Down 70% from its 2011 High, Why Cliffs Natural Resources is a Buy
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There have been 2 Motley Fool articles in the past week focusing on Cliffs Natural Resources, (NYSE: CLF). In one, the stock was described as not safe enough for retirees and in the other a wait and see approach was recommended based on weak coal / iron ore markets and high debt levels. While these articles identified key pros and cons, in this piece I advance the discussion by advocating a BUY of CLF shares.
Forget About Coal, Ferrochrome, it's All About the Iron Ore for Now
Despite having thermal and coking coal assets in the U.S., Cliffs is almost entirely an iron ore play. As such, more negative news on the coal front will not impact overall earnings that much. Focusing on iron ore, market fundamentals are astonishingly weak. Much has been written, (including by me) about price support from global marginal cost producers in China. The high-end of the iron ore cost curve is thought to be about $110-$120 per metric tonne.
However, spot prices are currently at about $90 per tonne. The decisive move below $100 per tonne is surprising and caught most analysts and many management teams off guard. Several production curtailments have been announced. Fortescue Metals Group, is slashing cap-ex by $1.6 billion, scaling back its aggressive growth to an annual rate of 115 million tonnes by next year from a planned 155 million tonnes. BHP, (NYSE: BHP) has put $10's of billions of cap-ex allocation decisions (for a bunch of commodities, not just iron ore) on hold until next year. Labrador Iron Mines pushed back an important project until mid-2013 at the earliest.
Yet, so far we're just seeing the tip of the iceberg. With iron ore prices 10%-25% below the industry's marginal cost, further production cuts are unavoidable. For emerging producers, 2-4 years away from first production, obtaining financing has gone from difficult to nearly impossible. Meanwhile, Rio Tinto, (NYSE: RIO) and Vale, (NYSE: VALE) are sitting pretty. With all-in costs in the $40's to $50's per tonne they remain highly profitable, albeit not insanely profitable like they were in 2011.
As a mid-sized iron ore producer, Cliffs benefits from the strength of the BIG 4 producers Vale, Rio, BHP and Fortescue. These 4 account for about 75% of global seaborne trade. As such, the BIG 4 can support prices by cutting back production and slowing new capacity builds. Cliffs benefits from this pricing support without having to cut back themselves. However, Cliffs will always be a higher cost producer with all-in costs in the $60's to $70's per tonne.
As I write, CLF is trading at $32.50 per share for a dividend yield of 7.7%. At $31.25, CLF would be yielding 8.0%. Recent commentary from a few sell-side analysts suggest that Cliff's dividend is unsustainable. I completely disagree. Management has drawn a line in the sand. They have very clearly stated that the $2.50 per share dividend is safe. If the company's payout ratio were 50% or more, then management's stance would be questionable. But, the payout ratio is only about 15%-25%, (depending on future earnings).
Some analysts worry about Cliff's high debt leverage. I agree that debt leverage is high compared to the global diversified miners, but it's not especially high in absolute terms. Net Debt divided by 2013e EBITDA is about 1.5x. This compares to a range of 0.5x-1.25x for the majors. Assuming that CLF's consensus EBITDA for 2013 and 2014 proves to be too high, Net Debt leverage may increase to 2.5x, a level that's not unreasonable in a depressed part of the iron ore cycle.
Unless one believes that iron ore prices which are down 35% in the past 2 months will remain below $100 per tonne for the next year or longer, then Cliffs offers compelling risk/reward with the strong support of a safe dividend. Debt levels are not as worrisome as some fear, and management maintains multiple levers to pull to cut costs and raise liquidity if need be. I believe that CLF has 10% downside and 40%-50% total return potential over the next 12 months.
MockingJay2011 has positions in CLF and VALE. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.