Tuesday, February 19, 2013

Cliffs Natural Resources (NYSE:CLF): Actionable Call Alert!

J.P. Morgan Metals king Michael Gambardella is making a major call in Cliffs Natural Resources (NYSE:CLF) this morning upgrading the iron ore miner to Overweight from Neutral with a $40 price target (prev. $35).

- Since mid-September 2012, Cliffs’ peer group is up 17% on average while CLF is down 37% despite a 53% rise in seaborne spot iron ore prices – the current discount between Cliffs’ stock price and iron ore prices is now at the widest spread on record.

Gambardella attributes this substantial relative underperformance to persistent disappointments at Bloom Lake presented to the market piecemeal over the last two years, ultimately culminating in a 20% writedown on the initial $5B purchase price, a threefold increase in Phase II capex, and a 76% dividend cut. Additionally, the recent capital raise diluted shareholders by 15-17% but reinforced Cliffs’ balance sheet to endure future commodity volatility and possibly fund future growth projects.

In his view, Cliffs’ shares reflect this series of negative events and are only pricing in $110/tonne iron ore in 2015, 29% lower than current spot prices, based on the stock’s average EV/EBITDA multiple of 5.6x. Gambardella believes the stock’s reduced sensitivity to rising iron ore prices post 3Q12 earnings and the historically wide gap versus spot seaborne indices should dampen any potential downside if the recent run loses momentum following the end of the Chinese New Year. In his opinion, management has reset Bloom Lake’s expectations to an achievable level and given sentiment appears apathetic at best (9% buys after three recent cuts to neutral/hold) he believes merely meeting guidance at the key project will be enough for Cliffs to begin climbing over a large wall of worry. As this process unfolds Gambardella sees the market re-rating CLF’s valuation higher for its renewed leverage to iron ore prices, which he believes have a positively skewed risk profile in the medium term.

In his opinion, 2015 seaborne iron ore prices have more potential upside price risk in the medium term than reflected in forecasts by J.P. Morgan’s commodity team or consensus estimates.

Some of the more interesting details from the call:

- Execution on Bloom Lake key to stock appreciation...
We believe the stock’s muted correlation with robust iron ore fundamentals and record discount to current prices suggest this former prime driver will take a back seat to results delivered by management relative to the new Bloom Lake plan. In our view, Cliffs has likely reset the bar to an achievable level in 2013 after the recent streak of poor performance and a 20% write-down of the initial purchase price perpetually disappointed investors. Given this poor track record, merely meeting the new guidance could be enough to boost sentiment and the share price; we would note the first phase at Bloom Lake exited the year on track with its stand-alone 2013 target.

- … and re-establishing leverage to seaborne prices. We expect Cliffs’ leverage to seaborne prices will gradually increase over the next three years with the addition of Bloom Lake Phase II and long term USIO contracts rolling over into shorter, spot centric agreements. Assuming management delivers Phase II on time and budget, CLF’s valuation should re-link to iron ore prices, which we believe could ultimately remain higher for longer than consensus and our internal commodity team expect.

- Potential value outside of Bloom Lake. Although Cliffs declared the project is the future of the company, we believe management is also in the process of unlocking value in several other areas. We estimate Cliffs could net EBITDA improvements of 10% and 11% versus our 2013 and 2014 forecasts if Wabush operations break-even ahead of our current 2015 timeline. Separately, we believe management could conservatively monetize the estimated $500mm spent on purchasing the chromite properties and bringing the project to feasibility by taking on a partner or selling the stake outright. Additionally, we expect the company will take steps to mitigate material contract expirations at USIO by developing and marketing DRI pellets while potentially expanding its optionality to export more than its estimated current limit of 2mm tonnes of pellets annually.

- We would note holding the current $155.10/tonne iron ore price in 2015 yields a $75 price target utilizing the stock’s long term average EV/EBITDA multiple of 5.6x, 160% above the current stock price.

Actionable Call Alert!

- Gambo is the Axe in the space. He downgraded CLF back in Sept '12 - 15 pts higher. One of the few analysts that can actually time the market.

- Gambo notes management has reset Bloom Lake’s expectations to an achievable level. Remember this guy has a very good management bullshit detector. Molycorp anyone? So if he says Bloom Lake is good, it's likely good. At it's mostly about Bloom Lake right now.

- It's an out-of-consensus call as Gambo himself notes. There are very few Buy-rated analysts out there. Shorting CLF has been the hip trade. Chart looks awful and I suspect everyone and their mother has been expecting a downside break. Short intrest stands around 20%. They could be in for a nasty surprise if Gambo is right.

- Note Gambo is going against JPM commodities team and Consensus on iron ore pricing. He thinks there's more upside.

- If he is right on iron ore pricing, CLF is a $75/share stock vs. ~$30/share today.

All in all, this call has potential to propel the stock back above the $30 mark and likely closer to $31 today. I say +7%.


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