Cleveland Cliffs Bonds Maturing In 2040 Offer 7.7% Yield To Maturity
- Cliffs saw a notable decline in revenue and gross profit in Q1.
- Cliffs did not need additional financing in Q1 as it had a large cash balance.
- While operating cash flow was negative, a deeper dive shows a rational explanation.
Cliffs Natural Resources (NYSE:CLF) reported first quarter earnings that missed expectations a couple of weeks ago. Despite what appeared to be disappointing numbers, management made upward revisions to full year guidance. Earlier in April, I wrote about the fixed income opportunity related to investing in Cliff's 2025 maturing bonds. With the possibility of the company raising the cash necessary to reduce debt, fixed income investors may want to look long term at the company's 2040 maturing bonds. Priced at 85 cents on the dollar, and a 6.25% coupon rate, the 2040 bonds are yielding 7.7% to maturity.
Cliff's disappointing first quarter numbers were centered around lower revenues. The company posted revenue of almost half of what was reported in the same quarter a year ago. Along with the lower revenues, the company's gross profit sank to slightly negative, roughly $100 million less than a year ago. Operating income differences were even lower by $120 million.
Source: SEC 10-Q
While an examination of the profit and loss statement may cause investors to turn away, a look at the balance sheet can provide some explanation. Cliff's burned cash in the first quarter and nearly doubled its inventory. Since the company had a large cash balance entering the quarter, they did not need to borrow additional funds and debt remained unchanged.
Source: SEC 10-Q
Cliff's cash flow statement can provide better insight into the company's first quarter activities. The $193 million build in inventories negatively impacted operating cash flow. These inventories can be sold later in the year, thus boosting earnings and cash flow. The $220 million cash draw in the first quarter was two thirds operations and one third capital expenditures. As demonstrated by reviewing the balance sheet, financing activities were virtually nothing in the quarter.
Source: SEC 10-Q
Included in the first quarter earnings release was an updated 2018 outlook. Based on the upwardly revised pricing increases, I've increased our revenue expectations by 5%. By taking the sales increase and incorporating the cost structure (which remained largely unchanged), income excluding depreciation should increase by $25 to $30 million versus prior guidance.
Source: 2018 Outlook numbers provided in Q1 compared to numbers provided Q4
Bondholders holding long term bonds should have knowledge of the company's maturities by year to ensure that a "debt wall" may not impede the company's ability to service its debt over a long-term length of time. For Cliffs, more than half of its outstanding debt comes due in 2025. If Cliffs can generate the cash necessary to significantly reduce debt, which will make the 2040 bonds more attractive.
Source: SEC 10-Q
When it comes to the company's cash flow projections, I made a few changes to the prior model presented with fourth quarter earnings and original 2018 outlook. The model assumes that net income excluding depreciation will equal operating cash flow (although changes in working capital may change that). Based on 2018 guidance and earnings expectations, Cliffs should have nearly $1 billion in cash following 2021. With $1.4 billion of debt due in 2024 and 2025 (excluding the 2025 convertible), Cliffs may be able to retire most of its debt prematurely.
Source: Combined 2018 Guidance and Earnings Expectations
Cliff's bondholders should not be discouraged by first quarter earnings. The company burned cash but built inventory to help future sales. Management also raised its outlook for 2018, which should increase cash flow. With the company's near-term bonds priced so high, investors can turn to the 2040 bonds for good income and price appreciation over time.
Yield to Maturity: 7.700%
Date of Maturity: 10/1/2040
Credit Rating (Moody's/S&P): Caa1/CCC+
This article was written by
Analyst’s 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.
I am long CLF 2020 maturing bonds.
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