Cliffs Natural Resources: Still Juice Left In This One?

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

Summary

Capital structure is improving and should result in a stronger entity.

Credit metrics have improved and the leverage ratio is now below 6x.

Full year 2017 adjusted EBITDA estimates and debt reduction should result in an extremely impressive leverage ratio.

Market conditions and contract renewals should enhance the profitability.

Cliffs Natural Resources (NYSE:CLF) still remains a good pick despite the stellar gains in the last six months. At the end of August, I predicted that the stock will break the $10 barrier in the next few months. At the time, it was trading below $6, and in December, we saw it breach $10. I have been bullish on metals due to the recovering global economy, increased infrastructure spending from the emerging markets in Asia-Pacific, India and China. As I expected, most of the commodities have gained considerably in the last six months and iron ore prices have more than doubled to over $80/ton. I believe the commodity prices will remain strong in the next two years as the infrastructure spending continues to rise. We are going to see substantial spending in the US as well, which is sure to further increase demand for the US steel. In addition to the market conditions, Cliffs' internal efforts to improve the capital structure have gone a long way in making it an attractive investment.

First of all, the debt metrics. Based on my calculations, I expected the company to report full year adjusted EBITDA of $300-310 million (explained in the article linked above). However, the reported adjusted EBITDA figures of $374 million show that my iron ore price expectations were on the conservative side. The latter half of the year resulted in better than expected adjusted EBITDA figures. This changes a lot for Cliffs Natural Resources. Its total leverage comes down considerably. $300 million in adjusted EBITDA would have resulted in debt/EBITDA ratio of over 7x. However, current EBITDA figures mean the leverage ratio has come down to 5.8x. A reduction in leverage ratio along with the better business prospects have resulted in an upgrade from the credit ratings agencies. Its credit rating has been bumped up to B2 from Caa1. It is still in the "speculative" band but a bump of two ratings points is encouraging. The debt was in "substantial risk" category before the upgrade.

The debt profile is going to improve further. The management had already created a lot of breathing space by paying near-term debt (maturing in 2018), and its earliest debt payment was in 2020. However, they are going to replace and reduce the debt with new offering. A$500 million new notes issue and a secondary offering of 55 million (63.25 million if the underwriter exercises option to purchase 8.25 million additional shares) new shares will be used to finance this reshuffling/payment of debt. The target is again to eliminate near-term debt maturities. They are targeting 2020-21 debt maturities in this new push. This will serve two purposes. First, the debt will be reduced and the debt payment obligations will be pushed back. Secondly, pricier debt will be replaced with cheaper notes. Reduced debt and lower interest rate will have a double impact on the bottom line.

The management has been extremely resourceful regarding the stock issue. The stock has gained more than 100% in the last six months and the demand remains strong. As a result, the management has been able to raise cash at an attractive price without hurting the share price. Even after the announcement, the stock price remained unaffected and it has just pulled back slightly even after two weeks. It is a clear indication that investors/shareholders are confident about the business prospects and are willing to accept dilution. It shows a lot of confidence in management's ability to continue improvement in business.

If the debt reduction is in the range of $400-500 million, then we are going to see the leverage ratio fall in the more respectable range of around 4x. However, if the company is able to meet its full year 2017 adjusted EBITDA figures of $850 million, then the investment grade rating might be achieved. With $850 million in adjusted EBITDA and $1.7-1.8 billion in debt, Cliffs Natural Resources will have a leverage ratio of around 2-2.1x. It is an extremely tempting situation. However, we will have to see by how much the debt is reduced and what sort of full year EBITDA figures we get.

US infrastructure spending plans might be pushed into 2018. This is one factor that might affect the company and the demand for iron ore in North America. Other factors are in favor of Cliffs Natural Resources. Stricter regulatory environment for the imported ore, renegotiation of contracts with buyers and rising demand/price in the North American as well as the Asian markets will continue to push the stock price higher in 2017. Improving capital structure and debt profile give it a better foundation to take advantage of the market conditions. Based on all these factors, Cliffs Natural Resources remains a good investment and the turnaround is not complete yet. There is still a lot of juice left in this one.

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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