Why Cliffs Is Going For An Equity Offering At Subdued Valuations

Cliffs Natural Resources has filed an S-1 form with the SEC, which is a precursor to a $300 million equity offering by the company. ^[1] As per Cliffs’ S-1 filing, the company intends to use the proceeds of the equity issue for ‘general corporate purposes, including the repayment of debt, in particular the company’s 2018 Senior Notes.’ ^[1] Though Cliffs’ stock has rallied nearly 200% so far year to date, the company’s current $5 stock price is still roughly 95% lower than the $100 peak value attained in the last five years. ^[2] Thus, issuing equity at this juncture may not result in the company realizing the best value for its stock and result in significant equity dilution for existing shareholders. However, it is a cautious move by the management to ensure that the company pays off debt maturing in 2018 and averts the possibility of default as it continues to grapple with a challenging business environment.

Cliffs had notes with a principal amount of $283.6 million maturing in 2018 outstanding at the end of Q1 2016. The following is a summary of the company’s debt maturities, as mentioned in its Q1 2016 10-Q.

If the company provides for debt maturing in 2018, it does not have any more debt maturities to worry about until 2020. Moody’s downgraded Cliffs to a Caa1 rating (which is a junk bond grade) with a negative outlook in January this year. ^[3] With a junk bond rating, raising more debt at reasonable terms would be extremely difficult for Cliffs. Thus, the equity offering is insurance against a potential default in 2018. However, at the current market price (around $5), issuing $300 million worth of equity would result in an approximate 25% dilution for existing shareholders. Is the timing of this equity offering right?

Cliffs continues to face weak iron ore prices largely resulting from oversupplied global markets, caused by a sharp increase in production by iron ore majors such as Vale and Rio Tinto in the face of weakness in demand, with Chinese demand for iron ore weakening considerably. In addition, Cliffs has also suffered due to a downturn in the fortunes of the U.S. steel industry as a result of the sharp increase in cheap steel imports into the U.S. However, in response to the U.S. steel industry’s petition to U.S. trade authorities, the Department of Commerce (DOC) has imposed preliminary antidumping duties on steel imports from several countries including China, which is the world’s largest exporter of steel. Though the preliminary ruling will be confirmed by the U.S. International Trade Commission (ITC) later this year, the preliminary ruling has already boosted the prospects of the domestic steel industry with a recovery in steel prices in the U.S. and a rally in the stock prices of steel companies as well as Cliffs (which produces iron ore pellets – a raw material for steelmakers). In addition, demand uncertainty for Cliffs has also dissipated with the recent signing of long term supply agreements with ArcelorMittal and U.S. Steel Canada.

Thus, the business environment has certainly improved for Cliffs so far this year. It could improve further if the ITC confirms the DOC’s preliminary ruling, killing off competition from cheap steel imports. If Cliffs waits a few months for its equity issue, it could get significantly greater value for its stock. However, a favorable ruling from the ITC, though likely, is not certain. Moreover, improvements in the iron ore pricing environment are dependent on the actions of global iron ore majors and a recovery in Chinese demand – factors that are beyond the company’s control. Cliffs’ cash flow from operations and the ability of the company to pay off its debt with these cash flows is contingent on several variables beyond its control. Ensuring the company’s survival in the midst of this uncertainty is the management’s priority – and it has taken decisive action towards that objective. Though the equity offering will lead to equity dilution for existing shareholders and the company may not be realizing the best value for its stock, it will buy the company freedom from the insecurity of a debt default in the near term. From a long-term perspective, trading equity dilution for ensuring the company’s survival looks like a good deal. Moreover, with a 200% rally in the company’s stock price so far this year, the timing of the issue, though not the best, is certainly not the worst.

Have more questions about Cliffs Natural Resources? See the links below.

• What Is Cliffs Natural Resources’ Fundamental Value Based On 2015 Results?
• What Is Cliffs Natural Resources’ Revenue And EBITDA Breakdown?
• How Has Cliffs Natural Resources’ Revenue Composition Changed Over The Last 5 Years?
• By What Percentage Did Cliffs Natural Resources’ Revenue & EBITDA Decline Over The Last 5 Years?
• By What Percentage Can Cliffs Natural Resources’ Revenue & EBITDA Change Over The Next 3 Years?
• How Will Cliffs Natural Resources’ Revenue Composition Change by 2020?
• How Do Cliffs Natural Resources’ Margins Compare With Those Of Iron Ore Mining Giants Such As Rio Tinto And Vale?
• Why ArcelorMittal Is The Most Important Customer For Cliffs’ U.S. Iron Ore Sales

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1. Cliffs Natural Resources S-1 Filing, SEC [↩] [↩]
2. Cliffs Natural Resources Stock Price, Google Finance [↩]
3. Moody’s downgrades Cliffs’ ratings (CFR to Caa1) outlook negative, Moody’s Investor Service [↩]