Morgan Stanley has lowered its outlook for iron ore prices in 2014, and says Cliffs may not be able to maintain dividend payments if it wishes to avoid hurting its credit rating
Cliffs Natural Resources Inc (CLF) closed Tuesday at a multiyear low of $13.76 amid a selloff in the mining industry following a downward revision to Morgan Stanley’s (MS) outlook for iron ore prices in 2014. Morgan Stanley also said it expects iron ore prices to decline further in 2015 due to a supply glut in the global seaborne iron ore market and faltering support from Chinese producers.
Iron ore inventory in China – the largest consumer of iron ore in the world – is currently at a record high. Inventory levels of iron ore at known and reported warehouses in China have risen by more than 51% over the last year to 107.67 million tons, and destocking in the near future will further depress iron ore prices.
The price of iron ore at the Port of Tianjin in China for immediate delivery has dropped below $100 per ton for the first time since 2012. Iron ore prices have declined more than 18% YoY to $91.50 per metric ton.
Morgan Stanley analysts Joel Crane and Rachel Zhang project a downward shift in the complete cost curve for iron ore, which will likely drag down cost support levels with it. They see cheaper iron ore replacing the costlier ore produced in China and some other places. Increased supply from large miners in Australia, like BHP Billiton Limited (BHP) and Rio Tinto plc (RIO), will also put downward pressure on iron ore prices.
Among sell-side firms, Morgan Stanley is one of the most bearish on iron ore. It earlier slashed its price outlook from $134 per ton to $118 in May, and this month further reduced it to $105 per ton for the year. For 2015, too, the bank has slashed its price outlook to $90 per ton from $114 per ton. Goldman Sachs Group Inc (GS) and UBS AG (UBS) are expecting iron ore prices to remain at $109 and $111 per ton this year.
Cliffs Natural Resources will be most affected by the fall in iron ore prices, as more than 85% of its revenues are generated from iron ore mining. The company’s total shipments of iron ore took a hit in the most recent fiscal quarter, falling 2.2% YoY to 7.086 million tons. Iron ore revenues declined 2.4% year-over-year to $4.87 billion in fiscal 2013 (FY13), and in its latest fiscal quarter (1QFY14), were down 16.5% to $773.8 million. Sales margin per ton for Cliffs’ US Iron Ore segment declined from $62.30 to $95, while the Eastern Canadian Iron Ore segment’s margin dropped from $69.10 to $49.70.
The realized product revenue rate for the US Iron Ore segment declined 9% YoY to $109.02 per ton. In its Eastern Canadian Iron Ore business, the miner’s realized product revenue rate plunged 25.4% to $98.45 per ton. Likewise, the Asia Pacific Iron Ore segment’s rate fell 18.1% to $96.25 per ton. Cash flows from operations (CFOs) subsequently declined by $56.6 million in the first quarter, resulting in a cash outflow of $82 million.
Morgan Stanley analyst Evan Kurtz forecasts Cliffs’ declining CFOs to lead to a violation of a funded debt-to-EBITDA covenant, which is part of a credit facility extended to the miner. In order to keep funded debt-to-EBITDA below the stipulated maximum level of 3.5x, the company will need to cut payouts in order to repay debt. If Cliffs sticks to its current dividend policy, Morgan Stanley says the ratio will increase to 4x by the end of 2014.
Cliffs Natural Resources has been trying to sustain dividend payouts and survive the fall in iron ore prices. After cutting capital expenditures (capex) by $460 million in 2013, the company announced this year that it will reduce capex by another $100 million.
Kurtz and his team note that Cliffs requires approximately $92 million each year in order to maintain cash payments to holders of common stock. Cliffs’ preferred stock will be converted to common stock in 2016, after which the miner will require approximately $108 million each year to pay dividends. The team forecasts that Cliffs will barely break even in terms of free cash flows before it pays out the 2015 dividend.
If Cliffs does not renegotiate its debt covenants, the miner may be refused further credit facilities. Axiom Capital Management analyst Gordon Johnson explains that Cliffs requires the average per ton price of iron ore to remain at around $120 in order to avoid violating the debt covenant.
Cliffs Natural Resource’s board has recently come under a lot of fire from investor Casablanca Capital on a $4.9 billion transaction that saw Cliffs acquire the Bloom Lake mine. The board later on had to approve another $1.5 billion for capex to develop the project.
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