Replies to post #7191 on The Rising Influence of Rising Affluence

[jbog]

CS suggested the Essar deal this morning.


Investors and Great Lakes iron ore producers alike have queried some of the targets published by new entrants like Essar in the context of our thesis on the Great Lakes iron ore market.

¦ We are not naïve enough to think that all of the targets will be met, but frankly we don’t think it really matters if Essar’s costs are $20/t, $40/t or even $80/t. Once the capital has been deployed however, and Essar has its own iron ore mine, the ‘ship will have sailed’ for CLF. At this point, it wont matter whether Essar’s costs are $20/t or $80/t, it will still make more sense for Essar to use their own ore than to buy it from a third
party (i.e. CLF).

¦ What this all boils down to is that CLF is the only iron ore producer on the Great Lakes that is not vertically integrated into steelmaking. CLF therefore does not have an inhouse customer for its product. Everyone else does.

Essar’s Phase 1 project costing ~ $1.1bn and delivering 4.1mtpa appears relatively low risk, but it is our understanding that the company is still working on the $600mn required for Phase 2 which would take total production to 7.0mtpa (incremental 2.9mtpa). We
believe that it would be in CLF’s best interests to prevent this Phase 2 (2.9mtpa) from being funded and built.


We wonder whether CLF might be able to block new entrants out of the market by:

¦ Providing Essar with a lower cost, long term off take alternative to compete with building their own supply. In other words, provide Essar with the security of low cost, long term iron ore supply that is more attractive to Essar than finishing construction and financing of its own project.

¦ Alternatively, if Essar is intent on owning 7mtpa of iron ore capacity, then perhaps CLF could sell / JV the incremental ~2.9mtpa at less than what Essar will otherwise spend building it.

[DewDiligence]

CLF extends IO-pellet-supply contract with AKS through 2023:

http://finance.yahoo.com/news/cliffs-natural-resources-inc-announces-204500189.html

Cliffs Natural Resources Inc…announced today that it has entered into a new Agreement with AK Steel (AKS) to supply iron ore pellets from 2014 through 2023. The new Agreement includes minimum and maximum volume iron ore pellet purchases from Cliffs, as outlined in the Agreement. Cliffs will continue to supply AK Steel with iron ore pellets for the remainder of 2013 and 2014 under the previous Agreement between the two companies.

…the new Agreement provides a pricing mechanism for the volumes sold in the contracted years. The annual price will be determined by a formula-based pricing mechanism, where the annual price is adjusted by multiple factors including seaborne pricing for iron ore and certain producer price indices.

Today’s deal with AKS follows a similar deal struck with Essar Steel in June (#msg-88988001).

[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.