The Rising Influence of Rising Affluence

[DewDiligence]

Barron’s is bullish on CLF. This feature article in today’s issue is
not especially well-researched (there are some misstatements noted
in my bracketed annotations), but it gets the main story correct:
Bloom Lake is a world-class asset and (unless iron-ore prices crash)
CLF will eventually make very good money from it, propelling the
share price or instigating a buyout offer. Please see the links in
#msg-86318042 for related information.

http://online.barrons.com/article/SB50001424052748703769504578398890045935294.html

›Climbing Up the Mountain

Shares of Cliffs Natural Resources already discount a sharp drop in iron-ore prices, and could double in the next year. Good news at Bloom Lake…

APRIL 6, 2013
By DAVID ENGLANDER

In the past two years, a slowdown in China has clobbered the price of iron ore, a key ingredient in making steel. Iron-ore prices fell to $85 a ton last fall from a high of $189 in 2011, before recovering to a recent $137.

Few companies were hurt as much as Cliffs Natural Resources, a Cleveland-based miner of iron ore and coal founded in 1847. The company's earnings plummeted, and its shares (ticker: CLF) lost 73% of their value in the past year, including a drop of 52% in 2013. That makes Cliffs, which closed Friday at $18.45 the worst performer this year in the Standard & Poor's 500.

Cliffs was laid low, in large part, by its $5 billion acquisition in January 2011 of a Canadian iron-ore miner, whose Bloom Lake mining project has proved a huge disappointment [#msg-58708254 has the Jan 2011 PR announcing the Consolidated Thompson acquisition with my annotations]. In recent months, a dilutive equity offering and a large dividend cut, along with fears the seaborne iron-ore market is becoming oversupplied and heading for a significant price drop, have sent more investors running for the hills.

But the latest selloff, which has left the shares trading at 60% of tangible book value, appears overdone. Michael Gambardella, an analyst at JPMorgan, thinks the stock is already discounting a significant drop in the price of iron ore, and says the oversupply fears are overblown [I agree, of course]. As Cliffs' management shows improved execution at Bloom Lake in the next year, he sees the shares more than doubling. [I’ve posted on numerous occasions that CLF shares have a built-in 50% discount for management’s prior ineptness, so Gambardella and I are basically on the same wavelength.]

Gambardella is a rare bull on Cliffs, which has attracted a large cadre of short sellers. About 20% of the stock's float was sold short as of mid-March. Barron's was bullish on the company in an ill-timed story early in 2012, only to see the shares slide sharply.

Cliffs operates five iron-ore mines in Michigan and Minnesota, and seven coal mines in West Virginia and Alabama. It also operates Wabush, a second iron-ore mine in Canada, and has interests in mines in Australia and Latin America. [This prior sentence is somewhat misleading: Wabush, which is adjacent to Bloom Lake in Eastern Canada, was recently idled and does not figure into CLF’s LT plans, and CLF’s equity stake in Brazil was recently monetized.] The company is a relatively small player in iron ore compared with the industry's four largest miners, BHP Billiton (BHP), Rio Tinto (RIO), Vale (VALE), and Fortescue Metals Group (FMG.Australia). Cliffs sold 42 million tons of iron ore in 2012, and 6.5 million tons of coal.

Cliffs earned $493 million, or $3.45 a share, last year, down 72% from 2011. Earnings were hurt by lower prices for seaborne iron ore and higher costs associated with Bloom Lake. Revenue declined 11%, to $5.9 billion. Earnings could fall to $1.89 a share this year, but begin rising in 2014 as production at Bloom Lake ramps up.

Bloom Lake, in Ontario, is the centerpiece of Cliffs' strategy to tap growth in Asia by expanding its production of seaborne iron ore. [Bad fact-checking by Barron’s: Bloom Lake is in Quebec, not Ontario.] Bringing the mine online has taken longer and been costlier than expected. Management is targeting production of 14 million tons at Bloom Lake by 2015. [By comparison, CLF’s US mining segment is expected to produce 20Mt of ore in 2013.]

On an annualized basis, based on December production, the mine produced seven million tons of ore, below the company's previous target of eight million. Expected production costs this year of $70 to $75 a ton compare with the original target of $40 to $45 a ton. Management is committed to completing the project by 2015. On a Feb. 13 earnings call, Cliffs' CEO, Joseph Carrabba, called Bloom Lake "the future of the company." Carrabba couldn't be reached for comment.

Cliffs has $3.8 billion in net debt, much of it acquired to finance the Bloom Lake buy. [I commented on CLF’ balance sheet in #msg-86289416.] A credit ratio triggered a violation of a debt covenant late last year. To shore up its balance sheet and proceed with Bloom Lake, Cliffs restructured some debt, raised more than $900 million by selling equity, and slashed its dividend by 76%, saving $250 million a year. Shares now yield 3.3%. The moves, while painful, are likely to keep the company on track.

The wild card is the price of seaborne iron ore [obviously], which some analysts expect to fall below $100 a ton, as the market becomes oversupplied. Gambardella disagrees [as do I]. He thinks the large miners will exercise supply discipline, as they did last fall, and that marginal iron-ore costs could remain above $100 through 2020.

His price target is $40, based on a multiple of 7.5 times enterprise value to 2015 estimated Ebitda (earnings before interest, taxes, depreciation, and amortization).

The downside for Cliffs could be limited, given the stock's depressed valuation. If the shares fall further, the company could become an acquisition target [duh]. That probably would send the price higher, and the short sellers to the hills.‹