Cleveland-Cliffs CLF W
September 03, 2006 - 6:27pm EST by
2006 2007
Price: 37.45 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,560 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Cleveland-Cliffs Inc is the largest producer of iron ore pellets in North America and owns 80% of Portman, the third-largest iron ore mining company in Australia. Its shares are undervalued (EV/EBITDA= 3.8; P/E= 7; EV/FCF=6.6), even taking into account the cyclical nature of the industry. Demand has increased due to China’s industrialization and it is difficult to rapidly increase global iron ore capacity due to massive supply chain disruptions in skilled labor, tires, and other mining equipment. Until 2004, CLF's financial results were poor. Its change in fortunes is due to a strategic shift borne out of a near death experience, in addition to the worldwide improvement in commodity pricing.
The Industry
Most iron ore is used to make steel. Iron ore is sold in different forms: fines (fine ores), lump, pellets, and iron ore concentrate. Fines are defined as iron ore with the majority of Individual particles measuring less than 4.75 millimeters diameter. Conversely, lump is iron ore with the majority of individual particles measuring more than 4.75 millimeters diameter. Fines and lump are produced from the same ore and are separated by screening and sorting. Neither product is concentrated. Pellets, the third product type, begin as a fined-grained concentrate. A binder, often clay, is added to the concentrate, which is then rolled into balls. The balls then pass through a furnace where they are indurated and become pellets, usually measuring from 9.55 to 16.0 millimeters. Although fines and lump ores cost about the same to produce, fines fetch lower prices than lump because they must be sintered by the steel mill before they can be charged to the blast furnace. Pellets can be charged directly into the blast furnace as can lump ore, but the latter can shatter in the furnace, thereby lowering its value to the steel mill operator. Pellets are usually the most desirable form of iron ore because they contribute the most to the productivity of the blast furnace. Lump ore is the next most desirable ore in terms of blast furnace productivity. The least desirable form is fines, because of the required sintering.
Currently, almost all North American iron ore pellets are consumed in blast furnaces, which is the first step in the steelmaking process. The blast furnaces produce iron in molten form, which is further processed in basic oxygen furnaces where carbon is removed and steel scrap and other alloys are added to produce molten steel. The molten steel is then cast into steel shapes.
There are many different types of iron ore: Taconite is very hard and fine-grained. It only contains up to 30% Magnetite and Hematite, which are more desirable. Taconite is mined in the Great Lakes area and is usually converted to pellets. Pellets can contain up to 65% pure iron. Magnetite has magnetic properties. Furthermore, each mine’s ore can have slightly different characteristics.
Almost half of the world's iron ore is supplied over the ocean. The 3 big suppliers of seaborne iron ore (70% combined) are CVRD (Brazil), BHP Billoton (Australia), and Rio Tinto (Australia and Canada). In 2000, world iron ore consumption was 1065 Million Tons (MT). Of this consumption, 295 MT was Chinese. In 2005, 1520 MT were consumed with 690 due to China.
Each year the major iron ore producers and consumers hammer out a global benchmark pricing agreement. Pellets are priced about 50% higher than Fines, with Lumps about midway between the two. This arrangement makes it easier to forecast revenues each year, since the benchmark is fixed. Recent benchmark price changes were:
                        2004            2005            2006
Pellets               +21%            +86%            -3%
Lumps/Fines            +19%            +72%            +19%
The Supply/Demand balance remains fairly tight worldwide. BHP estimates that sea borne capacity will increase by about 100MT from 2005-2007. CLF estimates that global demand will increase by 130MT in that same period. Of course some of that increased demand will be met by local production, not seaborne. Nonetheless, it does not look like there is an imminent major change in the global supply/demand balance, although in North America demand is dependent on possible additional closings of blast furnaces, such as Mittal’s recent closing of Weirton.
Increasing industry capacity is proving to be difficult. For example, CLF 's new CEO (the old CEO just retired) was quoted recently regarding the unlikelihood of new expansion projects coming online this decade: "Capital equipment is just so hard to procure, if you just look at a few long lead time items, if they aren't already ordered and put the time into build them, find the people to erect and construct them .... it's just hard to construct a timeline that would suggest anything different." This is a bit of a stream of consciousness quote buy you get the idea. In fact, an expansion of Portman’s capacity is going a bit slower than hoped, due partly to the difficulty keeping experienced contractors. BHP made similar comments in their August 23 conference call. Giant tires for mining equipment are especially difficult to procure. A recent (8/28/06) WSJ article on Terex give some more background on the problems mining companies are having.  Thus, while forecasting is dangerous, especially when it is about the future, a near-term global pricing collapse due to excess supply (barring a global recession) seems unlikely.
Recent related VIC writeups are on MSB, GNI, KHD, and FMG.AX.
The Company
CLF is over one hundred years old. In North America, it manages and operates six iron ore mines located in Michigan, Minnesota and Eastern Canada that have a rated capacity of 37.5 million tons of iron ore production annually, representing approximately 46 percent of the current total North American pellet production capacity. Its share of the rated pellet production capacity is currently 23.0 million tons annually, representing approximately 28 percent of total North American annual pellet capacity (up from approximately 11% in 2000).  CLF sells the majority of its pellets to integrated steel companies in the United States and Canada. In Australia, CLF now owns 80.4 percent of Portman, the third-largest iron ore mining company in Australia, selling lumps and fines.
About six years ago, CLF was in very bad shape, as was the US steel industry. For example, in December 2000, LTV declared bankruptcy.  Until then, CLF primarily held a minority interest in the mines it managed, with the majority interest in each mine held by various North American steel companies. Earnings were principally comprised of royalties and management fees paid by the partnerships, along with sales of the equity share of the mine pellet production. For lack of any better options and hoping for a rebound, CLF embarked, through increasing ownership interests in its managed mines, on a strategy to reposition itself from a manager of iron ore mines on behalf of steel company partners to primarily a merchant of iron ore. CLF started buying even more distressed mining operations and even bid for LTV's Cleveland Works steel mill, but was outbid by Wilbur Ross. CLF eventually chipped in for 7% of Ross' newly formed ISG and received a long-term supply contract from ISG, albeit with generous payment terms. Shortly thereafter, tariffs were imposed on steel imports into the US, which helped give the industry some breathing room. CLF later participated in ISG's purchases of Acme and Bethlehem. In 2004, CLF sold their interests for a tidy $150 million profit. ISG of course is now owned by Mittal.
The April 2005 purchase of Portman was a significant milestone in CLF’s effort to diversify away from the North American market. In Q2, Portman represented 22% of CLF's iron ore revenues. In North America, unit revenues are impacted by several contract escalation factors including higher steel pricing, higher PPI, and lag year adjustments, in addition to international benchmark pellet prices. Cliffs' 2006 pellet pricing will also be determined by the net impact from other price-adjustment factors which will not be finalized until after yearend, namely changes in the producer price indices (PPI) and average hot rolled coil prices for 2006. Each one percent increase in the PPI-All Commodities Less Fuel index is currently expected to add $0.12 per ton to Cliffs' 2005 average pellet sales pricing; each one percent increase in the PPI-Fuel and Related Products index will result in an approximate $0.06 per ton increase to Cliffs' 2005 average pellet sales pricing; and, each $10 per ton increase from $520 per ton average hot rolled price in a number of Cliffs' contracts is expected to result in a $0.30 per ton increase to Cliffs' 2005 average pellet sales pricing. This resulted in an increase in 2006 unit pricing despite the 3% reduction in pellet benchmark pricing.
For 2006 Cliffs-managed North American pellet production is expected to be approximately 35 million tons, with their share representing 21.7 million tons. Their forecast of total year 2006 North American sales is 21 million tons, reflecting higher inventories at North American steel plants, the shut down of Mittal Steel USA’s Weirton blast furnace and a programmed 2005 contractual change that modified and reduced consignment tonnage. This implies an increase in inventory of 700k tons for the year, and a year-end balance of 4.0 million tons, up from the 2005 balance of 3.3MT, but down from the current 5.9 MT. They usually maintain ownership of the inventories until payment is made. Maintaining iron ore products at ports on the lower Great Lakes reduces risk of non-payment by customers, as CLF retains title to the product until payment is received from the customer. Customers require a three-month supply of inventories during the winter when product shipments are curtailed over the Great Lakes.  
About 95% of CLF’s revenues are term sales. The average term in North American is 8 years and is four years for Portman. In 2005, the following customers accounted for 93% of revenues: Mittal, Algoma, Severstal, WCI, and Stelco. US Steel has its own supply of ore.
One of the limitations of the taconite pellets produced from CLF's North American mines is that they are only useful for those steel mills using blast furnaces, not those using scrap. Since 2002, CLF has been participating in the Mesabi Nugget Project to test and develop Kobe Steel’s technology for converting iron ore into nearly pure (95%) iron in nugget form.  The high-iron-content product could be utilized to replace steel scrap as a raw material for electric steel furnaces and blast furnaces, along with other applications. Approvals and financing for the first commercial plant (to be located in Minnesota) are in the works. CLF would have a 25% equity interest. This has the potential for tremendously improving the market and stability of CLF's North American mines. The plant should cost $215 million and produce 500,000 metric tons annually. It is scheduled to become operational in April 2008, but it is still in the financing stage (although it has been permitted). Given that this is the first plant beyond the pilot phase of this technology, I would give heavy odds that it will be delayed.
Capital expenditures for 2006 are expected to be $138 million. I approximate Maintenance Capex at $100 million since much of the remainder is designated for increasing capacity at Portman by 1/3.
CLF has the usual ongoing litigation. Regarding the legal dispute between KHD and CLF that was mentioned in the VIC writeup on KHD, if the arbitration were to be fully decided in favor of KHD, CLF’s liability would be on the order of C$15 million. I have no opinion regarding the merits of the case.
CLF is actively looking for reasonably priced acquisition candidates but does seem to show financial discipline. They have specifically mentioned their interest in acquiring a metallurgical coal company, assuming the price is right. There are common customers for iron ore and metallurgical coal. CLF has an undrawn $350 million line of credit. Despite their interest in maintaining the financial capability for another acquisition, they have shown their willingness to give back money to shareholders. In May-June, CLF purchased 2.3 million shares (5% of basic shares outstanding) and in July, the Board authorized the repurchase of another 2 million shares.
Given their valuation, however, I believe that CLF is likely to be an acquisition or LBO target, perhaps by one of their customers (Mittal?) or a mining company not currently active in iron ore. Due to antitrust concerns, CVRD, Rio Tinto, and BHP are unlikely to be purchasers. Valuations in this whole space are still so low compared to cash flow that many acquisitions prove to be immediately accretive.
Market Cap: $2.035 Billion (based on diluted shares)
Zero Debt
Cash: $127 Million
EV: $1.91 Billion
2006 EPS ~ $5.50
2007 EPS ~ $5.50 (based on slight increases in both costs and pricing)
Maintenance Free Cash Flow: ~$5.30 using $100 Million Maintenance Capex
P/E ~7
2006 EBITDA ~ $500 million
ROA: 15%
ROE: 39%
Basic Shares Outstanding: 42.7 million
Diluted Shares Outstanding: 54.4 million-dilution mostly due to a convertible preferred
Maintenance Free Cash Flow: ~$5.30 per diluted share using $100 Million Maintenance Capex
Reserves (Proved/Probable): 25 years in North America; 11 years in Australia (a bit lower than I would like)
Comps (per a database).
It’s hard to find a reasonable match with CLF. It is less diversified and smaller than many of its competitors.
                        P/FCF            EV/EBITDA      FWD P/E       ROA
RIO                  64            4.7                   7.8                   20%
PD                   17            5.3                   8.5                   11
AA                    n/a            6.6                   12.6                  5.2
SCHN               39            6.8                   11.3                  13
a) Reduction in global steel demand. So far there’s no real indication of this. For example, Portman’s recent filing with the Australian government stated “Demand remains extremely strong, especially for fine ore.”
b) Weakness in North American market caused either by surge in imports or more blast furnace closures.
c) Capacity comes on line faster than expected (and faster than demand increases).
d) CLF’s Inventory buildup in first half seems excessive. It is forecast to decline by 30% over the next six months. If it does not, that will be a danger sign. 




Takeover or LBO target
Accretive acquisition
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