Upside/Downside Scenario for Cliffs Natural Resources

Cliffs Natural Resources (NYSE:CLF) is an international mining and natural resources company. It is the largest producer of iron ore pellets in North America and a major supplier of direct-shipping lump and fines iron ore out of Australia. It is also a significant producer of metallurgical coal. Competitors include Vale (NYSE:VALE), BHP Billiton (NYSE:BBL) and the Rio Tinto (NYSE:RIO) group.

We currently have a Trefis price estimate of $103 for Cliffs Natural Resources’s stock, about 10% above the current market price.

Cliffs’ North American Iron Ore Division: Old Faithful

Our analysis shows that Cliffs’ North American iron ore division is its most valuable division contributing almost 60% to the company’s stock value. This was Cliffs’ only division for well over a century – its operations can be traced back all the way to the 1850s. And the growth in the steel industry will ensure that the division remains key to Cliffs’ profitability.

This is because of the sheer size of this division’s operations. The total estimated production capacity of all mines in North America is almost 85 million tons, of which 30 million tons is contributed by Cliffs. This represents a 35% share of the North American iron ore industry.

The division also benefits from long-term supply contracts with some of the world’s largest steel producers including ArcelorMittal and Severstal. But there are many important factors that determine the success of this division. Below we highlight upside and downside scenarios for our Cliffs price estimate based on the outlook for drivers affecting the earnings for the North American iron ore division.

10% Upside – Steady Increase in Global Iron Ore Prices

The revenue per ton generated by Cliffs’ North American iron ore division has increased from $44 in 2004 to $102 in 2010. This can be attributed to the increased Chinese demand for iron ore and a continuous rise of international sea freight which pushed up iron ore prices sharply during this period.

But over-capacity in the industry combined with the Chinese government pushing for iron ore self-sufficiency suggests a decline in iron ore prices in the years to come. We factored this in while forecasting the division’s revenues per ton.

If iron ore prices continue to grow at even 2% every year from 2012, then it would mean that the revenue per ton for the division could cross $137 in the next 5 years. This represents an upside of 10% to the $103 price estimate.

7% Downside – Gross Profit Margins Remain at Current Level

Cliffs’ North American iron ore division had gross profit margins around 23% prior to 2007. Increasing iron ore prices helped push the margins to above 31% in 2008 and 2010. The margins were also helped by the fact that most of the division’s sales were to the 3 big customers – ArcelorMittal, Algoma and Severstal.

Going forward, if Cliffs’ is not able to deliver the iron ore profitably to its growing customer base, then the margins could be hit. Even if margins remain at 2010 levels of 31.6% till the end of the Trefis forecast period, this would represent a 7% downside to the $103 price estimate.

See our full analysis and $103 price estimate for Cliffs Natural Resources