What's so Great About Cliffs Natural Resources?
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What's so Great About Cliffs?
There have been a few articles out on Cliffs Natural Resources, (NYSE: CLF) in recent weeks suggesting that the dramatic rebound in spot iron ore prices, up about 80% to $140 per metric tonne from $87 per tonne, is a harbinger of things to come. However, there's a big problem with this thesis. The forward curve for iron ore shows it falling back to $120 per tonne towards the end of the year.
Of course, it's difficult to predict where any commodity price might be in a year, but directionally iron ore prices appear to be headed south. An iron ore price of $120 is a reasonable longer-term assumption, as it's about where many believe the industry's marginal cost of production is. Cliff's is no bargain if iron ore prices do in fact settle near $120 per tonne. At a current price of $37 per share, and a $10 billion Enterprise Value, "EV," (market cap + debt - cash), I see limited upside in Cliffs stock.
Cliffs Needs High Pricing to Thrive
Cliffs is a bull market stock, it needs long-term iron ore prices of $140 to make it thrive. Otherwise, its operations are just $10-$20 per tonne away from mediocrity and another $10-$20 away from serious trouble. Cliffs has 3 iron ore operating segments. It also has some coal operations, but they are not worth much at all in today's coal environment. The company's U.S. iron ore business is a consistently profitable cash cow. If only the entire company had these margins.
The other two segments, Asia and eastern Canada, struggle to do well at $120 per tonne. That's because industry-wide costs have been a problem. In fact cost inflation is a problem for many extractive commodities, not just iron ore. Those bullish on Cliffs will no doubt be angry at me for not yet mentioning the company's 6.8% dividend yield. There, I said it. That's a healthy yield for sure, but it comes at a price. Cliffs can't grow production the way it planned to back in early 2011 when iron ore prices were $170-$190 per tonne. Without production growth, higher costs eat away at per tonne margins. Contracting margins lead to contracting valuation multiples.
Costs Don't Lie, Cliffs Can Never be a Low Cost Producer
Foolish investors, I saved the best (or worst) for last. No matter what Cliffs can achieve on the cost side, they will always be middle-of- the-road by industry standards. BHP, (NYSE: BHP), Rio Tinto, (NYSE: RIO) and Vale, (NYSE: VALE) have costs in the $40-s-$50's per tonne. In niche markets like the U.S., Cliffs can thrive, but elsewhere they are continually behind the eight ball on costs.
BHP is the largest producer of iron ore in the world. It also has an industry leading coking coal business and a huge oil and gas segment. BHP offers diversification, good margins and a steady yield of about 3%. Rio Tinto derives a large majority of earnings from iron ore, but is further diversifying into copper and gold with a massive project in Mongolia. Vale is more of a pure-play iron ore player with operations almost entirely in Brazil. Having said that, Vale is growing in coking coal and is looking at potash opportunities.
Foolish Bottom Line
To be fair, there's a time to own Cliffs, but that time has passed. When middle-of-the-road Cliffs is trading at a cheap valuation, say an EV to Earnings Before Interest, Taxes, Depreciation and Amortization, "EBITDA," ratio of 5x-6x times, then Cliffs' dividend yield plus the possibility of meaningful capital appreciation make for a compelling investment opportunity. At an EV / EBITDA of 8x, the stock is fully valued.
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