The Negative Thesis
Iron Ore and Met Coal Supply Glut
Years of buildup in supply by major producers like BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), and Brazil's Vale (NYSE:VALE) to match Chinese demand has caused a supply glut. Chinese demand cooling has exacerbated the problem. China accounts for around 50% of worldwide steel production, and the spot prices for iron ore and met coal organize there in North China. The supply glut is real and the major problem for iron ore producers worldwide. Often, counter-intuitively, production tends to initially increase for a while in the face of falling spot market prices as producers attempt to make up shortfalls in margin with higher production. Another reason for this is that some of the larger players in the market with the best balance sheets attempt to put smaller less well-funded players out of business. Cliffs still faces this situation with its met coal operations in the U.S. and the Australia Koolyanobbing operation.
China Steel Dumping
Likely the biggest risk to Cliffs medium term is the flood of Chinese steel imports resulting from a combination of decreasing or flat demand, and increasing production capacity in China. The leftover steel must find a home, and often it's the second largest consumer of steel in the world, the United States. Steel producers in the U.S. have been feeling the sting of lower priced Chinese steel. According to a Washington Post article, steel imports in the U.S. have been on the rise for years, rising 68% in 2014. If steel production by America's producers declines, naturally their demand for met coal and iron ore pellets declines as well. Of course, the U.S. along with governments from other countries seek anti-dumping protection when this type of event occurs. But negotiations and legalities concerning anti-dumping laws can linger long term, so I place no faith in those actions to assist Cliffs. Declining U.S steel production in the U.S. is the biggest potential negative for Cliffs over the next few years in my view.
Worldwide Spot Price Paints a Dismal Picture
With worldwide demand weakened by China's slowdown, iron ore seaborne supply growing by 100M tons, and substantial risk to the downside to the consensus analyst forecast of $68, what's to like about the macro picture for iron ore? Nothing. And it's aptly reflected in the price of CLF stock price.
With the iron ore spot price hovering near a record low of around $60, many unprofitable mines will have to be shuttered. The consequences from the over-supply created by major producers will be seen for several years. Prices could be depressed for a long time, so Cliffs customer relationships and positioning as a stable, consistent supplier is crucial to their survival. While Cliffs is not unaffected by the spot market price, it does have a golden shield.
The Positive Thesis
"While other mining companies will continue to suffer the consequences of an oversupplied seaborne iron ore market, Cliffs is focused on its core business in the United States." Cliffs CEO Gonclaves
Cliffs Golden Shield
Cliffs Great Lakes U.S. customer base somewhat protects the company from the ravishes of the worldwide spot market for iron ore. For example, in the most recent Q4 period Cliff's reported a selling price of $99/ton with production costs of $57/ton. These prices are for Cliffs value-added pellets, rather than iron ore fines in the spot market, which is currently around $60/ton. Cliffs benefits from long term contracts for its U.S. iron ore pellets. The nearest term substantial contract negotiation for this division is December, 2016 with Arcelor Mittal. I expect the golden shield U.S. Iron ore operations to earn cliffs $650M in adjusted EBITDA in 2015, down 21% from 2014.
Cliffs Koolyanobbing Australia operation will likely be around break even EBITDA for 2015 if the current iron ore prices in China hold. The operation has a low cost of production of around $40-$45/ton, and better mix than many mines with 51% lump (better grade of iron ore) than the more prevalent fines. This expectation assumes no divestiture of this operation. Cliffs will maintain the mines with little Capex cost. The mines are unofficially for sale, and current mine structure there has a 5 year life, at which time they will be idled if they have not been sold. My guess is that these mines will account for around 30% of sales in 2015 after the restructuring.
Eastern Canada Operations
Cliffs closed the unprofitable Wabush mine in Eastern Canada, and has "resolved" the Bloom Lake mine there. Bloom Lake was the biggest sore spot for the company as the mine carried a very high cost structure. CEO Gonclaves committed almost immediately upon taking the CEO position to either selling or closing Bloom Lake, and he's followed through. Cliffs acquired the mine in an ill-timed purchase in May 20111 and it's nearly sunk the entire ship. Fortunately, the Bloom Lake mine operation was in a subsidiary company structure (with another partner) and Cliffs has "ringfenced" the liabilities through restructuring, which I would guess means bankruptcy. Whatever the terminology, it's happily off the books of Cliffs and that's the major reason for the huge asset impairment from last quarter.
Recent Capitulation Selling
The slaughter of negative news both macro and micro has caused the consistent slide of the share price of Cliffs Natural Resources (NYSE:CLF) and the increase of shorts as well. The news and analyst downgrades have overwhelmed the excellent actions being made at the company by new CEO Laurenco Gonclaves. Yahoo! Finance put the short % of float at a stout 43.7% as of February 27th. The dividend has been cut to zero, smartly in my opinion, in favor of debt reduction. Moody's recently downgraded the company's credit rating. The company now has negative shareholders equity due to asset impairments. There is little to keep the stock price from falling. But based on the operational changes taking place at the company, I believe the share price is starting to bottom now at around $4 - $4.50 per share.
One person not selling is CEO Gonclaves, who purchased 100,000 shares March 4th at $6.5/share. While not a huge purchase, it's at least a vote of confidence on his part.
After the great impairments of PP&E assets on the balance sheet from $11.1B to $1.4B in 2014, Cliffs has negative shareholders equity of around $1.7B - a terrible balance sheet situation to say the least. With $2.9B in long term debt, nearly $400M in post retirement benefit obligations, and substantial convertible preferred stock there is no margin of safety on the balance sheet for this company. The positive side of the huge asset impairment is clearing out all the dead wood to enable the company to become cash flow positive going forward. My calculations for cash flow include offsetting Capex and Depreciation of around $150M, and conclude with around $500M in Adjusted EBITDA for 2015. I base this on $650M, $0, and -$100M in Adjusted EBITDA from U.S. iron ore ops, APAC Iron ore ops, and NA coal ops respectively. Net income could come close to this figure if deferred tax assets (DTAs) offset interest expenses of around $180M plus $51M in preferred stock dividends. The company will also show improvement in reducing SG&A expenses. Cliffs will use future free cash generated to reduce the $2.9B pile of debt. At a share price of $4.20, market cap of $645M, and potential $500M in free cash flow, Cliffs would trade at 1.29X cash flow. Even after deducting interest expense, Cliffs would trade at 2X levered free cash flow. My estimates must be too rosy. Either that or the consensus opinion is just so negative that there are few buyers for the stock.
New CEO Gonclaves has done a remarkable job over the past seven months since taking the helm of Cliffs. He's "resolved" of the biggest company sore - the Canadian Bloom Lake outfit, and sold another non-core holding in North America - Logan County coal. While having to impair the balance sheet by billions of dollars, he's given the profitable core U.S. iron ore operations and Koolyanobbing mine in Australia a chance to shine. He's done everything possible in my view to help the company survive. To me, the biggest risk to the company is not the declining worldwide spot market price for iron ore as the market presumes, but rather unhealthy production demand from U.S. Steel producers. Cliffs debt profile is also and obvious risk. More conservative investors may want to take a, "wait and see" approach while seeking an uptick in iron ore price via the Platts Steel Raw Materials Outlook. However, if you're the type of investor with a high risk/return profile, and you like to "lean into the wind" a bit with contrarian bets, you can purchase Cliffs shares at a nice discount to CEO Gonglaves recent purchase.
Disclosure: The author is long CLF.
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.