80% Upside If This Stock Falls To $1

A turnaround specialist can help to deliver huge returns for investors. By cutting costs or re-orienting a company into more appealing markets, a money loser can steadily morph into a money-maker.

That’s been the hope for Lourenco Goncalves, who became CEO of beleaguered miner Cliffs Natural Resources, Inc. (NYSE: CLF) last summer.

#-ad_banner-#Under his watch, the company’s per ton mining costs have fallen, he’s slashed general overhead (with corporate headcount falling from a peak of 338 to a recent 139), and Goncalves reduced the company’s exposure to global markets. The re-focused business is directed more squarely on North America, which has better pricing dynamics. Moreover, a series of asset sales has enabled Cliff’s to pare debt by more than $1 billion in recent years.

All of these factors have bought the company ample breathing room to sustain an eventual potential turnaround. Had this company not taken such bold action, Cliff’s might have already declared bankruptcy by now.

Trouble is, those moves won’t help the stark reality of an industry that has too much supply and not enough demand. And shares of this miner, despite a recent mini-rebound (in an otherwise extended slump), may fall to just $1. That represents more than 80% upside for short sellers.

Cliff’s is a leading producer of iron ore, a key commodity that has underpinned China’s construction boom. Thanks to expectations that Chinese demand would be insatiable, global iron ore producers opened a lot of new mines in the past five years. Cliff’s went on a massive borrowing binge to capitalize on that boom. The company and its rivals now produce more iron ore than the market can handle, and iron ore prices have generally been in a multi-year down trend.

In 2015, however, iron ore prices have managed to rally. Yet, as noted in a recent The Wall Street Journal article, the drivers behind a recent rebound in iron ore prices look unsustainable, and pricing appears set to slump anew in the months ahead. Another look at the topic finds that the iron ore market may be massively oversupplied by 2018

Although Cliff’s delivered impressive Q1 results, thanks to firm pricing tied to legacy contracts, such strength is likely to prove ephemeral. For the remainder of the year, management concedes that it will only generate $80-to-$85 per ton for ore, and the firm may not be braced for a steep pullback in iron ore prices in coming quarters.

Even if Cliff’s manages to avoid deep financial distress, shares are still quite overvalued. Analysts at Clarkson Capital Markets anticipate the company will generate $300 million in earnings before interest, taxes, depreciation and amortization, or EBITDA, annually, and suggest that the business should be worth roughly $3.23 billion on an enterprise value basis. Trouble is, if you back out the $2.78 billion debt load, the equity portion of enterprise value is worth around $450 million, placing a fair value on shares of just $2.50. Currently, shares trade around $5.80.

Analysts at Credit Suisse believe that even this assessment is too optimistic. They think Cliff’s EBITDA will average just $30 million in 2016 and 2017, which is not sufficient to support annual interest expenses of nearly $200 million. As a result, “we have no earnings-based valuation support for CLF,” and they see shares falling to just $1.

Concerns are also growing that CEO Goncalves is cutting costs too deeply. When a miner skimps on capital spending and mothballs key personnel, it can set the stage for diminished output in the future.

Even with Cliff’s smaller footprint, the iron ore industry will likely remain in oversupply for the next few years. CEO Goncalves noted on a recent conference call that key rivals such as Vale S.A. (NYSE: VALE) and BHP Billiton Ltd. (NYSE: BHP) have yet to take steps to meaningfully reduce output. Notably, those firms are better prepared to ride out a pricing slump, while Cliff’s is in a relatively weaker financial position.

Analysts at Merrill Lynch, who have a $3 price target, rate shares as underperform “to reflect increasing conviction that CLF’s iron ore and met coal will be high-cost production that struggles to compete with new Australian and other global supply.”

The industry supply problem means that there are severe limits on how much EBITDA the slimmed-down company can generate. Short sellers appear to anticipate a sobering revised view of EBITDA in coming quarters, as iron ore prices slip back. As of the end of April, the short interest stood at 74.6 million shares, representing more than half of the trading float. It’s a “crowded short,” but one that is likely to be profit for short sellers in coming quarters.

Risks To Consider: As an upside risk, Cliff’s continues to seek asset sales which may give the balance sheet even more breathing room and might give short sellers a reason to cover positions.  

Action To Take –> A successful turnaround requires bold moves and favorable industry conditions. Cliff’s CEO gets ample credit on the first count, but is facing an intractably oversupplied iron ore industry. Although a bankruptcy filing is quite unlikely in 2015, investors will likely come to see that limited EBITDA potential will lead to a much lower valuation for this stock.

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