Cliffs Natural Resources' (NYSE:CLF) first quarter results were, in a word, terrible. Headline figures showed that revenues collapsed 18% year over year, operating income slumped from a profit of $168 million to a $51 million loss, and net income dived from a profit of $97 million to an $83 million loss.
It's very easy to pinpoint where these losses are coming from: Cliffs' high-cost mines located within Canada and North America.
Loosing cash fast
Cliffs' poorest performing division is the company's coal business. During the three months ending March 31, Cliffs reported that each short ton of coal cost the company a total of $119.41 to produce, up 9.2% year over year. Meanwhile, Cliffs only reported revenues per ton sold of $88.61, a loss of $30.80 per ton of coal produced during the period.
Additionally, Cliffs' Canadian assets reported equally terrible results as the cost per ton of iron ore produced stood at $129.35, up 6.4% year over year, but revenue per ton fell to $98.45. A $31 loss per ton sold was reported.
The two bright spots of Cliffs' quarterly report were North American iron ore production, and Asia Pacific production. These two divisions both reported a profit per ton mined of $25.1 and $33.5 respectively, although this was not enough to offset the loss-making mines above.
What's really worrying though, is the fact that while Cliffs' costs are going up and margins are shrinking, the company's peers are reporting wider profit margins and lower costs.
Peers are profiting
Cliffs' main peers on the international stage are BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO). These two mining behemoths are currently producing such vast quantities of iron ore that their cost of production per ton is far below the key $100 per ton level.
These costs show how much work needs to be done at Cliffs, and the picture looks even worse if we dig into the numbers.
Rio's management told investors earlier this year that the company's cash cost of production per ton of ore was $20.80. Analysts at UBS estimate that Rio's all-in sustaining cash cost of production is $43 a ton and that BHP's cost is slightly higher at $45 per ton, indicating a profit margin of 150% per ton at the current iron ore spot price.
More bad news
Unfortunately, in addition to rising production costs and falling revenues, Cliffs' report contained other bad news.
During the quarter, the company's gross margin contracted to 6.7% from 21% year on year, despite management's drive to cut costs. Cliffs' management also reported a 64% rise in operating expenses.
Interest expenses declined 15%, but this was not enough to offset slumping margins and surging costs.
Still, there were one or two bright spots within the report. Cliffs' capital spending fell 55% year over year, and the new Bloom Lake project achieved a record first-quarter production volume of 1.5 million tons. That said, the company did record a $16 million penalty incurred from a minimum tonnage rail shipment contract not being met as a result of the delay in the Bloom Lake Phase II expansion.
Taking a deeper look at the progress of the Bloom Lake project. It seems as if the project is moving forward, albeit slowly. Bloom Lake Mine's first quarter cash costs were $94 per ton, including a $7 per ton lower-cost-or-market inventory adjustment.
Excluding this, Bloom Lake Mine's first-quarter 2014 cash cost was $87 per ton. This is compared to $89 per ton in the year-ago quarter.
Soon after this set of results was released, some analysts on Wall Street picked out the fact that Cliffs was using a base price assumption of $120 per ton for iron ore during 2014. This is odd because the price of iron ore is currently below $110 per ton and consensus estimates forecast a price per ton of around $100 or less for the next few years.
However, according to a note published by Barron's from analysts at Axiom Capital, there is a good reason for Cliffs' higher-than-average forecast:
... we now know why the company is projecting iron ore prices, on avg., of ~$120/ton in 2014... because at $119.99/ton, [Cliffs Natural Resources] will be in violation of its most restrictive financial covenant (i.e., the one that says debt cannot exceed 3.5x EBITDA).
That's a worrying prediction to say the least. It could also explain why Cliffs' management has been aggressively seeking to improve the company's liquidity during the space of the last year.
What does the future hold?
So what does the future hold for Cliffs? Well, the company is still at the mercy of iron ore and coal prices, which means that Cliffs is dependent upon China's and the United States' economic health.
There is also the issue of Casablanca Capital, an activist investment fund, which is pressing for the breakup of Cliffs' and the replacement of the company's management.
Casablanca has some great ideas for Cliffs, which I have covered here. However, Casablanca's most attractive proposal is the replacement of Cliffs' management. Casablanca claims that Cliffs' current management team has been in place while the company has destroyed nearly $9 billion of shareholder value.
The fund also notes that Lourenco Goncalves, a board member Casablanca is putting up for election, has purchased 50,000 shares in Cliffs. This fact in itself does not seem important, but according to Casablanca, Cliffs' management team (including the CEO, Executive Chairman, and other board members) have purchased only 3,460 shares in Cliffs for cash. This shows almost no faith in the company.
All in all, it would appear that Cliffs is in trouble. Unless the company can aggressively cut costs and ramp up output, Cliffs could find itself breaching debt covenants and this would be really bad news.
It would seem that Casablanca's plan is the company's only hope, unless there is a sudden sustained rise in the price of both iron ore and coal.
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