Cliffs Natural Resources: Buy, Hold, or Sell?

Cliffs Natural Resources (NYSE: CLF  ) has been the subject of a slew of bearish articles lately. For example, on June 18 an article by Fool contributor Rupert Hargreaves had the catchy title "Cliffs Natural Resources Could Disappear." Another article on Cliffs from June 17 references a Morgan Stanley report that warns of Cliffs possibly breaching its Funded Debt to EBITDA covenant. Is Cliffs a contrarian buy? Or, as a price taker, is it at the whim of the spot iron ore price? Unfortunately, I think the answer leans more toward the latter.

Like coking coal producer Walter Energy (NYSE: WLT  ) , Cliffs made a large debt-financed acquisition a few years ago that's killing it today. In Walter's case, it acquired Western Coal, a high-cost Canadian coking coal producer. Walter's Canadian segment is now on care and maintenance and the company is stuck with $3 billion in debt. Walter's debt-to-EBITDA ratio is a whopping 20 times.

Cliffs made its own transformational acquisition, paying $4.9 billion to acquire the Bloom Lake project in Eastern Canada. According to an activist shareholder, Cliffs has since spent approximately $1.5 billion on development and capex at Bloom Lake. The activist shareholder believes that Bloom Lake is creating a $2 billion drag on the overall valuation of Cliffs. As a result of this horrible investment decision, Cliffs has $3.5 billion in debt on a market cap of just $2.2 billion. Both Walter and Cliffs have made (and continue to make) progress in cutting costs, but both are dead unless coking coal and iron ore prices rebound significantly. 

Outlook for iron ore prices
A quick search for news on iron ore prices tells a terrible tale. A few research analysts are now saying that iron ore prices will average $80-$90 per metric tonne in 2015. If that's the case, then all bets are off on Cliffs. Even if Cliffs could get amendments to its credit facilities, the company's stock would be a poor investment if iron ore prices average less than $100 per ton next year. The chance of a continued low iron ore price is greater than 50% in my opinion. Currently, the price is at $90 per ton. 

The well-known problem for iron ore is simply too much supply, too much inventory, and weak/uncertain demand from Chinese steel mills. Visibility of supply additions this year and next is high, while visibility of global demand is low. BHP Billiton  (NYSE: BHP  ) , Vale (NYSE: VALE  ) , Rio Tinto (NYSE: RIO  ) , and Fortescue Metals are all well into multi-year production ramp-ups that will materially increase global supply for at least 2014-16. This poses a serious problem for prospective investors in Cliffs as it appears increasingly unlikely that iron ore prices will rebound sustainably to a level of, say, $120 per ton -- a level that would support a much higher stock price for the company. 

Big 3 iron ore producers hold the cards
There's simply no way around it. BHP Billiton, Rio Tinto, and Vale dominate the market, and Fortescue is a major player as well. The Big 3 have operating costs per ton in the $20's and $30's, well below that of Fortescue, Cliffs, and several African iron ore producers. It's now believed that the Big 3 are perfectly content to see the spot price fall in order to weed out competition. The question is, how far will they let prices fall? Seeing as these giant enterprises are in iron ore for decades to come, a 1-2 year pricing strategy that curtails future supply among competitors seems to be a rational one. 

Bottom line
Despite Cliffs' stock price trading near a 52-week low, there are good reasons for its decline. The debt-fueled acquisition of Bloom Lake has weakened Cliff's balance sheet, and the Big 3 iron ore producers have every incentive to keep iron ore prices low to drive out the competition. While it's always tempting to be a contrarian and buy a company's stock near its low, a bet on Cliffs today is a bet against BHP Billiton's, Rio Tinto's, and Vale's ability to control the iron ore price. That's probably not a wise bet to make at this time. 

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