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Friday, August 26, 2016 2:00:34 PM
Price movement over the last three months has solid foundation.
Improving cost and capital structure positions it well for any headwinds in the industry.
Rising EBITDA will result in improved debt metrics.
Recent dilution is bearable as the reduction in debt reduces stress on the earnings as well as cash flows.
Investing in commodity companies has not been an attractive prospect over the last two years. These companies have seen one of the biggest falls in commodity prices which prompted a number of capital restructuring efforts. These companies operate in an industry where they do not have any control on the price of their product and their competitive advantage does not allow them to dictate the selling price. Iron ore producers came under a lot of pressure when the prices started to fall from the historical highs of over $187/tonne.
Cliffs Natural Resources (NYSE:CLF) was no different and the stock price took a nose dive - it was trading at above $25 in January 2014 and it had fallen below $3 by mid May this year. However, since May, good news has started to flow in for the company and the stock price has responded accordingly. Long-term deal with ArcelorMittal (NYSE:MT) and energy deals for mines have pushed the stock price up. The stock has gained more than 100% since May. ArcelorMittal accounts for 37% of its overall business and 49% of the company's US business. A new contract through 2026 with this company was hugely positive news.
However, these are recent news which has already been baked into the stock price. The fortunes of the company are still dependent on the iron ore prices. Cliffs Natural Resources is a major player in North America and the imports from Brazil and other sources are hurting the North American iron ore and steel prices. United States is the third largest steel consumer in the world behind China and Japan. North American markets have mainly been dominated by the local players. However, the decline in Chinese consumption and consistently rising supplies from Australia and Brazil has created a supply glut in the global market. As a result, imported iron ore has become cheap and attractive for some of the North American steel mills.
Cliffs Natural Resources operates on long-term contracts like the one it has with ArcelorMittal. This business model gives it some security regarding the sale of its product. However, it does not guard the company against the drop in commodity prices. The imported iron ore is not having a direct impact on the volumes shipped by the company; instead it is purring the domestic iron ore prices under pressure. As a result, Cliffs Natural Resources has reported some heavy losses over the last two years. First half of the current year was good for the market as iron ore spot prices again went above $60. However, the second half has started with a declining trend in prices. This pressure is expected to further intensify in the near future due to the concerns about China closing down steel mills near the cities.
In the long-term, however, the outlook for iron ore looks good. Decrease in Chinese demand will be made up from the Asia-Pacific nations such as Thailand, Indonesia and Philippines, while Indian consumption is also rising. Major players in the iron ore production area are expecting the demand gap to be filled by these rapidly growing economies as these countries are spending a lot on infrastructure and a number of mega projects are on the way.
In the meantime, the company can only control its internal factors which are the capital structure and the cost structure. There has been a lot of improvement in the cost structure which has resulted in positive earnings as well as rising EBITDA. Adjusted EBITDA for the second quarter was $102 million and six month adjusted EBITDA reached $137 million. These adjusted EBITDA figures account for idle expenses in the mines. Shareholders have seen some dilution due to the stock issue. The company announced a secondary offering of more than 44 million shares which brought in $300 million in gross proceeds. Normally, this type of dilutive event will be greeted with a lot of negativity. However, the proceeds from this stock issue are being used to pay the debt maturing in 2018.
After the payment of 2018 senior notes, the maturity profile of the company's debt will be extremely favorable. All the remaining notes are maturing on or after 2020. This gives the company a lot of breathing space and its cash obligations come down substantially. Debt restructuring and reduction in debt has been the common theme in the sector and the payment of this note will improve Cliffs' profile. According to Cliffs' management, this transaction will result in a decrease of $17 million in annual interest expense. So, the impact of this transaction will be dual. Total debt will come down to $2.39 billion and interest expense for the year will be $211.5 million, down from $228.5 million for the last year.
This means that the adjusted EBITDA to debt ratio as well as the interest coverage ratio will improve. As the company has increased its sales guidance due to the idle mine coming online again, I am deducting idle expenses in the future expected EBITDA. Let's assume that the next two quarters yield similar results to the second quarter and the company generates $150 more in adjusted EBITDA. We will be left with a full year adjusted EBITDA of $287 million. Adding the idle expenses back we will have adjusted EBITDA of $300-310 million. This will result in Debt/EBITDA ratio of 7.9x-7.7x and interest coverage ratio of 1.42x to 1.46x. Interest coverage becomes quite strong with rising EBITDA for Cliffs Natural Resources.
The stock price movement for Cliffs Natural Resources has sound foundation and I believe it is in a good position to break $10 mark over the next few months. Restructuring efforts by the management are shrewd and the cost structure is improving. More importantly, the debt is under control and there are no immediate maturities which the company has to deal with. Cash balance of $285 million is showing improvement compared to the last year and the liquidity position is strong enough to take care of any short-term dip in iron ore prices. All these internal factors along with an improving iron ore market point towards a brighter future. The fundamentals of the company are improving and it is looking like a good long-term bet on the iron ore market.
http://seekingalpha.com/article/4002383-cliffs-natural-resources-good-long-term-buy
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