Wall Street hates Cliffs Natural Resources (NYSE: CLF), or at least a large part of it does. According to The Wall Street Journal, more than 46% of Cliffs shares are sold short, making it the sixth-most shorted company on the New York Stock Exchange. Is this massive short-sale position merited? Let's look at what the Cliffs haters are thinking and what they could be missing when they look at this mining company.
The short-sell argument
Take a quick look around the steel market, and you have half of your answer. This past year has been abysmal for any company that mines iron ore or produces steel. The benchmark spot price for iron ore headed to the world's largest market -- China -- fell 42% last year to $74 per ton, which is at the lowest level since the bottom of the recession in mid-2009. With prices that low, very few companies can sell iron ore at a decent profit. With China's economy looking weaker than it has in recent years, and a focus there on consumer-driven growth rather than infrastructure spending, it is unclear how long this could last.
To add insult to injury for Cliffs, it is stuck with some particularly unprofitable assets, most notably its iron ore mines in eastern Canada and its metallurgical coal operations. In 2010, Cliffs management made the flub of acquiring these Canadian mines at the height of commodity prices, spending $5 billion to acquire Consolidated Thompson. One of those mines has been shuttered because of poor performance, and Cliffs plans to close the second mine -- Bloom Lake -- over the next several years at a hefty cost.
All of this makes Cliffs a company that is selling a product at low, low prices and has several unproductive assets that are hemorrhaging money each quarter. If that was the whole story it would be hard to blame investors for betting against this company.
The one thing that could keep short-sellers from being right
Still, there is one component of the company to keep in mind before predicting Cliffs' demise: its U.S. iron ore mines. It can be easy to lump these mines in with the narrative of the global market, but that simply isn't the case. Not only are these mines very lucrative -- last quarter, the company achieved an EBITDA margin of 32% on its U.S. iron ore production -- but Cliffs here is much more isolated from the global markets because it sells exclusively to North American steel manufacturers under multiyear contracts.
Image Source: Cliffs Natural Resources.
Looking across the entire business, U.S. iron ore production generated about $250 million in EBITDA in the past quarter -- on an adjusted basis because of a $7 billion asset writedown -- enough to prop up its less profitable Australian mines and its nonprofitable coal and Canadian mine operations.
According to management, it will cost $600 million to $700 million over five years to shutter the Bloom Lake mine. This sounds like a huge amount, but let's put the cost in context. By remaining in operation this year, Bloom Lake has so far resulted in a sales margin loss of $165 million. If such losses were to continue over the time period needed to close the mine, they would amount to $1.025 billion. This is only a hypothetical situation, but it demonstrates why closing this mine was the right decision based on the outlook for iron ore.
Also, while Cliffs' debt level looks a little scary for a company of its size -- debt to capital today stands at an odd 105% -- the company generates enough operational profit that debt default isn't an imminent threat. Cliffs' EBITDA-to-interest-expense ratio stands at 5.5 times. This is not the most healthy metric for any company, but it is sufficient to keep investors from losing too much sleep.
A contrarian conclusion on Cliffs
The iron ore and steel markets are cyclical in nature, and many companies have brought on significant new mining capacity in recent years because China's demand at the time showed no signs of letting up. This might not be the bottom of the market, but eventually the market will correct itself as it always has. With a profitable core segment that is less subject to international market influences, Cliffs Natural Resources should outlast the rough parts of this market if it can follow through with plans to shutter its nonprofitable business segments. That might take some time, but Cliffs' position in the iron ore market makes it hard to justify hating this company's stock as much as Wall Street does right now.
