the company's stock is down 32% year to date.
To make matters worse, Bloom Lake -- the mine that once held great promise for the company -- has become a figurative anchor that threatens to weigh down the entire ship. At present iron ore prices of around $90/ton, the mine is deeply uneconomical. Investment Bank Nomura believes that Bloom Lake currently generates an EBITDA of negative $60 million and a free cash flow of negative $260 million annually.
Because of all that has gone wrong, Cliffs shareholders have asked for a change. At the company's annual shareholder meeting, shareholders voted in Casablanca Capital, which has promised to cut costs as much as possible. Casablanca's plan is to sell or spin off the Bloom Lake mine and Cliffs' international assets. So, with Casablanca and its nominees set to take charge of Cliffs, what lies ahead for Cliffs and its stock?
Stock Price Depends on Magnitude of Cost Cutting
It can be said that given the horrible climate, previous management did not cut costs fast enough to please shareholders. Previous management cut costs reactively to falling iron ore prices in order to try and remain cash flow neutral, rather than cut costs all at once to preserve profits. Previous management did this because they wanted as much of Cliffs intact so that the stock could rebound greatly if and when iron ore prices rose to healthy levels again.
With Casablanca in charge, however, new management will likely cut costs to the bone all at once. How much more Casablanca's new management can cut will likely decide how well Cliffs stock will do. Given its large negative impact on the bottom line, what happens to Bloom Lake, in particular, will play a big part in deciding where Cliffs stock ultimately settles.
If new management manages to sell Bloom Lake to another company or finds a significant equity partner for the mine, this event would likely trigger a significant rally and be the best-case scenario, as Cliffs would no longer have to bear the brunt of Bloom Lake's negative cash flows or bear the cost of shutting down the mine. Analysts estimate that the cost to shut down Bloom Lake could be as high as $350 million. Any additional cash realized from a Bloom Lake sale would add to Cliffs' liquidity.
Once Cliffs frees itself from Bloom Lake, Cliffs would be a relatively solid company. Besides its small and unprofitable coal division and Bloom Lake, Cliffs' other divisions are relatively healthy and profitable. The company would then just be a boring and predictable domestic iron ore company that pays a healthy dividend.
If new management does not manage to sell Bloom Lake to another company, but rather spins it off into a separate company along with the company's Asia-Pacific assets, the stock would still do OK as Cliffs shareholders would not have to suffer the worst-case scenario of Bloom Lake going bankrupt and taking the healthy U.S. division with it. Even though the international unit would have a much higher probability of going bankrupt, Cliffs' U.S. unit would still be safe and paying solid dividends.
If new management does not manage to spin-off/sell Bloom Lake but rather shuts it down, Cliffs would likely have to drain more of its already limited liquidity. This could lead to a tepid stock price and would be the worst-case scenario with Casablanca in charge.
While Cliffs' stock has rallied significantly over the past two months, the rally is not a sign of improving fundamentals. The iron ore market remains very challenged due to a weak Chinese economy. It could get a whole lot worse before it gets better.
Instead, the rally reflects optimism that Casablanca will cut enough costs to make Cliffs profitable again. How much Casablanca manages to cut will likely decide how well Cliffs stock will do in the coming quarters.
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