When the shareholders of Montreal-based Consolidated Thompson Iron Mines Ltd. sold their company to Cliffs Natural Resources Inc. in the spring of 2011, they weren't offered the high-flying shares of the U.S. acquirer as payment. They had to settle for cash, instead.
That proved to be fortuitous, as Cliffs' shares have since, well, fallen off a cliff. At recent trades around $25 (U.S.), they are down by more than 70 per cent.
Cliffs' plunge may suggest that it's a buying opportunity – but if so, it's an opportunity only for the brave. While the shares could conceivably double from current levels, there's also a good chance they could approach zero.
Investors seeking upside in the sector have safer options in the three international giants BHP Billiton Ltd., Vale SA and Rio Tinto Group. But they should be aware that the clouds hanging over the iron-ore sector show no signs of clearing any time soon.
Cliffs' fall from favour provides a dramatic demonstration of how quickly circumstances have deteriorated for miners. Only a couple of years ago, raw-materials producers were riding high, largely on the strength of China's building boom. To investors and mining CEOs, it seemed clear the Asian country's white-hot growth would require an endless supply of materials, from iron ore to copper to previously little-known rare earths.
Cliffs, of Cleveland, Ohio, had the expertise and size to benefit from surging Chinese demand. More than 80 per cent of its revenue comes from selling iron ore to steel makers to use in creating finished steel products, making it close to a pure play in the sector.
Back in 2011, Cliffs looked at strongly rising prices for iron ore – from $30 a tonne in 2004 to $170 a tonne in 2011 – and made an all-in bet on Canada. The $4.9-billion (Canadian) deal for Consolidated Thompson gave it Quebec's Bloom Lake project, which has the seaport access necessary to ship to Asia.
The transaction quickly soured, however. Like the entire mining sector, Cliffs has been hit hard by cooling demand from China. As skepticism about China's future growth has increased, many commodity prices have plunged.
Meanwhile, Bloom Lake has disappointed. Per-tonne mining costs continue to top $80 (U.S.) versus the roughly $65 Cliffs said it expected. That, coupled with an inability to ramp up production, contributed to a billion-dollar writedown in January. Cliffs followed it with a dividend cut and equity offerings that whacked the stock.
The worst may not be over. Cliffs is a high-cost producer compared with the global giants. While iron ore has recently reached $150 a tonne, – the assumption built into the company's earnings guidance – most forecasters see prices sliding to $120 to $130 per tonne this year, with even more softness after.
"If I'm a BHP Billiton, a Rio Tinto, a Vale, and I can dig the stuff out of the ground at $30 to $40 a tonne, iron ore can plunge from $150 to $90 and I'll still be profitable, just less profitable," says analyst Daniel Rohr at Morningstar. "Cliffs' costs are roughly twice as high, even before you tack on depreciation and interest and taxes. So when iron-ore prices slump, Cliffs can find it tough to pay the bills. And that's what scared them into raising the equity and slashing the dividend, giving them a balance sheet that's better suited to endure the slumps of iron ore."
Cliffs has older mines than its larger competitors, says Garrett Nelson of BB&T Capital Markets. "They've been mining their sites for decades versus some of those [competitors'] sites in western Australia, many that just started up in the last few years. The golden rule of mining is your best reserves were always mined yesterday, and Cliffs is at a place where they've mined the highest-grade ore already, and the costs have risen over time."
Cliffs' lower margins means the effect of price changes have a far greater impact on profits. Mr. Rohr of Morningstar bases his fair value estimate of $21 a share – another 15 per cent below current levels – on $133 per tonne iron ore this year, with prices falling to $96 in 2015.
His bearish scenario, based on $80 iron ore in 2015, – a level twice as high as the 2004 price – means "very little, if any, recovery for shareholders." Or, as he said in an interview, "I don't think the assets would be worth more than their debt load."
To be clear, implosion is not imminent. Will Frohnhoefer, a special situations analyst for the firm BTIG who covers steel maker ArcelorMittal, says Cliffs can do more equity offerings to raise cash. In addition, its debt doesn't mature for several years, and its cash flow covers current interest expense several times over.
Mr. Rohr does sketch out a bullish scenario, where iron-ore prices stay around $120 a tonne through 2016, resulting in Cliffs' shares doubling to $53 apiece. However, a slow descent seems just as likely given the industry's swelling capacity.
In many ways, iron ore works the way markets should: Greater demand, thanks to global growth, raises prices; higher prices create more supply; more supply lowers price. For Cliffs, the problem is the potential for a much greater supply of iron ore coming on the market, creating a long-term drag on prices.
"BHP, Vale, ArcelorMittal, Cliffs and a number of other players have a number of projects either underspent or on hold," BTIG's Mr. Frohnhoefer said. "If you start seeing significant recovery in iron-ore prices, there's so much pent-up production capacity that can come into the market, I don't see iron-ore prices getting back to [peak] levels any time soon … there's no fundamental underlying driver for enormous demand recovery. And if there's any significant demand recovery, there's incentive for a lot of players to start up the projects they've had on hold."
That suggests that Cliffs may yet tumble over another cliff.