The Case for Buying Cliffs Natural Resources (The Motley Fool)

Dan Shainberg is the portfolio manager for BHIC LLC, a $100 million "Special Situations" hedge fund based in Los Angeles. He previously worked at Sun Capital, where he helped launch its $1.3 billion distressed public securities investment fund. Dan graduated from NYU's Stern School of Business cum laude and began his career as an investment banker at Credit Suisse, where he focused on underperforming industries. The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors.

Thesis
While iron ore and coal pricing can be very volatile in the short term, leading to stock price volatility, the significant increased production capacity from the acquisition of Thompson and other recent capital expenditure (capex) initiatives should more than offset any potential pricing weakness. Cliffs Natural Resources (NYSE: CLF - News) recently purchased Thompson and is expecting to ramp up annual production capacity into the seaborne market from Thompson from 8mm to 16mm over the next two years.

Chinese interest rate hikes to offset inflationary pressures are possible, but the emerging markets construction theme is likely to play out over many years. China just released its five-year plan, which includes a focus on the economic over taming inflation.

India recently banned exports of iron ore, forcing Asian iron ore spot prices higher from $175/ton to $190/ton. The forward curve implies some slight near-term declines due to Queensland supply coming back on line. The early March price sell-off and the current substantial drop in Asian markets due to the earthquake in Japan are presenting a good entry point. While Cliffs has 6% of its sales tied to Japan, the earthquake there will likely be a short-term headwind as factories are shut down, but a long-term growth opportunity because of rebuilding of infrastructure.

Almost all 2011 pricing is already contracted, reducing short-term risk. Ninety-five percent of 2011 met coal, 100% of 2011 thermal coal, and 70% of low-vol 2011 met coal are already contracted and the current spot prices for the un-contracted portions are much higher than the contracted price -- leading to likely higher than estimated revenues. The general guidance and forecasts are for continued high levels of steel demand globally from emerging markets and a rebounding U.S. but even if prices decline slightly, Cliff's is expecting to double its Thompson production capacity of Asian iron ore from 8mm tons to 16mm tons by late 2012. That would add $1.4 billion of revenue and an estimated $750 million gross profit at current prices and margins.

Management's implied 2011 EBITDA guidance is for $3.0 billion, but that includes less than three quarters of Thompson (the acquisition is set to close Q2 2011). The company's $2.4 billion operating cash flow guidance, including maintenance capex, puts the free cash flow (FCF) yield at 20% assuming commodity prices generally hold stable and there is minimal dilution from the Thompson acquisition (financing structure not yet finalized).

With the thesis laid out, let's look at Cliff's Natural Resources in bite-sized bullets:

Demand

Cliffs Natural Resources expects GDP growth in China, India, Brazil China released data showing a trade deficit and rising CPI, which fueled concerns about slower global growth Investors also concerned due to slight recent iron ore price decline Iron ore futures curve is slightly down-trending, but China steel ordering on hold due to Chinese New Year India, without the seasonality of China, showed exports surging 50% year over yearChina imported record amount in January Chinese consumption robust in Japan, South Korea, and Taiwan European steelmakers' furnaces are returning to production U.S. actually growing steel demand as auto sales and other manufacturing sectors rebound slowly

Supply

Chinese iron ore production expected to increase from late April to early May Spot prices very high; likely to retreat some, but stay strong Most experts expect average prices in 2011 to be higher than in 2010 2010 prices average = $185/ton vs. 2009 average price = $61/ton No new supply coming on stream over the next two years Indian states restraining output through export bans Cost inflation delaying projects by small players in Australia and Brazil Chinese output increasing but country is near max production limits Chinese (marginal producer) production costs increasing thus raising prices

Thompson Acquisition

To be completed in Q2 2011 Acquisition price is $5 billion, but not yet paid for Management guided to potential equity dilution with debt financing Analysts currently believe financial position strong enough to not have to dilute at all Strategic purchase to open Cliff's to seaborne trade Expects half of all iron ore to sell to Asia All Consolidated Thompson capacity contracted with long-term arrangements Contracts specify sales/ton rates to be determined with global seaborne market rates Currently, Thompson will add 8 million tons iron ore capacity Projects under way to increase capacity to 16 million tons Guidance of $75 million synergies

Industry News

Vale announced a $35 billion joint venture to build railways in Africa to transport commodities to China/India Riversdale Mining, pending buyout by Rio Tinto, said it will issue debt if top shareholders nix buyout Recent Cliff's acquisition of Consolidated Thompson increasing exposure to seaborne market ArcelorMittal and Nunavut Iron Ore bidding against each other for Toronto's Baffinland Iron Mines

Guidance

Iron Ore guidance price of $140-$145/ton Current bear case futures price = $140/ton Spot price recently pulled back from $200 to $177 Assumes average 2011 hot rolled coil steel price of $650-$700 Current spot price up from $700 to $870 since Q4 2010 Volume guidance is for 2011 2011 will only include partial incremental Thompson acquisition Acquisition to be completed Q2 2011

Valuation P/E = 6.5-7.0x forward earningsEV/EBITDA = 5.3-5.6x forward EBITDA FCF Yield = 20% (forward guidance; pre-growth capex)

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