Cliffs Nervous Bondholders

| About: Cleveland-Cliffs, Inc. (CLF)
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Summary

A rough year for Cliffs stockholders and bondholders.

Impairment charge reduced total assets as a percentage of total liabilities from 210% to 96%.

Possible December tax loss and or margin selling may send prices lower.

Cliffs Natural Resources (NYSE:CLF) stockholders and bondholders have had a rough 2014. The weak stock performance helped elect a new board of directors. Unfortunately, the new board has not been able to stem the decline. Bond prices have been under pressure since the new board was installed. The stock price has seen a few rally attempts, but they have failed with the stock hitting new lows.

The August 25, 2014 decision by the board to authorize a $200 million share repurchase program while iron ore and coal pricing was under pressure may have shaken bondholders. The share repurchase announcement was likely intended to be a message of faith and confidence in the firm's prospects. It was not received that way. Bond prices began falling after the September 9, 2014 release announcing changes in the multicurrency credit agreement.

The table below illustrates the magnitude of the decline in bond prices using data obtained from the Finra website.

Credit downgrades

S&P and Moody's have lowered Cliffs credit rating to junk or high yield from investment grade. The $500 million issue due 2018 has seen its coupon increase from 3.95%, (original) to 5.95%, per Finra. Interest expense will increase by $10 million per year because of the 200 basis point coupon increase. That is $10 million unavailable to common stockholders or roughly 6 cents per share. Moody's on December 4 downgraded the credit to B1. S&P has a BB- rating as of October 7, 2014.

Assets write-downs weaken financial metrics.

The new board had little choice but to write-down the value of long-lived assets by $7.695 billion for the quarter ending September 30, 2014. The prior board was in charge when the assets were purchased. The assets were mostly debt financed and purchased at what now appears to be rich valuation.

Total assets declined from $13.121 billion on December 31, 2013 to $4.811 billion on September 30, 2014. Total liabilities fell from $6.237 billion to $4.988 billion. Total Assets as a percentage of Total Liabilities declined from 210.4% to 96.4%.

Credit Agreement $1.75 billion to $1.125 billion:

On September 9, 2014 Cliffs amended its credit agreement reducing the size from $1.75 billion to $1.25 billion, and it permitted using $200 million to repurchase stock. On October 24, 2014 the credit facility was reduced to $1.125 billion.

Bond tender or not:

Bond tender: November 19, 2014

The Company currently intends to finance the purchase of Securities tendered in the Tender Offers by issuing at least $1.1 billion in aggregate principal amount of senior secured debt securities that will mature prior to the 2020 Notes (the "New Debt Financing"), but, subject to market conditions and at the Company's sole discretion, the Company may elect to enter into alternative debt financing.

The bond tender relied upon selling secured debt to fund the unsecured debt purchase. The bond tender was pulled as financing was not available on acceptable terms. When the bond tender was announced, it seemed odd that financing was not already in place. The tender documents mentioned the desire to sell over a billion dollars of secured debt. In hindsight, it might have been better to secure financing before announcing a bond tender. The bond tender announcement, like the share repurchase announcement, may have been designed to signal confidence by the board. For a short time, the bond prices did stabilize.

Bond Tender Termination December 3, 2014

The Tender Offers are being terminated because the Company's debt refinancing has been postponed due to perceived adverse market conditions.

The pulled bond tender may create more bondholder concerns. The selling of over $1 billion secured debt would increase the risk for remaining unsecured debt holders. The $200 million share repurchase authorization combined with the common stock dividend, roughly $90 million per year, may have unsecured debt holders nervous.

If bond investors were confident in the financial outlook would they tender bonds for 65 cents to 80 cents on the dollar before accounting for an early tender premium of 5 cents? In early September, the bonds were trading materially higher as shown in the table below. Bond investors tendered more than $600 million worth of bonds.

Casablanca Capital is a large Cliffs stockholder that engaged in a proxy contest. They won a number of board of director seats and own 7,906,520 shares or 5.2% of the outstanding shares. The total purchased cost is reported to be $200,748,000 or roughly $25.39 per share.

According to a from filed with the SEC

"The shares of Common Stock reported herein as beneficially owned by Casablanca are or may be held from time to time in margin accounts established by the Accounts with their respective brokers or banks and a portion of the purchase price for the Common Stock may be obtained through margin borrowing. Securities positions which may be held in the margin accounts, including the Common Stock, may be pledged as collateral security for the repayment of debit balances in the margin accounts."

If margin debt was used to finance the purchase of Cliffs common stock it could be problematic given the decline in the share price from $25 to under $8. It is unclear what, if any, margin debt has been used.

The stock price weakness may, in part, be a result of forced selling by leveraged investor to satisfy margin calls or to realize a tax loss.

The new leadership at Cliffs has signaled a change in strategy to refocus on the US domestic iron ore market and to exit the coal business. Exiting the coal business makes sense given that Cliffs and Invenergy are considering a cogeneration facility for the Michigan Upper Peninsula operations. Being a coal miner that prefers anything but coal for power generation might send the wrong message.

December Tax Loss Selling

December might be another rough month for Cliffs stock, mandatory convertible preferred stock, and the bonds as tax loss selling takes place. The high yield market might have some liquidity issues that hampered Cliffs refinancing plan and may result in depressed prices. The mandatory convertible preferred stock has limited liquidity.

Steel Demand

The sharp crude oil price decline since June may lessen demand for some steel products. ConocoPhillips announced a reduction in its capital budget. Applications for new drilling permits were down nearly 40% for November. How the decline in capital spending budget impacts end steel demand remains to be seen. However, the weak global economy may increase steel imports and pressure US domestic pricing.

The demand for steel used for construction and road repair might pickup with the decline in energy prices and the need to maintain roads. It remains to be seen if falling crude oil prices help or hinder economic growth.

Credit Positive Moves

The suspension or termination of the common stock dividend would be viewed positively, especially if the roughly $90 million per year were used for debt reduction.

The cancelation of the share repurchase program might suggest that the board can make tough financial decisions and would be viewed positively.

The table below shows the current bond yields.

Shareholder Friendly Moves

Simplify the return of capital and place all owners on a level playing field. Cancel the share repurchase plan and replace it with a dividend that pays a percentage of net income. If paying dividends works for private equity, then it should work for a public firm. If the share repurchase made the most financial sense, as some will suggest. Then why do IPO firms pay out dividends rather than repurchase shares? A single case of an IPO prospectus detailing a share repurchases cannot be recalled but many with dividend distributions can.

Dividend payout will require regaining and maintaining an investment grade rating. This could lower funding costs and assist when the debt comes due and needs refinancing. Regaining an investment grade rating could save Cliffs $10 million per year on the 2018 issue. The savings could be made available to stockholders.

Bottom-line

Cliffs bond issues offer a better risk adjusted return compared to the common stock. The bonds pay an investor while they wait for a turnaround while being higher in the capital structure. While the common stock may offer attractive longer-term returns with an improving balance sheet and improved iron ore demand and pricing. The bonds need to perform better for the stock to perform better.

Disclosure: The author is long CLF, CLV.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.