Rising Tensions Between Cliffs & its Largest Customers

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Cliffs Natural Resources ( CLF ) has been able to leverage its position as the largest producer of iron ore pellets in North America to forge long-standing relationships with some of the largest steel manufacturers in the world. Cliffs' biggest customers are ArcelorMittal ( MT ), Algoma and Severstal - each of which individually accounts for more than 10% of Cliffs' total revenues in the last 3 years. While this is no doubt a strength for Cliffs, it also exposes the company to some concentration risks should any of these companies break off their relationships with Cliffs in the future. Cliffs competes with other international mining and natural resources companies like Vale ( VALE ), BHP Billiton ( BBL ) and the Rio Tinto group. We maintain a $103 price estimate for Cliffs Natural Resources stock , roughly 8% ahead of market price.

The Benefits to Cliff's Relationships

Cliffs has multi-year supply agreements with almost all customers of its North American iron ore business. This division is the company's biggest source of revenue, contributing to almost two-thirds of Cliffs total sales for the year 2010. The division's five largest customers together have accounted for more than 80% of the division's revenues in recent years.

Also, in most of the cases, Cliffs is also the sole supplier of iron ore pellets to these customers. And they have significant price advantages linked to the agreements which require them to buy a minimum quantity of iron ore each year. This ensures the sale of a bulk of Cliffs' produce every year.

…However

This arrangement obviously comes at some cost to Cliffs. The guarantee of purchase by any customer is offset by a discount of as much as 10% in the prevalent spot-price for iron ore. This limits the potential upside for Cliffs in case there is a significant rise in the price of iron ore in a particular period.

Moreover, in our recent article titled, A relationship between giants - Cliffs Natural Resources & ArcelorMittal , we highlighted how ArcelorMittal's focus on iron ore self-sufficiency in order to reduce its steel production costs will lead to a fall in sales between the two companies.

… And Recent Changes

The biggest concern is the building tension between Cliffs and its two biggest customers, ArcelorMittal and Algoma. In 2010, global iron ore producers moved away from the annual international benchmark pricing mechanism in favor shorter-term pricing arrangements linked to the iron ore spot market. Cliffs has these supply agreements with ArcelorMittal and Algoma, and this change resulted in arbitrations and litigations between Cliffs and these companies. While the results of the individual proceedings can result in material revenues or costs for Cliffs, it can adversely lead to a cancellation of the supply agreements.

What this Would Mean for Cliffs' Stock

We currently estimate that Cliffs sales to ArcelorMittal will reduce to about 8 million tons by the end of our forecast period. However if we consider a scenario where volumes are halved from current events like a loss of Algoma's contracts, this would mean a fall in slightly more than 5% of its total estimated value.

See our full analysis for Cliffs Natural Resources stock here



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: BBL , CLF , MT , VALE , X

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