Dig It: Cleveland-Cliffs is Cheap

Dig It: Cleveland-Cliffs is Cheap

By Andrew Bary

1697 words

18 September 2006

English

Thanks to shrewd, low-cost acquisitions during the steel industry's downturn earlier in this decade, Cleveland-Cliffs emerged as the top North American producer of iron ore -- just in time to benefit from the surge in steel and iron-ore prices in the past two years.

Now Wall Street is wondering whether Cleveland-Cliffs' prosperity may mean the end of its independence, because it's an attractive, small company in the consolidating global mining industry.

Its attributes include long-lived mines in the upper Midwest, the third-largest iron-ore mine in Australia, a debt-free balance sheet and a digestible market value of less than $2 billion.

Cleveland-Cliffs' shares (ticker: CLF), at around 36, aren't expensive, fetching 6.4 times projected 2006 profits of $5.55 a share, and seven times 2007 earnings of $5.16 a share. The stock, which peaked at 55 in February, has come down with other mining and resource shares, even though the price of iron ore, the key raw material for steel, has remained strong. Leading steel stocks are also down from their spring highs, with U.S. Steel trading at 58, below its May peak of 77.

The sharp recent drop in oil prices has hurt investor sentiment on all commodity plays, and prompted an exodus of hot money.

"Our fundamentals haven't changed. We're as baffled as anyone" about the stock price, says Joseph Carrabba, who took over as Cleveland-Cliffs' CEO on Sept. 1. The Cleveland, Ohio-based company's price/earnings ratio is low relative to most others in the mining industry.

True, the company is exposed to any downturn in the global economy and in particular to Asia. But only a fraction of its sales go to Asian steel makers. Still, since China accounts for about a third of global steel production, any weakening in the robust Chinese economy would have ripple effects throughout the worldwide steel industry.

Cleveland-Cliffs commands four times estimated 2006 pre-tax cash flow, versus six to eight for most big mining outfits. This financial measure is commonly used by potential acquirers in evaluating businesses. "This company probably isn't independent in a year or two," says Robert Marcin, the head of Defiance Asset Management, a Conshohocken, Pa., investment firm that holds Cleveland-Cliffs shares. "It could be taken private or sold to a strategic buyer."

Marcin values the company at more than 50 a share. and says he'd be happy if the stock market accorded Cleveland-Cliffs a higher valuation, and the shares moved up to 50 without any deal. "The stock could trade at 10 times earnings, or there could be a strategic transaction," Marcin says.

Morgan Stanley credit analyst Greg Peters does a monthly screen of potential leveraged-buyout targets in the stock market, and Cleveland-Cliffs is near the top of this month's list. If the company were purchased for $50 a share, that would translate into a modest five times projected 2007 cash flow, defined as earnings before interest, taxes, depreciation and amortization. Private buyers probably would be trumped by mining companies if the company ever gets put in play.

Potential acquirers include mining giants BHP Billiton (BHP), Rio Tinto (RTP) and CVRD (RIO), which together dominate the global iron-ore market. CVRD admittedly has its hands full now because it has a deal to buy Inco (N), the Canadian nickel company, for $15 billion in cash.

Other possible buyers include Mittal Steel, the global steel behemoth and Cleveland-Cliffs' biggest domestic iron-ore customer. Mittal could be interested in greater control of its iron-ore supply, emulating rival U.S. Steel, which is self-sufficient in iron ore. Canadian miner Teck Cominco (TCK) also is seen as a possible buyer of Cleveland-Cliffs, which has annual sales of $2 billion.

Cleveland-Cliffs is No. 1 in North America with annual iron-ore production of 21 million tons, 28% of the market. Its six mines produce 46% of North American iron ore. (The company shares that output with partners in several of its mines.) Yet its total annual production of 28 million tons, including 7 million tons in Australia, is less than 2% of the global iron-ore market and puts the company far behind Australia's BHP and Rio Tinto, and Brazil's CVRD.

Cleveland-Cliffs has limited internal-expansion opportunities, so it is looking at potential acquisitions, either in the international iron-ore business or in other steel-related resource areas, such as coking coal, Carrabba said last week. "We're not starry-eyed. We look at acquisitions. We will do the right thing," he said, adding that if an acquisition can't be done, the company will evaluate other options, such as a more aggressive share-repurchase program.

"So far, the company has behaved responsibly. They've made it clear that they don't intend to do anything undisciplined with their balance-sheet capability," says Mark Liinamaa, a mining analyst at Morgan Stanley. "It's going to be hard to find a transaction that will make investors happy, because nothing out there looks as attractive as their own stock." A bullish Liinamaa has a 48 price target on the stock.

One reason for Cleveland-Cliffs' share-price weakness is investor concern that it will overpay for something. Yet the company's 2005 deal to buy an 80% interest in Portman, the Australian iron-ore producer, for $433 million, has paid off for shareholders.

Cleveland-Cliffs bought back 2.5 million shares in the second quarter, roughly 5% of its 54 million shares outstanding, and subsequently authorized another buyback of 2 million shares. These amounts aren't trivial, but some investors would like to see much more. The company pays a modest dividend of 1.4%. Without a big buyback or sharply higher dividend, the company's cash is likely to build in the coming years.

Liinamaa projects cash could hit $700 million by the end of 2008, up from $127 million on June 30. The company has pension and post-retirement health-care liabilities totaling about $500 million.

Asked about a possible takeover, Don Gallagher, the company's chief financial officer said: "We're pragmatic. We work for the shareholder. If someone comes along and offers a significant premium for the stock," the company will seriously evaluate that offer.

Carrabba quickly emphasized that Cleveland Cliffs "isn't shopping the company. We have the right strategy for growth. We feel good about the next few years." While down from its 2006 high, the stock price is up sevenfold since 2003.

Carrabba says he's bullish on iron ore, noting that Asian spot prices are above a widely followed international benchmark. One advantage of the North American iron-ore market is that it's protected from international competition because of the high cost of transporting overseas ore to Midwestern steel mills. The disadvantage is that there's little growth in the domestic integrated steel industry.

Cleveland-Cliffs has mined iron ore for 159 years, providing the raw material for the steel that built this nation. High-grade ores in Minnesota and Michigan have long been exhausted. The result is that Cleveland-Cliffs produces ore with about 25% iron content from open-pit mines, then processes the ore into marble-sized pellets with about 65% iron concentration. The pellets are shipped via the Great Lakes to blast furnaces operated by integrated steel producers in Illinois, Indiana and Ohio.

One of Cleveland-Cliffs' initiatives is to develop an enriched form of iron ore with about 90% purity that can be used in place of steel scrap in "mini-mills" operated by Nucor, Steel Dynamics and others.

The biggest risk to Cleveland-Cliffs is a decline in steel and iron-ore prices. So far, that hasn't happened. The company's realized iron-ore prices in North America, which are based on a host of factors, including steel and international iron-ore prices, were up 12% to $67 a ton in the second quarter from the year-earlier period. Cleveland-Cliffs' second quarter profits, however, declined to $1.53 a share from $1.79 a share in the second quarter of 2005, reflecting lower sales volume. A rise in inventories mildly concerned Wall Street. Investors are aware that as recently as 2003, the company was losing money during a period of weak iron-ore prices.

It was during that time that former CEO John Brinzo, who retired on Aug. 31, took advantage of bankruptcies in the steel industry to transform Cleveland-Cliffs from a company that primarily managed iron-ore mines on behalf of steel companies to a major mine owner.

Cleveland-Cliffs increased its interest in several mines very cheaply, often by doing little more than assuming such legacy liabilities of bankrupt steel companies as pension and environmental obligations. Two of its six mines are located in Michigan's Upper Peninsula, three are in Minnesota and one is in Eastern Canada. The reserves at two of the most productive mines, Minnesota's Northshore, which is wholly owned by Cleveland-Cliffs, and Tilden, in Michigan, which is 85%-owned, are very long lived at 30 years or more. The company prides itself on a strong safety record, highlighted by an accident rate below industry averages.

Cleveland-Cliffs also controls land in Utah and Colorado where there could be 1 billion barrels of oil locked in shale deposits. Carrabba says the technology and economics of oil shale "are a long way off" but that the company is happy to sit with the properties, which is acquired in the 1950s. "Maybe in another 50 years," he says. "We have minimal carrying costs to hold it."

The revival of the domestic steel industry -- now in its best shape in decades -- has revived Cleveland-Cliffs. Its stock has fallen victim to commodity pessimism. If the pessimists are wrong, Cleveland-Cliffs ought to reward investors, either independently or as part of a larger mining company.