I’m having a lot of trouble finding anything to buy these days, but I think the secured debt from Cliffs Natural Resources is a compelling investment. After having been short the company’s stock for most of last year, I now own both the 8.25% Notes due 2020 and the 7.75% Notes due 2020. The 8.25% Notes are first lien obligations of the company and trade at 91% of par to yield 10.6% to maturity. The 7.75% Notes are second lien obligations of the company and trade at 61% of par to yield 20.7% to maturity.
Cliffs is the largest manufacturer of iron ore pellets in the United States and produces approximately 22 million tons per year of pellets. Substantially all of its production is sold to steel manufacturers that use blast furnaces to manufacture steel. Sales tend to be on multi-year contracts and are often at prices that have a fixed component and an adjustable component based on either seaborne iron ore prices, steel prices, or both. As a result, Cliffs’ iron ore business is a somewhat less commodity-price sensitive business than traditional iron ore mining, but it still has significant swings in realized pricing. The chart below shows the sensitivity of realized pricing for the company relative to seaborne iron ore prices:
The U.S. Iron Ore business is only partially tied to the seaborne market for two major reasons. First, the U.S. steel market is concentrated around the Great Lakes, which makes taking seaborne iron ore deliveries very tricky. In the seaborne market, prices are quoted delivered to the port in China. This means a miner such as Vale realizes net revenue equal to the seaborne iron ore price minus inland transportation to the exporting port, fees at the exporting port, and bulk shipping costs to China. The Chinese steel manufacturer purchases the ore delivered to the Chinese port and is then responsible for the port charges in China and the inland transportation to the steel mill. In contrast, the logistics for seaborne iron ore to reach the Great Lakes is significantly more challenged. Seaborne iron ore must be unloaded from large bulk carriers at the mouth of the St. Lawrence river and loaded onto barges, which must then travel through multiple locks (as many as 15), before reaching a port and being loaded onto inland transportation. We believe that this could make purchasing seaborne iron ore as much as $30-35 per ton more expensive for a Great Lakes-based purchaser than it is for a Chinese purchaser. The second reason that there is only a limited link between domestic iron ore prices and seaborne prices is because the domestic market is composed primarily of iron ore pellets whereas the seaborne market is composed mostly of iron ore fines. U.S. mills are not configured to produce pig iron directly from iron ore so they use pellets, which command a premium to unprocessed fines. Even at today’s iron ore prices, we believe that premiums are at least $25-35 per ton.
At current seaborne iron ore prices, we believe that an integrated miner which owns its inland transportation and ports, such as Vale, realizes about $40-50 after paying for shipping. For Vale to realize a similar amount and sell to the Great Lakes-based steel manufacturers, we believe that costs for the steel manufacturers would be $80-100, which is calculated as follows:
This supports an assertion that Cliffs made in a recent investor presentation that “any potential competition from outside the US has a breakeven price of $95 - $100 per ton”.
Furthermore, as recently as February 2015, Essar Steel Algoma stated “Essar’s only option for obtaining iron ore pellets in the Great Lakes is through Cliffs because Cliffs does not have a reliable competitor for the production and supply of iron ore pellets at this time. The reason Cliffs does not have a competitor that Essar could turn to is because the breakeven cost for any competitor to enter this market from Brazil or from Eastern Canada (for example) is prohibitive. Essar has no choice, therefore, but to work with Cliffs regarding its current iron ore pellet needs.”
In comparison to the $80 100 cost per ton for a Great Lakes-based steel manufacture to purchase seaborne iron ore, current prices of $75-80 per ton seem supportable. Obviously, if iron ore drops another $10-20, seaborne could become more competitive. However, a prolonged period of seaborne iron ore at today’s $50 price, much less 20-40% lower, seems unlikely in light of the industry cost curve as presented below:
The significant differences between the U.S. Iron ore market and the seaborne iron ore market as well as Cliffs’ strong market position had historically resulted in a negotiated price that was entirely separate from the seaborne price. This changed in mid-2000s when the company saw the seaborne iron ore market go bananas and decided to include a link between seaborne prices and its prices going forward. That decision looked brilliant for a while, but it has obviously come back to haunt the company. Going forward, we actually expect that the company will earn a fixed price per ton similar to what it previously did. The efforts by the steel manufacturers to backwards integrate into iron ore pellets have been disastrous, such as Magnetation where cash costs are over $100 per ton. Hence, it makes sense for the steel manufacturers to stay with Cliffs, but there are few reasons for them to take risks on seaborne prices like they did in the past.
In addition to the U.S. Iron Ore business, Cliffs also owns two ancillary businesses: a metallurgical coal mining business and an Australian iron ore business. Each of these businesses operates near EBITDA breakeven, but after accounting for SG&A and capex, we believe that annual cash losses from these businesses will be nearly $65 million in 2015. We believe these cash losses are approximately equally split between SG&A and capex but that the coal business accounts for about 60% of the losses and the Australian iron ore business accounts for about 40% of the losses. The company has already sold half of its coal assets in the last 6 months and has repeatedly stated that it is in the process of selling the other half. We believe that the company will realize about the same for its second set of coal assets as it did for its first ($175 million) and that the company will be able to reduce SG&A by $10 million and capex by $30 million following this sale. While we would be pleased if the company also sells its Australian assets, we do not believe that this is part of the current plan.
We believe that the company’s secured debt (both the first lien and the second lien debt) are well covered by the asset value of the company. Following the first lien offering, the company has approximately $475 million of cash on its balance sheet and. After taking into consideration a $180 million working capital reversal expected in 2H 2015, a $185 million income tax receivable expected in 2H 2015 and $175 million of proceeds from the sale of coal mines, we believe the Cliffs will have over $1 billion in pro forma cash. This means that the company has more cash than it has first lien debt outstanding: