Higher Iron Ore Prices Will Boost Cliffs’ Year-Over-Year Quarterly Revenues And Profits

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Cliffs Natural Resources (NYSE:CLF) will announce its fourth quarter results on February 13. Given the higher iron ore prices this year compared to levels in 2012, we expect the company to post higher year-over-year revenues and profits. [1]

Iron ore prices were higher in the fourth quarter as China defied slowdown expectations. However, a lot of new supply is set to hit the market in the next few years. Large players such as BHP, Rio Tinto and Vale are going ahead with their expansion plans almost simultaneously. This will push down prices and put pressure on margins of higher cost producers like Cliffs.

In November, Cliffs decided to suspend the Ring of Fire chromite project in Canada’s Ontario province for an indefinite period of time. This will be a setback to its diversification efforts. Last month, Casablanca, a hedge fund with a substantial stake in Cliffs, recommended that the company should spin off its international operations into a separate entity to improve the investment rating of its U.S. business.

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See Full Analysis for Cliffs Natural Resources Here

Iron Ore Prices

Although the majority of Cliffs’ revenues come from its North American iron ore business, which sells primarily to U.S. customers, sales prices are nevertheless benchmarked to global prices, which are influenced to a large extent by the Chinese demand.

Iron ore prices in the fourth quarter were higher than expected because the sentiment about China’s economy was buoyant, defying previous expectations. The production of steel surged due to the stimulus aimed at stabilizing the country’s economy. Since inventories of iron ore were low, increased demand from the steel industry triggered a rise in demand for iron ore. Thus, we think that Cliffs’ fourth quarter results will benefit from higher iron ore prices and profits will show a year-over-year increase.

Going forward, we think that iron ore prices are likely to go down. According to the Bureau for Resources and Energy Economics, the official Australian commodities forecasting agency, iron ore exports from Australia are expected to grow at an annual rate of 8% between 2014-2018. The rise in demand is not expected to commensurate with the rise in supply. [2]. Therefore, Cliffs will face more challenging times than its bigger rivals such as Vale, Rio Tinto and BHP Billiton who have much lower cash costs per ton of iron ore and coal. While Rio, BHP and Vale are estimated to have a production cost of less than $50 per tonne, Cliffs has a cash cost of production in the range of $65-70 per tonne. ((Cliffs Q3 2013 10-Q, SEC))

In fact, it is their low operating costs which are likely responsible for the mining giants’ decision to go ahead with a production surge despite the inevitable fall in prices they would have to face. They may be banking on pushing the high cost miners out of the market in an environment of falling prices and capturing their business. [3]

Ring Of Fire Suspended Indefinitely

Cliffs announced in November that it was suspending the $3.3 billion Ring of Fire chromite project indefinitely because it was no longer financially viable after the company was denied permission to build a road to its deposits at Black Thor. This road was proposed to pass through a region claimed by rival miner KWG, which wants to build a railroad instead. The region is too fragile to support two heavy ore transportation systems. While Cliffs proposed a $600 million road, KWG proposed a $1.6 billion railroad. The Ontario land and mining commissioner ruled against Cliff’s. While the company says that it will continue to work with all parties over the issue, we think that the project is as good as dead for a long time. [4]

Casablanca Capital’s Recommendations

On January 28, Casablanca Capital filed a Schedule 13D document with the Securities and Exchange Commission where it disclosed its 5.2% shareholding in Cliffs Natural and included a letter sent by the fund to the company’s board. The fund said that Cliffs should bundle its Bloom Lake project and Asia Pacific operations into an independent entity. According to the fund, Cliffs’ international business is exposed to the seaborne iron ore market and has a different risk/reward profile than its U.S. business where barriers of entry for other players are high. The letter included other proposals about increasing dividends and corporate structuring of the U.S. business. The fund’s thrust was on unlocking value for shareholders and boosting the stock price. [5]

What We Will Be Watching

Cliffs’ earnings conference call after declaring fourth quarter results should be interesting. We expect questions from analysts on the Ring of Fire project as well as Casablanca Capital’s recommendations. We will watch out for the management’s responses to these in order to gauge the future strategy of the company. Also, we will keep an eye on the company’s reported cost of production in each of its business divisions to gauge its performance prospects in a likely environment of low iron ore prices going ahead.

Our price estimate for Cliffs Natural Resources is $32, which represents 59% upside to the current market price. This will be revised after the earnings results are out.

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Notes:
  1. Iron Ore Spot Price Chart, YCharts []
  2. Australia raises China iron ore import forecast, Financial Times []
  3. BHP, Rio gamble with stacked iron ore deck – Russell, MineWeb []
  4. Cliffs Natural Suspends Chromite Project Indefinitely, Trefis []
  5. Casablanca Capital Letter To Cliffs Natural, SEC []