Cliffs Natural Resources: Revised $48 Estimate On Lower Pricing And Margins

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In line with our expectations, Cliffs Natural Resources (NYSE:CLF) reported a decline in revenues in its second quarter earnings as iron ore prices took a toll in the second quarter compared to the same quarter last year, while iron ore shipments marginally declined. A decline in margins, mainly due to lower realized prices coupled with soaring cash costs, led to a steep fall in operating income of the company. Cliffs is the largest producer of iron ore pellets in North America, a major supplier of direct-shipping lump and fines iron ore out of Australia and also a significant producer of metallurgical coal.

In light of earnings and other recent developments as well as the near-term outlook for iron ore and coal, we have lowered our price target for Cliffs Natural Resources from $71 to $48, which is still nearly 25% ahead of the current market price.

See our full analysis for Cliffs Natural Resources

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Earnings at a Glance

Revenues declined nearly 10% to $1.6 billion, from $1.8 billion in the same period last year. The decrease was primarily driven by lower realized prices for key commodity iron ore. Iron ore shipments marginally declined mainly due to vessel shipment timings in the North America offset by increased volumes from Asia Pacific following completion of Cliffs’ expansion project in Asia Pacific Iron Ore. Increase in low-volatile metallurgical coal sales more than offset decline in thermal coal demand.

Lower iron ore prices, higher labor and mining costs led to lower margins, which translated into a nearly 40% decline in operating income of the company.

Iron Ore Businesses Disappoints in Near Term

In the near-term, we are cautious as a result of weakness in iron ore as well as rising costs. We expect iron ore prices to remain under pressure throughout our forecast period due to additional capacity coming online globally over the next two years.

We have lowered 2012 shipments from North America iron ore business due to lower production expected from Bloom Lake Mine. However, the company’s shipments may still show healthy growth on the back of an eventual recovery in the U.S. economy – North American iron ore constitutes 67% of our price estimate for the company. Healthy automotive sales and a recovery in the housing construction market in North America will drive the need for iron ore demand.

We have increased sales from the Asia Pacific iron ore operations as the company is eying the Asia-Pacific region to tap into the continued strong demand compared with the stagnant outlook in North America.  However, we have lowered average realized prices primarily due to an unfavorable change in product mix.


Coal to Add Value

Cliffs’ primary coal operations are in North America, consisting of five metallurgical coal mines and one thermal coal mine. We believe Cliffs enjoys a unique advantage in the highly fragmented coal industry as a result of its long-term relationships with some of the world’s largest steel manufacturers, owing to their iron ore supply contracts. These existing relationships make it easier to win coal supply contracts. We expect Cliffs’ coal shipments to increase steadily going forward, reaching nearly 9 million tons by the end of the Trefis forecast period as a result of these relationships and an expected increase in production.

However, the company has decided to sell its 45% economic interest in the Sonoma coal project in Queensland, Australia, which accounts for all of its coal operations in the Asia-Pacific region. The transaction is expected to close by December and could fetch as close to $140 million dollars. We will update our models once the deal is complete.

Overall Margins to Slump

While we were already expecting margins to decline, the company lowered its margin expectations far worse than our original expectations.  Costs are rising exponentially mainly in North America iron ore division. Further, Asia pacific iron ore mix is expected to decline steeply. Therefore, we have reduced our 2012 margin expectations for all the divisions due to unfavorable product mix, lower production and soaring input costs. This was the main reason for a steep reduction in our price estimate as you can notice how a minor change in margin could affect our price estimate.

Beyond 2012, we expect that falling prices of heavyweight iron ore will drag the company’s overall margins down for some years before recovering even as North America coal margins eventually improve. Rising energy, labor and other input costs will also put pressure on margins.

Customer Concentration a Concern… But Declining

Our primary concerns relate too the fact that the North American iron ore and coal divisions’ revenues are highly dependent on a few customers – ArcelorMittal, Algoma and Severstal together make up about 35% of Cliff’s total revenues. A loss of sales to any of these existing customers could have a substantial negative impact on the company’s revenues and profitability. However, in last couple of years their share has been declining, which could be a relieving sign.

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