What Casablanca Capital’s Proxy Contest Victory Could Mean For Cliffs

Cliffs Natural Resources (NYSE:CLF) has announced the appointment of Casablanca Capital’s nominee, Lourenco Goncalves, to the positions of chairman, president and chief executive officer, bringing to an end a six-month proxy fight with the activist hedge fund. ^[1] This appointment followed the election of six Casablanca Capital nominees to Cliffs’ 11-member board of directors at the company’s annual meeting of shareholders, giving Casablanca control of the company’s board. ^[2] Casablanca’s victory is likely to result in a significant strategic shift for the company, including the sale of its international mining assets.

See our complete analysis for Cliffs Natural Resources

Casablanca Capital

Casablanca Capital, founded in 2010 by Donald G. Drapkin and Douglas Taylor, is an activist hedge fund that holds a 5.2% stake in Cliffs. ^[3] Casablanca favors strategic focus on the company’s U.S. Iron Ore operations and the sale of its other businesses, which comprise of the Asia-Pacific Iron Ore, Eastern Canadian Iron Ore and North American Coal operations. ^[4] Cliffs’ former management was of the view that selling off these assets in a low commodity price cycle would destroy shareholder value. ^[5] Negotiations between the two sides did not result in a settlement, with Casablanca ultimately succeeding in its bid to take control of Cliffs’ board. Under the direction of the new management, the company’s strategy to combat commodity prices is likely to involve asset sales.

Iron Ore and Coal Prices

Iron ore and metallurgical coal are important raw materials for the steel industry. Thus, demand for these raw materials by the steel industry plays a major role in determining their prices. Though a majority of Cliffs’ iron ore sales are to the North American steel industry, sales agreements are benchmarked to international iron ore prices. International iron ore prices are largely determined by Chinese demand since China is the largest consumer of iron ore in the world. It accounts for more than 60% of the seaborne iron ore trade. ^[6] Flagging demand for iron ore from China in the wake of an economic slowdown earlier on in the year, put downward pressure on iron ore prices. According to data from China’s National Bureau of Statistics, growth in investment, factory output and retail sales slowed to multi-year lows in the first two months of the year. ^[7] A Chinese government crackdown on polluting steel plants has forced many of them to shut down. In addition, the tightening of credit by Chinese banks to steel mills that are not performing well has negatively impact their prospects. ^[8] Furthermore, the Chinese leadership has proposed structural reforms of the economy, shifting the emphasis from investment and export driven growth to services and consumption led growth. Such a transformation of the Chinese economy may negatively impact Chinese demand for steel in the long term. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. ^[9] Weak demand for steel has indirectly resulted in weak demand for iron ore as well as metallurgical coal.

On the supply side for iron ore, expansion in production by majors such as Rio Tinto and BHP Billiton has created an oversupply situation. A combination of weak demand and oversupply is likely to result in lower iron ore prices in the near term. ^[10] Iron ore spot prices stood at $92.74 per dry metric ton (dmt) at the end of June 2014, about 19.2% lower than a year ago. ((Iron Ore Spot Price Chart, YCharts)) The outlook on iron ore prices remains bleak in the near term, in view of the oversupply situation.

China is also the largest consumer of metallurgical coal in the world. Demand for the commodity by the Chinese steelmaking industry has been weak, adding to subdued demand from other major consumers such as Japan and the EU. Weak demand, coupled with an oversupply situation due to expansion in production by major mining companies, has resulted in plummeting coal prices. ^[11] This will have a negative impact on Cliffs’ North American coal business, which primarily sells metallurgical coal, whose prices are linked to prices of Australian metallurgical coal. Prevailing coal prices are around a third of their 2011 peak levels of $330 per ton. ^[12]

Potential Asset Sales

Cliffs’ U.S. Iron Ore operations constitute the bulk of its iron ore production, with 22-23 million tons in iron ore shipments expected in 2014. This is the company’s most profitable segment, with a sales margin of $33.94 per ton in Q2 2014, as compared to $37.77 per ton in Q2 2013. ^[13] Sales contracts for this division are mostly structured on 12-month averages and are less susceptible to fluctuations in iron ore prices, as compared to other segments which have contracts more closely linked to spot prices. This segment is expected to be the focus of the new management’s plans, with the other segments potential candidates for divestment.

The two segments that are the most likely to be involved in potential asset sales are the Eastern Canadian Iron Ore and the North American Coal operations. Both these segments reported operating losses in Q2 2014. The Eastern Canadian Iron Ore segment is Cliffs’ least profitable iron ore segment, with its sales margin standing at a loss of $19.36 per ton in Q2 2014. This segment reported an operating loss, despite the idling of the high cost Wabush Scully mine in Q1 2014. The sales margin stood at a loss of $25.70 per ton in Q2 2013. ((Cliffs’ Q2 2014 10-Q, SEC)) The North American Coal segment also reported an operating loss in Q2 2014. Sales margin for the segment fell to a loss of $25.89 per ton in Q2 2014, as against a profit of $3.16 per ton in the corresponding period last year. ((Cliffs’ Q2 2014 10-Q, SEC)) The new management has already signaled its intent to sell off assets from this division. In a recent SEC filing, the new management has reversed the decision of the former management to idle the Pinnacle coal mine, if market conditions do not improve. The reason given for this decision is to ‘facilitate unlocking the value of assets’. ^[14] Keeping the mine operational is desirable if it is to be sold off. Thus, the new management may be about to put its plans into action.

With a subdued iron ore and metallurgical coal pricing environment expected to continue in the near term, Cliffs will struggle to find buyers for its iron ore and coal assets. Further, the company may not realize the best value for its assets in the prevailing pricing environment. We feel that the company should selectively divest some of its high-cost operations, should a suitable opportunity present itself. It should continue the cost reduction initiatives and disciplined approach to capital allocation that the erstwhile management has already initiated. The company has lowered its full-year capital expenditure for 2014  to $275-$325 million, approximately 65% lower year-over-year. ^[15] Such measures will enable Cliffs to operate competitively in the prevailing subdued commodity pricing environment.

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1. Lourenco Goncalves Appointed Chairman, President and Chief Executive Officer of Cliffs Natural Resources Inc., Cliffs Natural Resources Press Release [↩]
2. Cliffs Natural Resources Inc. Announces Results of Annual General Meeting of Shareholders, Wall Street Journal [↩]
3. Cliffs Natural Resources Names New CEO, Wall Street Journal [↩]
4. Miner Cliffs names Goncalves CEO, cancels coal mine plan, Reuters [↩]
5. Cliffs Natural Resources Inc. Mails Open Letter to Shareholders, Cliffs Natural News Release [↩]
6. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg [↩]
7. China Premier Warns On Economic Slowdown As Data Fans Stimulus Talk, Reuters [↩]
8. The Latest Iron Ore Price Slump: Causes and Effects, Forbes [↩]
9. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association [↩]
10. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb [↩]
11. Coking coal price crashes through $100, Mining.com [↩]
12. Pain of low coal prices finally too much for Australian miners, Reuters [↩]
13. Cliffs’ Q2 2014 10-Q, SEC [↩]
14. Cliffs Natural Resources 8-K, SEC [↩]
15. Cliffs Natural Resources Inc. Reduces Full-Year 2014 Capital Expenditures by an Additional $100 Million, Cliffs Natural News Release [↩]