This Stock Is Off The Cliff

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Cliffs Natural Resources (NYSE: CLF) has literally falling off of a cliff over the past twelve months and there appears to be no bottom in sight. Of the major iron ore companies, Cliffs is by far down the most, down almost 70% over the last twelve months. 

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Cliffs still holds a 45% market share for iron pellets in North America and is a major supplier of metallurgical coal in North America, with 30% market share. The real headwinds include lower iron ore pricing, which should remain low due to oversupply in the industry, which has put prices under pressure.

What's more is that a large portion of Cliffs' sales are made under term-supply agreements, more than 95% of the North American iron ore sales volume, the majority of the North American coal sales, and virtually all of the Australian sales. The big issue is that these contracts limit the ability of Cliff to raise prices, where the inability to pass along prices negatively impacts impact margins and profitability.

Cliffs did have 23 hedge fund owners at the end of 2012, after a 5% increase from the third quarter. The top hedge fund owner by market value at the end of 2012 was billionaire Steve Cohen's SAC Capital, while number two was fellow billionaire D.E. Shaw (see Cohen's new stock picks).

Major headwinds 

  • Cliffs has a high customer concentration, spread across three customers, ArcelorMittal, Severstal and Algoma account for some 32% of sales.
  • Its largest customer, ArcelorMittal, represented about 17% of total product revenues last year.
  • Recently lowered expectation of cash flow from operations to roughly $600 million from $1.3 billion. 
  • Lowered full year 2012 expectation for Chinese crude steel production to approximately 715 million tons from its previous expectation of 730 million tons. 
  • Decreased its average full year 2012 seaborne iron ore spot price forecast to $128 per ton from its previous expectation of $145 per ton. 

Value trap industry

In reality, the entire industry looks a bit cheap. However, it could be a mere value trap. Vale (NYSE: VALE) is a Brazil-based metals and mining company that has also been facing huge declines in its metals and minerals prices. The year-over- year decline in 2012 revenue was 23%, which was primarily due to a downward movement of the price of iron ore. Vale has managed to miss EPS expectations by at least 13% in each of the last three quarters and analysts have one of the poorest outlooks for the stock among all the iron ore producers. 

Vale also had hedge funds dumping its stock from its portfolio during the fourth quarter. At the end of 2012 there were 25 hedge funds long the stock, a 14% decrease from the third quarter. Its largest hedge fund owner by position, billionaire Jim Simons, only had a $83 million billion position in the stock, a mere 0.2% of its 13F portfolio (check out how other hedge funds traded Vale). 

BHP Billiton Limited (NYSE: BHP) is diversified natural resources company, operating across nine segments, including aluminum, iron ore and coal. The key for BHP is its relatively diverse revenue stream, with BHP's major segments being iron ore (31% of revenues), Petroleum (18%), aluminum & nickel (11%), metallurgical coal (11%) and energy coal (11%). However, BHP is facing number of headwinds irrespective of industry, including equipment shortages and labor crises.

Even with its robust revenue stream BHP has some of the lowest hedge fund interest a the end of 2012, this after a number of funds dumped the stock form their portfolio. Going into 2013, there were a total of 14 of the hedge funds long the stock, a 30% decrease from the end of the third quarter. The biggest hedge funds dumping their stakes include billionaire Jim Simons and Israel Englander (check out what Simons cheap picks are). 

Rio Tinto (NYSE: RIO) mines and processes aluminum, copper, diamonds and iron ore, to name a few. The company took a $14.4 billion asset write down in 2012, which was roughly $3.4 billion for Rio Tinto Coal Mozambique (RTCM), with an additional $11.0 billion for the company's aluminum assets  (read more about the write down). Rio Tinto also managed to report weak 2012 results with a $2.99 billion loss, a 151% decline year over year from the positive $5.82 billion reported in 2011.

Rio Tinto also faces some of the more robust competitive pressures, form Brazil-based Vale and Australia-based BHP. Vale's iron ore production is a bit more cost effective in comparison, and transportation costs are lower for BHP given Australia's proximity to China. 

By the numbers

Cliffs pays the lowest dividend yield of the major iron producers:

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>Cliffs</p> </td> <td> <p>Vale</p> </td> <td> <p>BHP</p> </td> <td> <p>Rio Tinto</p> </td> </tr> <tr> <td> <p>Dividend yield</p> </td> <td> <p>2.90%</p> </td> <td> <p>5.60%</p> </td> <td> <p>3.20%</p> </td> <td> <p>3.40%</p> </td> </tr> </tbody> </table>

What's more is that Cliffs trades with high volatility, as does all the major iron companies:

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>Cliffs</p> </td> <td> <p>Vale</p> </td> <td> <p>BHP</p> </td> <td> <p>Rio Tinto</p> </td> </tr> <tr> <td> <p>5-year beta</p> </td> <td> <p>2.4</p> </td> <td> <p>1.5</p> </td> <td> <p>1.5</p> </td> <td> <p>1.7</p> </td> </tr> </tbody> </table>

And the stock has the worst balance sheet by long-term debt to equity standards:

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>Cliffs</p> </td> <td> <p>Vale</p> </td> <td> <p>BHP</p> </td> <td> <p>Rio Tinto</p> </td> </tr> <tr> <td> <p>Long-term debt to equity</p> </td> <td> <p>91%</p> </td> <td> <p>38%</p> </td> <td> <p>48%</p> </td> <td> <p>52%</p> </td> </tr> </tbody> </table>

Don't be fooled

Morgan Stanley even downgraded Cliffs near the end of March citing the poor outlook, surprise dividend cut and equity/convertible preferred capital raise as major headwinds for investors. Morgan also believes that Cliff's top iron ore market, the U.S., which accounted for some 60% of 2012 EBITDA, could be cut in half over the interim as new Great Lakes supply cuts into industry volumes and pricing. 

The global production of steel is a key driver for iron ore and metallurgical coal demand, which in large part is controlled by China. However, international demand and economic conditions, including an economic slowdown in China are expected to be a drag on prices over the interim, which is not only a negative for Cliffs, but the industry as a whole.

Marshall Hargrave has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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