Cliffs Natural Resources Needs Another Iron Ore Boom

By Stephen D. Simpson, CFA | February 15, 2013 AAA

By and large, it's good to have industry-low cash production costs in a commodity industry, but even high-cost producers can do well when prices shoot up. That's exactly what investors in Cliffs Natural Resources (NYSE:CLF) need to hope for in 2013, as this high-cost North American iron ore producer just doesn't look very compelling absent a big improvement in margins per ton.

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A Tough Close to the Year
Cliffs Natural Resources didn't end the year on a particularly strong note. Revenue fell 8% from the year-ago quarter and about 1% from the third quarter, largely due to lower prices for iron ore. Pricing and volumes were mixed across the company's segments. U.S. iron ore (USIO) volumes dropped 20% and pricing fell about 7%, while Canadian (ECIO) volumes increased 20% (but were about one-third those of USIO) and pricing fell 19%. In the Asia Pacific operations (APIO), volume shot up 56% but pricing dropped almost one-quarter, while North American coal operations saw a big increase in volume (up 94%) and pricing fell about 12%.

While revenue performance wasn't bad, the company saw gross profit decline about 50% on stubbornly higher costs. Even so, cash production costs weren't so horrible - falling 3% in USIO, falling 5% in APIO and less than 1% in the coal ops, while ECIO costs shot up 14% and were almost 16% higher than the per-ton sales price. Overall, EBITDA fell 58% from last year and came in almost one-quarter lower than analysts had expected.

SEE: A Clear Look At EBITDA

The Cost Problem Just Isn't Going Away
I don't want to harp on Cliffs' high production cost, but I think it's a key detail for prospective investors to understand. Iron ore prices are what they are. Cliffs gets a modest premium for the high quality of its Canadian iron ore, but it also has to accept a somewhat convoluted formula for its U.S.-produced iron ore (which largely is restricted by cost from the seaborne market).

Overall, Cliffs' costs run more than $60 per metric ton (with the costs in the Canadian operations much higher this quarter). While that's not terrible relative to a global average that is also in the $60s, it is not at all competitive with the world's largest producers - Rio Tinto (NYSE:RIO), Vale (NYSE:VALE) and BHP Billiton (NYSE:BHP) - whose costs run in the range of the low $30s to mid $40s per ton.

That cost disadvantage makes it considerably harder for Cliffs to do well when iron ore prices are weaker, and it makes the company highly dependent on higher prices. Unfortunately, with a lot of new iron ore capacity coming on-line this year, the prospects for a big upswing in iron ore prices are looking worse.

Shoring up the Balance Sheet
Management isn't sitting around waiting for things to get worse. The company announced a sizable dividend cut (from 62.5 cents per share per quarter to 15 cents), and also announced that it would be raising equity capital through two offerings that could bring in close to $900 million in new capital. Obviously, this capital raise will be dilutive to shareholders, but the company needs capital if it's going to continue expanding its operations.

Speaking of the expansion plans, it looks like the plans to double production from Bloom Lake are on hold until 2014. Given the costs of expansion and the generally mediocre outlook for ore prices, that may not be such a bad move.

SEE: Evaluating A Company's Management

The Bottom Line
It's hard for me to be positive on Cliffs Natural Resources. In particular, I believe the company has structural cost issues that just won't get substantially better. For instance, I think the company would normally consider shutting the high-cost ($166/ton) Wabush mine in Canada. However, doing so could create complications with permitting to expand Bloom Lake, so the company likely just has to swallow the higher costs at Wabush to reap the potential benefits from the high-quality Bloom Lake mine.

That said, nobody really knows where iron ore prices will go in 2013. If prices shoot up again, Cliffs Natural Resources will definitely benefit. I'm not terribly interested in commodity producers that are so highly leveraged to price, though, and I think these shares are quite expensive relative to Vale, BHP Billiton or Rio Tinto.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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