Diary of a Financier

Cliffs diving

In Trading Desk on Wed 27 Mar 2013 at 21:48

I would’ve though that we exhausted the “cliff” puns and metaphors at YE12, when Congress was wrangling with the Fiscal Cliff… but no, Cliff Natural Resources (CLF) couldn’t let it rest. I unleashed a stream of consciousness on StockTwits today (I/II/III), and I think this rant deserves full form prose to do it justice. I don’t usually discuss singlenames here, but I wanted to articulate my thinking–not to talk this iron ore/metallurgical coal mining stock higher, but to go on-the-record with an assertion of deep value.

Begrudgingly, I own this name. It’s one of two landmines ruining my quarter. I talked about this back at the beginning of March:

We’ve gotten picked-off this quarter in singlenames like Cliffs Natural Resources (CLF), a 2.5% position… We’d ridden CLF from dip to top twice in the last 3 years. CLF cashflow missed guidance by a long shot throughout 2H12, but I saw their inventories accumulate in [what I thought was] a conscious choice by management to wait-out a collapse in global iron ore spot prices. I was right, CLF management didn’t want to sell product into a dislocated market, they waited, and the market came back. As of 2/2013, iron ore prices had almost doubled to $130, so I opened my position, thinking that they’d preserve their fat dividend. As it turned out, CLF had waited too long: they needed cash, so slashed the divided and diluted shareholders with a dual tranche offering. Psychologically, it’s in the dog house; I’d prefer to unload (5 points ago) and reengage when value’s met <$20, but my partner strongarmed me into holding.

Inventories climbed from a $650-700mm quarterly run-rate to $925mm in 2q12, while Chinese Iron Ore (STF/) spot prices collapsed from $190 to $85. By YE12, CLF’s inventories settled down to an elevated $725mm, as Iron Ore recovered back up to $160… but the stock kept falling:

CLF v Iron Ore (weekly)- deeply negative correlation implies something

CLF v Iron Ore (weekly)- deeply negative correlation implies something

Management went back to raise capital on February 13, when a dual tranche offering added $1.1B in common stock and convertible preferreds plus a dividend cut that’ll save them $234mm in retained earnings annually. Truth be told, I was ready to sell at $29.50 the day of the followon offering. This was a $100 stock less than 9 months before, so a capital raise at such a depressed level screamed “liquidity crunch,” and I didn’t want to stand in the way of the weak hands–among them income investors–who’d be shaken loose by the media blitz. My partner insisted on holding, reasoning that doubling down at a [relatively shallow] lower low was an attractive enough risk juxtaposed to the reward of a mean-reverting snapback higher.

I digress. Rewinding the tape a bit, CLF took an enormous $1B goodwill writedown in 4q12 (announced in January), a one-time item related to its takeover of Consolidated Thompson Iron Mines, which it bought for C$4.07B ($4.06B) in 2011. Were we to extrapolate the average quarterly cash flow from their horrendous 2012, inclusive of that one-off 4q charge, CLF would have to weather almost -$350mm in cash flow declines every quarter. That’s -$1.4B annualized, and CLF balance sheet (quarterly a/o FY12) they raised just that amount in their financial jostling this February. Add to that $273mm in preexisting cash + $725mm in inventories, you realize that there’s a worst case downside buffer here at today’s closing price–not even including $11.2B PP&E and other Current Assets.

If the Street’s eye is on CLF’s solvency, then bring it on. Of $3.96B in LT Debt, there’s no financing to roll until the 7s of 2016 mature (2/1/16). In the meantime, CLF has a 1.19 Current Ratio. The Street, as it turns out, is not worried about solvency here, as all CLF’s bonds are trading above par,¹ except for their $500mm 2040 issue.

I never stick around long enough to take 50% losses in a name. By then, the story or the fundamentals must have changed. What’s changed for CLF? People are bearish on Chinese fixed investment, I get that–I am too. China accounts for a large portion of CLF’s revenue, 33% in fact (FY12). Take those sales away, all of them, and the stock’s trading woefully cheaper than a worst case forward run-rate (although peers like ACI & ANR are admittedly battered too):

$5.5B FY13 sales estimates less 33% Chinese sales
= $3.69B revenue v. $2.92B market cap
= 0.79 price-to-worst-case-sales ratio

This is deep value, disproportionate risk/reward. The teens is where I saw a significant margin of safety… CLF is there now.

–Romeo

¹CLF bonds as of 3/26: 3.95s of ’18 @ par; 5.9s ’20 @ $106.777; 4.8s ’20 @ 100.412; 4.875s ’21 @ 100.73; 6.25s ’40 @ 96.374

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  1. Barron’s favorably mentions CLF, bullish due to:
    1. JPM analyst MIchael Gambardella (who’s been bullish since CLF @ $100) thinks suppliers will exercise supply constraints to prevent iron ore prices from falling <$100
    2. Trading @ 60% of tangible book value
    3. Short squeeze should be triggered by buyout rumors

    http://online.barrons.com/article/SB50001424052748703769504578398890045935294.html?mod=BOL_hpp_highlight_bottom

  2. […] 0.79 (vs 0.76 benchmark) and monthly sigma 1.20 (vs 0.54 benchmark), which has helped reel-in the underperformance we had in […]

  3. […] to fair value—fully acknowledging the vacancy left by waning future Chinese demand; I’m still stuck in it, but I’m convinced it’s deep value […]

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