The Rising Influence of Rising Affluence

[jbog]

Essar provides further disclosure on USIO
offtake contract


¦ Earlier today CLF's third largest customer in the US (Essar Algoma) released an updated corporate presentation with some useful information regarding their off take contract with CLF. The presentation reiterates that on a pro-forma basis the new CLF contract would have saved Essar (and cost CLF) around $180mn (approximately $55/t on just over 3mt) in Essar's FY13, and also provides a little more color on longer term discounts.

¦ We remain cautious on CLF because we see the company as significantly over-leveraged relative to its mid-cycle earnings capacity. Ongoing off take renegotiations are expected to see the US Iron Ore business' average realised price gravitate towards long term levels of $85-90/t more quickly than would have otherwise been the case. On a consensus LT price deck, we see the current CLF portfolio as being capable of around $300mn EBITDA p.a., which when capitalised at 5x generates an enterprise value of around half the current net debt position.

¦ Essar expects World Price benchmarking to become more common for Great Lakes iron ore in the future. Previously Essar had a 'cost plus' contract, they now have a Platts 'cost minus' contract with CLF.

Under the new contract CY14 pricing has already been agreed, and will apply from 1 Jan. The discount that Essar receives increases in later years, and CLF's position as sole supplier to Essar ends in 2016.

All we're really talking about here is Economics 101. Very few industries globally are capable of maintaining abnormal profits of this magnitude without attracting new entrants, and that's exactly what has happened. Magnetation and Essar Minnesota seem the most credible examples.

Relative to the views we published back in March, it now seems increasingly likely that CLF's response to the threat of new entrants will be price related, and not volume related.

Both Essar and Algoma provide examples. We believe that CLF is behaving exactly as it should by lowering pricing – holding firm on prices would cost them volumes, which would be a mistake. Hopefully for CLF's sake, the adjustments CLF is making to ricing will make it difficult (perhaps even impossible) for Essar to raise the capital it needs to finance the expansion from 4.1 to 7mtpa.

In order to keep new entrants out of the Great Lakes market, we need to see the price revert to around $85-90/t. This implies that CLF's EBITDA margin of $20/t on a notional 20mtpa tonnage generates around $400mn EBITDA.

On LT US$90/t (62% IODEX) the APAC and ECIO businesses generate no earnings, and so the only adjustment we might make to get to corporate EBITDA is remove minorities and SG&A to get to perhaps $300mn group EBITDA for CLF. Capitalise this at 5x and you get a $1.5bn enterprise value, relative to a current net debt position of around $3bn.