Cliffs Natural Resources (CLF 7.96%) has come under attack from an activist shareholder who is pushing the company to spin off its mines and other assets located within the U.S. into a master limited partnership, or MLP. This would be a great deal for shareholders in the short term as share prices would rise, but based on Arch Coal's (NYSE: ACI) and Natural Resource Partners' (NRP 1.63%) recent performance, it would appear that over the long term the proposed spinoff plan is unlikely to succeed .
The proposition
The activist behind these demands is Casablanca Capital, which believes that splitting Cliffs up would allow the company to double its annual dividend and "significantly cut costs." Luckily, Cliffs' management immediately rebuked these demands, with this reply:
[The company is] making progress on reducing costs, strengthening its balance sheet with cash flows from operations, and taking a disciplined approach to capital spending [and] will continue to evaluate the strategic fit and value creation potential of all the company's assets as part of that process.
This is a great decision by Cliffs' management. If we crunch the numbers it quickly becomes apparent that if Cliffs were to spin off its U.S. coal business, the result would be, well, catastrophic. It's not hard to see how this would play out -- all you need to do is take a look at Cliffs' third quarter earnings report, within which the company gives a full breakdown of regional operating results. The best way to show this is in a table, so I have laid out the results below:
|
Reporting Period |
Q3 2013 |
Percentage |
Q3 2012 |
Percentage |
Nine months 2012 |
Percentage |
Nine months 2013 |
Percentage |
|---|---|---|---|---|---|---|---|---|
|
Coal |
($1.12) |
-1% |
($0.78) |
-0.6% |
$1.20 |
1% |
$0.82 |
0.6% |
|
Iron Ore |
$43.52 |
37% |
$38.91 |
35% |
$42.87 |
38% |
$46.04 |
40% |
North American operations: sales margin as a percentage of revenue per short ton
As we can see, Cliffs' U.S. operations have mixed fortunes. The company's coal division is losing money while the iron ore division is generating a healthy profit margin. While this in itself is not too bad, when we consider the rest of Cliffs' operations the whole picture appears a lot worse. For example, for the third quarter of last year, the profit margin on Cliffs' sales of iron ore from Eastern Canada was -$8.19 and the margin on Cliffs' Asia Pacific Iron Ore was only $28.98. So all in all, it would appear that Cliffs only really works as one unit, and splitting the divisions would make the whole company weaker.
Grim outlook
Further, it doesn't look as if things are going to get any better for Cliffs' U.S. operations anytime soon.
For example, Arch Coal is one world's leading coal producers with most of its operations based within the U.S., so it's a bellwether for the U.S. coal industry. Even as a bellwether and industry leader, Arch is still not able to make a profit on coal. The company reported an operating margin per ton of -$0.06 for full-year 2013 and an operating margin of -$1.19 per ton during the fourth quarter. These results don't instill much confidence about Cliffs' coal outlook.
That said, Arch Coal's management expressed optimism about the state of the market when they released fourth quarter results, although it remains to be seen if this optimism is anything more than delusion. Indeed, Arch's optimism was founded on the basis that high natural gas prices will drive customers back to cheap coal as a fuel, but the rally in these prices is likely to be short-lived. What's more, EPA regulations, which place stringent regulations on using coal as a fuel, are likely to put an end to any serious strength in the market.
What Cliffs could become
Natural Resource Partners, or NRP, is a great example of what Cliffs' U.S. operations could become. NRP owns coal, aggregate, and oil and gas reserves across the U.S., which it leases to operators, generating income for the partnership. Like both Arch and Cliffs, NRP has been suffering from the decline in coal use within the U.S. and as a result has been forced to diversify.
The company made $350 million of non-coal-related acquisitions during 2013 but has had to slash its distribution by 36% in order to conserve cash and ensure that it doesn't break debt covenants. We can use this to give us some indication as to what would happen to Cliffs' U.S. operations if they were spun off. The lagging coal side of things would either be divested or restructured, and the company would have to borrow heavily to drive growth elsewhere. To add insult to injury, NRP has almost doubled its number of outstanding shares during the past four years, and the company has underperformed the S&P 500 by approximately 140%!
Foolish summary
In conclusion then, it is apparent that Cliffs should not split itself up. While this could be beneficial in the short term due to a relief rally, over the long term the two entities are likely to underperform as the U.S. operations struggle with low coal prices.
