Cutting Spending to the Bone Might Not Be Enough for Cliffs Natural Resources

The sudden capital spending cuts are a good sign that Cliffs Natural has finally thrown in the towel in the iron ore market, but it faces the threat that larger miners like Vale don't have the same incentives to reduce production.

May 31, 2014 at 10:17AM

On news of further cuts to capital spending, it appears that Cliffs Natural Resources (NYSE:CLF) is finally giving up on a turnaround in the primary markets of iron ore and metallurgical coal. Such a capitulation from a market leader is an important step toward reaching a bottom for any commodity.

Cliffs Natural Resources has had nothing but negative news lately, with a weak first quarter report and plunging iron ore prices falling below $100 a metric ton. Unfortunately, leading iron ore miner Vale (NYSE:VALE) recently reported some concerning trends that capital spending cuts might not overcome in the short term.

Scrapping capital plans alreadyCliffs recently implemented a massive reduction in capital spending for 2014, making a further move noteworthy. The company spent $860 million in 2013 and had originally planned to spend on average $400 million for 2014. The massive 55% cut was already a testament to the rough pricing market for the prime commodity of iron ore.

The new forecast of $275 million to $325 million, or $300 million on average, cuts 25% from the original plan for 2014 and brings the total cut from 2013 levels to an incredible 65%. Cliffs has quickly jumped in to further reduce spending due to the continued declines in seaborne iron ore and metallurgical coal prices. More importantly, the company spent $103 million during the first quarter, leaving less than $200 million for the last three quarters of the year. Considering that the company recorded $141 million of costs associated with depreciation and depletion, the domestic iron ore miner will see some positive cash flow from reducing capital spending to the quarterly level of around $67 million.

Extremely weak market
With iron ore spot prices plunging below $100, the news of further capital spending cuts or further reductions in costs shouldn't surprise the market. Only last month, Cliffs reported a substantially larger loss than expected on plunging revenue. For the first quarter, Cliffs Natural Resources reported that revenue dropped 18% from last year to fall to $940 million.

During the first quarter, Vale produced nearly 10% more iron ore over the same period of last year to reach 71.1 million metric tons. The disturbing part for the market is that production was the highest first quarter since 2008. Despite the nearly 19% decline in iron ore prices, the company only saw an 11% impact to revenue. In total, Vale generated net income of $2.5 billion and adjusted EBITDA of over $4 billion for the quarter. Both numbers were down substantially, but neither decline was entirely punitive enough to discourage output going forward.

Bottom line
The drastic move by Cliffs Natural Resources to quickly adjust capital spending plans down to the bone could signal a bottom in a market. Unfortunately, the size of Cliffs is far overshadowed by a company like Vale with five times the iron ore production. With solid profits, Vale possibly doesn't have the proper incentives to cut spending enough to see that market bottom.

For investors, drastic and potentially desperate moves are signs of a bottom making it worth keeping on eye on the related stocks. Timing the market isn't recommended, but long-term investment returns are greatly enhanced by purchasing assets at distressed prices when all the bad news is in the market. Cliffs Natural Resources falls into that category, but unfortunately too many questions exist about whether other market participants are serious about pricing stability.

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Mark Holder has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. 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.

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