An All-or-Nothing Play on Cliffs Natural Resources?
Oct 1st 2013 1:50PM
Updated Oct 1st 2013 1:52PM
"We will continue to ignore political and economic forecasts which are an expensive distraction for many investors and businessmen." -Warren Buffett, 1994
As Warren Buffett so masterfully illustrated in this quote above, it is dangerous to pay too much attention to political and economic forecasts. While I believe this to be true, I also believe that it is wise to be on the lookout for large market bubbles, which can be discovered by analyzing raw data and comparing it to common sense conclusions. By maintaining this duel mind-set, the Foolish investor can remain focused on investing in companies that are fundamentally sound and undervalued, while avoiding value traps that could hinder their performance. It was with this logical thought process that I stumbled upon Cliffs Natural Resources , a large iron ore and metallurgical coal mining company located in Cleveland, Ohio.
Despite a large market position and tremendous revenue growth, the company has hit somewhat of a rough patch lately. Unlike in 2011, when the company had a net profit margin of 24.7%, 2012 proved to be somewhat problematic. This is attributable to a net profit margin of -15.3% as the company was faced with higher costs, a goodwill impairment of almost $1.05 billion, and lower revenue due to a decline in the price of iron ore. Although the net loss has not continued on into the company's current 2013 fiscal year, revenue has continued to decline, falling from about $1.58 billion in the second quarter of 2012 to roughly $1.49 billion (a decline of 5.8%) in the same quarter of this year.
However, the Foolish investor should keep in mind that Cliffs Natural Resources is not the only mining company being punished by falling iron ore prices. Vale saw its revenue decline by 21.7% in 2012 as a result of falling commodity prices. This decrease in revenue ultimately led to the writedown of goodwill and a subsequent 75.9% drop in net income for the year. Another company plagued by the recent downturn in iron ore prices is BHP Billiton , which saw its revenue decline by a more modest 8.7% and its net income fall by 29.5% from 2011 to 2012.
As China continues to slow (which I believe to be inevitable), it is highly unlikely that the price of iron ore will significantly improve. It is more likely than not that companies that mine iron ore and metallurgical coal will continue to see revenue declines, but for investors with a contrarian mind-set, Cliffs Natural Resources might be an attractive avenue. In addition to being the largest iron ore mining operation in the United States, the company has a reasonable current ratio (the company's current assets divided by current liabilities) of 1.44 and an attractive long-term debt/equity ratio of 0.59, which suggests that the company is both liquid and solvent. Furthermore, the company is trading at a steep 56% discount to its current book value.
Investing with protection
However, for those who want a piece of the action but who are afraid of the company going bankrupt from a continued and prolonged fall in the price of iron ore, there is an alternative to owning the company's common shares. By investing in the preferred shares of Cliffs Natural Resources , investors can gain a piece of the company and a hefty 8.7% dividend per annum, which is far higher than the nearly 2.9% dividend the common shares offer.
On top of this, the company's preferred shares have been given a liquidation preference of $25 each, which means that if the company shuts its doors, investors will receive $25 for each share that they own (assuming that there is enough cash after the sale of the company's assets to pay off their creditors). At a price of $20.65 as of the time of this writing, this appears to be free cash, but there is a catch!
Under the terms of the preferred shares, shareholders have the right (but not the obligation) to exchange the preferred shares for between 0.7037 and 0.8621 shares of common stock any time between now and Feb. 1, 2016. Following this period, shareholders will be forced to exchange their shares to common. In the event that shareholders are forced to convert and common shares are trading at $29 or less, they will receive 0.8621 shares of common for each share of preferred. However, this ratio will decrease for each penny increase above $29 down to a low of 0.7037 shares of common for each share of preferred. This presents an interesting scenario as shown in the table below:
According to the table I compiled above, the high dividend and liquidation preference comes at a cost. Although short-term returns might be higher, shareholders effectively cap their upside should the common shares skyrocket beyond $20 apiece. In exchange for this, they protect themselves from downside in the common shares and give themselves a fair chance of making a substantial profit in the event of a liquidation.
For an investor who is cautiously optimistic that iron ore prices will rise between now and 2016, or for the investor who believes that Cliffs Natural Resources may go bankrupt while still having enough asset value to ensure its liquidation preference, the company's preferred shares might hold some attractive opportunities. But, if upside is all you see moving forward, I would consider sticking with the company's common shares.
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The article An All-or-Nothing Play on Cliffs Natural Resources? originally appeared on Fool.com.Daniel Jones has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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