Trends Driving Our $10 Price Estimate For Cliffs

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20.07
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Trefis
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Cleveland-Cliffs

Tumbling iron ore and coal prices have taken their toll on the business prospects of Cliffs Natural Resources (NYSE:CLF). As confirmed by the company’s Q3 results, the subdued commodity pricing environment has reduced realized prices and margins for the company. Cliffs’ third quarter revenue stood at $1.3 billion, around 16% lower than its revenue in the corresponding period a year ago. [1] Excluding impairments and other one-time charges, the company reported an adjusted net income of $33 million in Q3 2014, around 77% lower as compared to an adjusted net income of $144 million in Q3 2013. [1]

We have a new $10 price estimate for Cliffs, which is around 3% lower than the market price. In this article we will look at the trends driving Cliffs’ business prospects and our valuation of the company’s stock.

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. [2] 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. [3] 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. [4] Furthermore, 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. [5] 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. [6] With weak Chinese manufacturing growth, demand for steel is expected to remain subdued in China.

On the supply side, 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. [7] 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. [8] This fall in iron ore spot prices was mirrored by the reported realized prices by the company in Q3. The realized prices for the company’s Eastern Canadian Iron Ore and Asia Pacific Iron Ore business segments fell 33.5% and 36.5% respectively, on a year-over-year basis in Q3. [1] The realized prices for the U.S. Iron Ore operations fell only 10.6% year-over-year in Q3, as contracts for this division are mostly priced based on 12-month averages and are less susceptible to volatility in iron ore spot prices. [1]

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. [9] In view of the persisting oversupply situation, iron ore prices will remain subdued in the near term.

China is also the largest consumer of metallurgical coal in the world. Demand for the commodity by the Chinese steel making 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. [10] 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. [11] Cliffs’ North American Coal division reported a 23.5% year-over-year decline in realized prices in Q3. [1] In view of the oversupply situation, metallurgical coal pricing is expected to remain subdued in the near term.

Cliffs’ Strategy

The U.S. Iron Ore segment is the most profitable division for the company. It reported an operating income of $32.05 per ton in Q3 2014, as compared to losses of $35.39 per ton and $13.06 per ton for the Eastern Canadian Iron Ore and North American Coal business segments, respectively. The Asia Pacific Iron Ore operations reported an operating income of $2.96 per ton in Q3. [1]

Cliffs’ management has articulated its strategy for the company. It favors focusing on its U.S. Iron Ore operations and the potential 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 management has already signaled its intent to sell off assets from the North American Coal division. In an SEC filing, the management reversed an earlier decision 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.

The company management has also made its intentions pertaining to the Eastern Canadian Iron Ore operations quite clear. The high-cost Wabush mine was idled in Q1. [13] The management also believes that the ongoing Phase I operations at its Bloom Lake mine are not economically feasible. In order to reduce the production cost and improve profitability, the company needs to undertake Phase II expansion of the mine. The capital requirements for Phase II expansion would be approximately $1.2 billion. [14] In order to undertake this expansion, Cliffs is looking for strategic equity investors who will  take up an addtional 30% stake in the mine, along with signing off take agreements for iron ore produced from Bloom Lake. These investors are likely to be integrated steel producers, such as Cliffs’ equity partners in its U.S. Iron Ore operations. [14] If the company is unable to attract investors by the end of the year, it would  idle the mine, instead of operating the unprofitable Phase I operations.

Trefis Estimate

In view of the prevailing iron ore and coal pricing environment, we have revised down our estimates for realized prices and margins for all divisions. This has led to a revision in our price estimate for Cliffs from $15.64 to $10.35. With the prevailing subdued iron ore and coal pricing environment expected to persist in the near term, prospects look quite bleak for Cliffs. Things may improve slightly for the company if it is able to offload some of its high-cost assets or find strategic investors for its Bloom Lake mine. We will be keenly following developments at Cliffs.

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Notes:
  1. Cliffs Natural Resources Q3 2014 Earnings Release, SEC [] [] [] [] [] []
  2. China Ore Stockpiles Rise to Record on Financing Deals, Bloomberg []
  3. Short Range Outlook for Apparent Steel Use 2013-2015, World Steel Association []
  4. Goldman Sachs cuts China growth forecast sharply, Market Watch []
  5. The Latest Iron Ore Price Slump: Causes and Effects, Forbes []
  6. China Manufacturing PMI, Trading Economics []
  7. BHP, Rio Gamble with Stacked Iron ore Deck, Mineweb []
  8. Iron Ore Spot Prices, Y Charts []
  9. Iron Ore Price Forecast Cut by Morgan Stanley on Supply, Bloomberg []
  10. Coking coal price crashes through $100, Mining.com []
  11. Metallurgical Coal at 6-Year Low as Chinese Demand Slows, Bloomberg []
  12. Cliffs Natural Resources 8-K, SEC []
  13. Cliffs Natural Resources Q1 2014 10-Q, SEC []
  14. Cliffs Natural Resources Q3 2014 Earning Call Transcript, SEC [] []