Cliffs Natural Resources: Projecting 2017 Financial Performance

| About: Cliffs Natural (CLF)

Summary

The rise in iron ore benchmark prices will have a positive impact on the realized price of CLF in both the US and APAC, leading to robust revenue growth.

If CLF manages to sustain its cost reduction rate this year as well, its EBITDA will grow to $452 million in 2017, which will lead to a higher enterprise value.

CLF’s 2017 EV has been calculated at a forward EV/EBITDA ratio that’s way lower than its trailing EV/EBITDA ratio, but since its projected EBITDA is 78% higher than TTM EBITDA.

Even if CLF does not repay any of its debt and its cash position remains stagnant this year, which seems unlikely due to financial improvements, its market cap will increase.

The iron ore price rally has continued in 2017 and it is likely that the momentum will continue for the rest of the year due to two factors - commodity production capacity cuts in China and higher infrastructure investments in the U.S. Both these factors will prove to be a tailwind for iron ore mining company Cliffs Natural Resources (NYSE:CLF) as the company's business is divided into two segments - US iron ore and Asia-Pacific iron ore.

In this article, I will take a look at the investment ramifications of a rise in iron ore prices on Cliffs Natural Resources.

Gauging the benchmark iron ore price as a result of end-market improvements

The key factor why iron ore prices have rallied in the past year is because of the potential for infrastructure development in key areas such as China and the U.S. For instance, the import of iron ore into China hit a record 1.024 billion tons last year, an increase of 7.5% year-over-year, according to Chinese Customs data.

The demand for Chinese iron ore will rise once again in 2017 due to two reasons - an increase in expected steel output and a drop in domestic production. More specifically, China's crude steel output is expected to rise 1% this year, which will lead to an identical increase in iron ore demand. Concurrently, China has decided that it will pull the shutters on producers of low-grade steel who use scrap steel to produce the metal.

On the other hand, China's domestic iron ore production will not be picking up any pace. This is because domestic producers of iron ore in China have inferior output with low iron ore content, which leads to higher-cost production. This is the reason why China imports a third of its iron ore to meet domestic requirements.

Therefore, imports of steel into China will continue to rise in 2017, thereby expanding the addressable market for Cliffs Natural Resources. At the same time, lower output of iron ore by China and a decline in scrap steel usage will restrict supply, which will lead to higher pricing of the metal. At the same time, the U.S. steel industry is also anticipated to report growth this year.

More specifically, production of crude steel in the U.S. is expected to increase 4.4% this year as the infrastructure policies of the new President come into play. Since iron ore is used in smelting steel, an increase in steel output will lead to an increase in iron ore demand as well. As a result of the secular growth in iron ore demand across the globe, the benchmark price of the commodity could average at least $60 per ton in 2017.

Now, I will be using this benchmark pricing to arrive at the potential realized prices for Cliffs Natural Resources' US and Asia-Pacific iron ore operations, and then focus on the cost profile to arrive at the EBITDA.

Impact of the benchmark iron ore price on Cliffs' top line

When the benchmark iron ore price trades at $60 per ton, the average realized price of Cliffs in its U.S. iron ore segment is $76 per ton. At the same time, the average realized price in Asia-Pacific at a benchmark iron ore price $60/ton is $43 per ton. Now, I will use these pricing figures to arrive at Cliffs' potential revenue in 2017.

This year, Cliffs anticipates its sales in the U.S. iron ore segment to come in at 18 million tons. Now, as steel production in the U.S. is expected to rise 4.4% next year as mentioned earlier, I will assume that an equal amount of demand growth will be seen in Cliffs' U.S. iron ore operations. This will take Cliffs' U.S. iron ore sales to 18.8 million tons.

On the other hand, Cliffs' sales in the Asia-Pacific segment are expected at 11.5 million tons. As mentioned earlier in the article, demand for iron ore in China could increase 1% this year. Since China is the largest iron ore importer globally, accounting for almost 64% of global iron ore trade, it will have the biggest impact on Cliffs' sales. As a result, I will assume that China will be the primary driver behind the increase in Cliffs' iron ore sales in China, taking its Asia-Pacific volumes to 11.6 million tons.

Now, I have already arrived at the potential iron ore prices for 2017 in both the segments. So, Cliffs should generate revenue of $1.43 billion from the U.S. segment (multiplying 18.8 million tons with a price of $76 per ton). The Asia-Pacific segment is expected to generate almost $499 million in revenue at the projected sales and pricing figures. This means that in 2017, Cliffs' total revenue should be $1.93 billion.

After this, I will now be focusing on Cliffs' potential costs for 2017 and then arrive at the company's EBITDA, which will be then used for valuation purposes.

Projecting the costs

Though Cliffs Natural Resources has not pointed out its cost profile for 2017, I will assume that the company is able to achieve an identical reduction in costs this year as compared to 2016. For instance, in 2015, Cliffs' cash costs in the U.S. iron ore segment were $60.27 per ton, while in the Asia-Pacific segment it had cash costs of $36.95 per ton.

For 2016, Cliffs projects its cash cost of goods sold at a mid-point of $57.50 per ton in the U.S., a drop of 4.5% from last year's levels. In the Asia-Pacific segment, Cliffs sees cash costs of goods sold of $32.50 per ton, representing a drop of 12%. Assuming that the company witnesses an identical drop in its costs this year and its G&A expenses remain constant at an annual run rate of almost $110 million as witnessed in both 2015 and projected for 2016, I will arrive at Cliffs' EBITDA.

CLF EBITDA calculation for 2017

US Iron Ore

Estimated sales (in million tons)

18.8

Estimated selling price/ton

$76

Estimated Revenue for 2017 (in millions)

$1,428.80

Estimated COGS for 2017/ton

$55

Total COGS for 2017 (estimated in millions)

$1,034

A

Gross profit

$394.80

Asia-Pacific Iron Ore

Estimated sales (in million tons)

11.6

Estimated selling price/ton

$43

Estimated Revenue for 2017 (in millions)

$498.80

Estimated COGS for 2017/ton

$28.60

Total COGS for 2017 (estimated in millions)

$331.76

B

Gross profit

$167.04

Total gross profit (A+B)

$561.84

Less:

G&A expenses (in millions)

$110

EBITDA (in $millions)

$451.84

Source: Author's calculations based on numbers arrived at earlier in the article.

Hence, this year, Cliffs Natural Resources can generate almost $452 million in EBITDA at a revenue level of $1.93 billion, which gives me an EBITDA margin of 23%. This is equivalent to the EBITDA margin forecasted by YCharts for the 2017 fiscal year as well, as shown below:

Valuation using EBITDA

Cliffs Natural Resources has a forward EV/EBITDA ratio of almost 10. At this EV/EBITDA ratio, the company's enterprise value in 2017 will be $4.52 billion. Since Cliffs Natural Resources has total debt of $2.26 billion, cash position of $132 million, and minority interest of $143 million, its market capitalization this year should be $2.25 billion considering its projected enterprise value. This is assuming that Cliffs does not pay off any more of its debt and fails to increase its cash position.

In comparison, its current market capitalization is $2.11 billion, so it is likely that Cliffs will see an improvement in its stock price this year.

Conclusion

After a strong performance on the market last year, Cliffs Natural Resources looks well-placed to deliver further growth this year. So, investors should continue to hold the stock for more gains as the rally at Cliffs Natural Resources is not over yet.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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