Cliffs’ Earnings Preview: Lower Iron Ore And Coal Prices To Weigh On Results

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Cliffs Natural Resources (NYSE:CLF) will announce its third quarter results on October 27 and conduct a conference call with analysts the next day. We expect lower iron ore and metallurgical coal prices to negatively impact Cliffs’ quarterly results year-over-year. ((Iron ore spot price chart, Y Charts)) In addition the company will report a $6 billion impairment charge mainly due to the depressed commodity pricing environment as a part of its third quarter results. ((Cliffs Natural Resources Inc. Expects to Include Non-cash Asset Impairment Charges within Its Third Quarter Results, Cliffs Natural News Release))

The third quarter earnings release will be the first since Casablanca Capital won control of the company’s board through a proxy contest. The new management’s stated strategy for Cliffs involves focusing on its U.S. Iron Ore business segment and the sale of its other operations. The conference call on October 28 will provide an opportunity to the new management to further voice its plans to operate the company competitively in a subdued iron ore and coal pricing environment.

See our complete analysis for Cliffs Natural Resources

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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. [1] Weak demand for steel in China has translated into weak demand for iron ore. Chinese steel demand growth is expected to slow to 3% and 2.7% in 2014 and 2015 respectively, from 6.1% in 2013. [2] A slowdown in economic growth has tempered the demand for steel. China’s GDP growth is expected to slow to 7.3% and 7.1% in 2014 and 2015 respectively, from 7.7% in 2013. [3] Further, 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, will negatively impact these mills’ prospects. [4] 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. The weak Chinese economic prospects are captured by the Manufacturing Purchasing Managers’ Index (PMI). The Manufacturing Purchasing Managers Index (PMI) measures business conditions in the manufacturing sector of the concerned economy. When the PMI is above 50, it indicates growth in business activity, whereas a value below 50 indicates a contraction. Chinese Manufacturing PMI, reported by China’s National Bureau of Statistics, stood at 51.1 for September, and has ranged between 50.2 and 51.7 for the whole year. [5] With weak Chinese manufacturing growth, demand for steel is expected to remain subdued in China.

On the supply side for iron ore, expansion in production by majors such as Rio Tinto and BHP Billiton despite weak Chinese demand, 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. [6] Iron ore prices stood at $82.38 per dry metric ton (dmt) at the end of September, around 38% lower than at the corresponding point of time last year. [7] As per Goldman Sachs, the worldwide surplus of seaborne iron ore supply will rise to 175 million tons in 2015, from an expected 72 million tons for 2014 and 14 million tons for 2013. [8] In view of the persisting oversupply situation, iron ore prices will remain subdued in the near term. This will negatively impact the company’s third quarter results.

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. [9] 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. The benchmark Australian metallurgical coal price stands at around $119 per ton, around a third of its 2011 peak level of $330 per ton. [10] In view of the oversupply situation, metallurgical coal pricing is expected to remain subdued.

Cliffs’ Response and Other Developments

In order to remain competitive in a subdued iron ore and coal pricing environment, Cliffs has cut costs as well as adopted a strategy of disciplined capital allocation. The company had earlier reduced its planned capital expenditure for 2014. The revised full-year capital expenditure range for 2014 is $275-$325 million, around $100 million lower than its original guidance of $375-425 million, and approximately 65% lower year-over-year. Around 75% of the planned reductions in capital expenditure are targeted at the company’s high-cost Eastern Canadian Iron Ore operations and North American Coal operations. ((Cliffs Natural Resources Inc. Reduces Full-Year 2014 Capital Expenditures by an Additional $100 Million, Cliffs Natural News Release))

The company recently announced that it expects to record an impairment charge of approximately $6 billion on its seaborne iron ore and coal assets in the third quarter. The impairment charge is mainly due to the company’s revised outlook on pricing and market conditions for these commodities. [11]

The new management favors focusing on the company’s U.S. Iron Ore operations and the sale of its high-cost assets. These include the assets of the company’s North American Coal, Eastern Canadian Iron Ore and Asia-Pacific Iron Ore business segments. The new management has already signaled its intent to sell off assets from the North American Coal division. In an SEC filing, the new management reversed the decision of the former management to idle the Pinnacle coal mine, if market conditions did not improve. The reason given for this decision was to ‘facilitate unlocking the value of assets’. [12] Keeping the mine operational is desirable if it is to be sold off.

Expectations from Conference Call

With the subdued iron ore and coal pricing environment set to continue in the near term, we would like to know whether the company has identified any other opportunities for reductions in operating costs or capital expenditure. We would also like to know if any asset sales, as per its strategy, are on the horizon. More clarity on this front will shed some light on the road ahead for Cliffs.

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Notes:
  1. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  2. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association []
  3. Goldman Sachs cuts China growth forecast sharply, Market Watch []
  4. The Latest Iron Ore Price Slump: Causes and Effects, Forbes []
  5. China Manufacturing PMI, Trading Economics []
  6. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb []
  7. Iron Ore Spot Prices, Y Charts []
  8. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  9. Coking coal price crashes through $100, Mining.com []
  10. Metallurgical Coal at 6-Year Low as Chinese Demand Slows, Bloomberg []
  11. Cliffs Natural Resources Inc. Expects to Include Non-cash Asset Impairment Charges within Its Third Quarter Results, Cliffs Natural News Release []
  12. Cliffs Natural Resources 8-K, SEC []