Thanks Mike M! Sorry it took so long to get to this. I just didn't have the time to get into it. Nice job. I don't agree with everything but much of it is right on. My comments are in italics below the analysis -- Phil
MEANING
Cliffs Natural Resources Inc. (CLF) f/k/a Cleveland-Cliffs is an international mining and natural resources company that currently focuses on mining essential minerals (iron ore and metallurgical coal (“met coal”)) that are needed to create steel used in building the world’s infrastructure (e.g., new buildings, tunnels, rails etc.) other products (e.g., cars, appliances, etc). Additionally, they also mine the less profitable and thermal coal, which is used for energy production and they are conducting feasibility studies on a large (and expensive) chromite project in Canada. The demand for iron ore and coal will be around for a long time to come because countries and businesses can‘t keep growing without increasing their need for steel and energy.
Cliffs is currently the largest producer of iron ore pellets for the steel industry in North America. Of the eleven iron ore mines in operation across North America, Cliffs operates six, which account for 46% of North American iron ore pellet production. In addition to owning and operating its own mines, Cliffs also manages mines for some steel companies from which they generate additional revenue (and experience). In short, they have the know-how to run mining operations around the globe.
Cliffs has also been expanding its mining operations beyond the U.S. market to such locations as Eastern Canada, Brazil and Australia. In addition to selling iron ore, Cliffs is also a producer of high and low volatile metallurgical coal operating coal mining complexes in North America and Asia Pacific (e.g., Cliffs owns 100% of Koolyanobbing complex in Western Australia). During 2011, two of Cliffs’ metallurgical coal mines were unexpectedly forced to shut down temporarily due to several reasons (equipment problems, a tornado, and high carbon monoxide levels) which caused a loss in revenue. Each of the company's North American coal mines are positioned near rail or barge lines providing access to international shipping ports, which allows for export of coal production. Additionally, metallurgical coal is currently in short supply and the demand is expected to continue to outpace supply. Once Cliffs becomes more profitable in this arena, it will result in a big boost to the bottom line.
Cliffs believes that “With growing demand (BRIC economies) and increasing supply constraints (regulatory, cost), the mining sector represents outstanding return potential” and that “Significant scale is both achievable and necessary.” We tend to agree.
MOAT
What is Cliff’s moat? In other words, what is its durable competitive advantage? Well, Cliff’s appears to have a toll moat and secret moat. Cliff’s owns (or is a partner in) numerous mines around the world. If you want to get into the mining business or you want the minerals that they mine, then you have to pay them. Iron ore and coal aren’t exactly luxuries that can be done without. Rather, they are essential minerals needed to create steel and to generate power.
Cliffs also has the know-how when it comes to operating mines such that other companies hire Cliffs to operate properties. Base on the Cliffs’ January 2012 investor slideshow, they indicated that there is a growing deficit of skilled labor in the global mining industry while the demand is massively growing. As such, it will be harder for new start-ups to compete with an experienced company life Cliffs. However, this is a double-edge sword because Cliffs’ larger competitors (BHP, RIO, VALE) will also be seeking the best skilled workers and employees. But, hey, that’s how Cliff’s got their CEO...he came from RIO!
Cliffs recently acquired a West Virginia mine from a company called INR. This new mine is called “Cliffs Logan County Coal, LLC” (CLCC) mine and it contains high-volatile metallurgical and thermal coal with long-life reserve base with an estimated 59 million tons of metallurgical coal and 62 million tons of thermal coal. Cliffs stated that this new mine will increase their “total global reserve base to over 166 million tons of metallurgical coal and over 67 million tons of thermal coal.”
If a competitor wants Cliffs’ assets, then they are going to have to pay up or seek to acquire Cliffs. Recently, there have been numerous mergers and acquisitions in the mining sector and it’s not beyond the realm of possibility that a bigger company could seek to buy-out Cliffs. No matter what, the world has huge coal reserves such that it will continue to be used for a long time to come. [It’s estimated that proven coal reserves total 897 billion tons (mostly in the USA, Russia, China and India, lead by North America), that’s enough to support current production rates for over 119 years. Natural gas on the other hand (the second most important fuel for electricity generation) only has 46 to 63 years worth of proven reserves.]
RED FLAGS
1) China. The main issue facing Cliffs is China’s growth because China is by far the largest consumer of iron ore. If China slows more than expected or if it cannot contain its inflation, then the demand for iron ore and met coal will be negatively impacted. However, if China continues to grow and can ward off inflation, then its demand for iron ore will continue to be strong. Iron ore is an essential component in making the steel used to build the world’s infrastructure - think about all of those buildings, roads, cars, etc. Even if the demand slows in the near term, there will surely be strong demand for iron ore for a long time to come because there just isn’t a glut of iron ore like there is with say aluminum (see Alcoa).
2) Pension. Cliffs appears to have a defined benefits pension plan, which is always a big expense for companies and by defined benefit plans are rare these days. However, Cliffs only paid $55 million in pension liabilities last year, which isn’t terrible.
3) Unions. Another big red flag is union exposure. In the US, Cliffs must bargain with the United Mine Workers union and the Bitumnous Coal Operators Association. Cliffs has just reached a 5 1/2 year labor contract with both unions, so the near-term uncertainty has been alleviated, but in my opinion, unions can create real uncertainty for investors (see Boeing’s recent struggles).
DEBT. As of 2011, Cliffs’ current debt was $3.6 billion and cash from operating activities was $2.289, so debt is not an issue.
GOODWILL. Goodwill is listed at $2.2 billion, due to the recent acquisition of Consolidated Thompson and some other smaller companies.
MANAGEMENT
CEO Joseph A. Carrabba, joined Cliffs after 22 years at RIO Tinto and has served as an officer since 2005. His salary was $814,000 USD in 2010 with total compensation including restricted stock awards of $5 Million USD. (In comparison, Tom Albanese from Rio Tinto makes $1.4 Million Salary with $8.3 Million in total compensation in 2010).
CFO Laurie Brlas. Ms Brlas had a base salary of $445,000 in 2010 with $1.8 Million USD in total compensation. The only negative news found on Ms. Brlas was that she recently sold 1,000 shares at an average price of $69.96. You knew never why someone is selling stock. There can always be legitimate reasons. Since this is such a small amount, it’s not a huge concern. She currently owns 78,900 shares .
William Brake, former VP of global metallics recently left Cliffs quite abruptly. We haven’t found a clear reason yet, so we must continue to investigate. It’s never a good thing when a high level executive resigns abruptly without any explanation.
Based on the 4thQ conference call, it appears that the CEO is a straight-shooter who knows his business and who can clearly communicate the given risks with exploring and developing new projects.
Management Decisions: One possible negative could be management’s commitment to the chromite project in Canada. Originally, the chromite project investment had an estimated capital cost to develop the property of about $1 billion, but that estimate has been raised to $3.3 billion due to costs for transportation. Cliffs made it clear that the initial projection was an estimate with a +/- 30% to 40 and it did not factor in transportation costs, so the recent increased estimate isn’t all that unexpected and Cliffs still believes that it's still a viable project.
The board recently authorized a stock repurchase plan in August 2011, which seems like a good use of the company’s cash considering its extremely low valuation. They bought back the stock at about $72/share. Another good sign is that management doubled the dividend in 2011 to $1.12 per share. Additionally, the company continues to explore ways to invest its cash to continue to grow organically more so that through acquisitions. However, they have not ruled out future acquisitions given the right situation.
MARGIN OF SAFETY
Cliffs has solid growth rates and return on capital. The publicly available information states: ROIC: 17% (5 yr); 20% (1 yr);
BVPS: 47% (10 yr); 24% (5 yr); 8% (1 yr);
EPS: 33% (10 yr); 35% (5 yr); 55% (1 yr)
SALES: 31% (10 yr); 29% (5 yr); 45% (1 yr)
OCPS: 68% (4 yr); 73% (1 yr)
Analysts growth expectations is 20%, Average BVPS Growth rate is 24%.
Cliff’s growth rates per Investools are as follows:
ROIC: 12.9% (1 yr); 12.1% (5 yr); 11.5% (10yr);
BVPS: 43.6% (1 yr); 37.8% (5 yr); 43.5% (10 yr);
EPS: 54.5% (1 yr); 85% (5 yr); 101% (10 yr)
SALES: 45% (1 yr); 37.4% (5 yr); 39.6% (10 yr)
CASH: 33.7 (1 yr); 388% (5 yr); 168% (10 yr).
VALUATION
Payback Time: 3 Years
Dividend: Cliffs’ quarterly cash dividend is $0.28 per common share.
Using the publicly available data, and assuming growth rate: 20% and a future PE: 13.8 (historical high third average, avg PE in 2011 was 7), the valuation based on these numbers yields a 72% MOS.
Sticker Price: 176,753 EUR / $234.03 USD
MOS Price: 88,377 EUR / $117.02 USD
Currently price: 49,897 EUR / $67.86 USD.
However, using the Investools data, we can see that there are three analysts following Cliffs who have assigned growth rates ranging from 3% to 18%, with an average of 10.9%. The BVPS growth rate that we would look to use would be 43%. The 10yr PEs ranged from -7 to 17.6 (from msn). Using a conservative growth rate of 10% and a high average PE of 15 yields a sticker of $112.66, so the MOS is $61.33. The stock is currently at $67.86 (as of Feb. 24, 2012). Obviously, there are some large discrepancies in the numbers based on where we get our data from. Regardless, the big 5 look great using either data set.
According to Barrons, “Cliffs’ stock changes hands at six times 2012 earnings estimates.” Due to this low valuation, many commentators have speculated that Cliffs could be a buy-out target for BHP or RIO, which would result in a premium being paid over the current stock price.
At its current price, Cliffs looks like a solid Rule 1 company that is “on sale” and poised to deliver a solid return on our investment.
Mike – Thank you for the analysis. Here are my comments:
A toll moat means the only way you can get that thing is to buy it from this company. Like PG&E power in CA or Southern Co. in GA. Most Toll moats are government created. There is no Toll moat here.
How about a Brand moat? Maybe a bit. Clearly, no one really cares who's mine the coal comes from any more than what farm produced wheat or oranges. It’s a commodity. But you do want a good responsible supplier. That’s a brand.
Secrets moat? Can they find coal better than anyone because of secrets. Maybe. Probably not.
Switching Moat? They have relationships. They do long term contracts. Perhaps they have a sort of switching moat for some reason. Doubtful but maybe.
Price? It’s a commodity. No price moat.
It’s hard to pin down the moat here. These guys have been around a long time. Here's one way to get to the bottom of what makes this thing great. Ask this question: Can someone run this who is an idiot and have the company survive?
If you think they can, then the next question is why. In this case - Probably. Why? Because they have coal mines. Even bad management can't destroy an entire coal mine very easily.
So in effect, what makes them durable is that they have real goods that are valuable and they either buy or find more as they use up what they have. The value of this business probably lies, like any no-moat company, in its balance sheet. These guys have $52 per share in Book Value and are selling for $64. They are selling stock like crazy to pay for acquisitions but they don’t appear to be diluting their shareholders so they must be buying right. They are borrowing to pay for acquisitions and have added $26 per share of long term debt but their earnings have climbed from acquisitions and an ending recession to $11 per share which means they can pay off debt quickly – in under 3 years.
Here's the Rule #1 Score from www.ruleoneinvesting.com:
ROE and ROIC are getting better. That’s a great sign for a business that’s been on a buying spree. Another sign that they got some great deals. What makes these guys good is that they can buy $10 of coal for $5 and then sell it for $20. So what are they worth as a business?
Valuation: They’re buying their growth so its very hard to know what the future holds for sustainable growth rates. That makes an MOS analysis pretty dicey. I’d do it very conservatively and base it on expected rises in the price of steel, increased production in China and India, and a long-term demand for coal. Analysts are putting growth at 19%. It might be they can sustain that for five years, but for 20? Probably not.
I like what you did: 10% with a 15 PE. I like 8% and a 16 PE better simply because the growth rate is lower, therefore more conservative, but the PE reflects a Bull Market sale at 2X the growth rate. Its rational. I like rational. Here's the Valuation analysis from www.ruleoneinvesting.com.
I get a MOS of $47 with a 4.5 year Payback Time at the current price of $63. We have a 33% MOS but a very short PBT. I like that. I'd like it more if I could buy this for $47. Is there a way to do that?
Sure: Wait.
So what to do? First, don’t buy this unless you are excited about the possibility of getting more at a lot lower price. That’s the case for everything we buy under Rule #1. Buy it and hope it goes lower and you will be a happy investor if you’ve done your homework well.
Second, its dropped 8% since Mike wrote this up. Find out what is causing Fear among the Big Guys. Never assume they are stupid. If they’re getting out, you have to figure out why.
Once you know their fear is unfounded, then if you like it go ahead. But never buy until you know. You don’t want to be the sucker at the poker table.
And remember that optimism is the enemy of great Rule #1 investing. But then so is the inability to pull the trigger when faced with a spectacular deal. Is this one? Dig into what's going on. If Fear of coal prices, world recession, a slowdown in China or anything else that is relatively short term, then I like it for a buy now. If you can't find the Fear, hold off until you can.
Now go play.
PS: It looks like when we come out of Beta we're going to have to price the tools at a price that reflects the cost of the data. We're probably going to be at something like $4000 a year. Nasty, I know. Sucks, really. I'm hoping we can grandfather y'all in at a much lower price point on a one-time only basis. I'll let you know soon. But if we do it it will absolutely be one time only and probably the door will be only open if you've been on the site for a while and can act immediately. Stay tuned. And remember, you can use free tools like I show you in both my books. You don't have to have this toolset. It just speeds things up.
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