Cliffs Natural Resources ( CLF ) holds the distinction of being the largest producer of iron ore pellets in North America. It is also a major supplier of direct-shipping lump and fines iron ore out of Australia and also a significant producer of metallurgical coal. It 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.
One of Cliffs' biggest competitive advantages in the iron ore business is its long-standing relationships with some of the largest steel manufacturers in the world. Iron ore pellets produced by Cliffs are almost entirely used as raw material for the production of steel. Because of this, Cliffs' ability to enter into long-term sales agreements with steel giants like ArcelorMittal ( MT ), Algoma, Severstal, and now Wuhan Steel, helps reduce major fluctuations in its sales figures. At the same time, the agreements also help Cliffs plan its production from individual mines more profitably.
How ArcelorMittal Figures into Cliffs' Business
ArcelorMittal has been the single biggest customer for Cliffs for quite some time. Since 2007, ArcelorMittal has bought almost 10 million tons of iron ore pellets from Cliffs every year. Because of this, it has contributed to at least 40% of the revenues for Cliffs' North American iron ore division. ArcelorMittal is also the largest customer for Cliffs' coal operations in North America with purchases of between 0.5 million and 0.8 million tons of coal. This made up about 30% of the division's total revenues in the same period.
ArcelorMittal's gain from its long-term contracts with Cliffs is that it obtains the required iron ore for its steel operations in North America at prices which have historically been about 10% lower than prevalent iron ore spot prices.
But Things May Change in the Years to Come
In early 2010, ArcelorMittal decided to improve its self-sufficiency in making steel due to increasing iron ore costs. Its share of iron ore mining operations across the world currently contribute to about half its requirements, but the company intends to increase this to between 75% and 85% by 2014.
For Cliffs, this could imply a potential reduction of more than 50% in its sales to ArcelorMittal. Moreover, there was an umbrella agreement between Cliffs and ArcelorMittal until 2010 that set a lower limit to the quantity of iron ore sold. But this agreement expired and was not renewed - which means supply will be limited by ArcelorMittal's requirement.
So How Can this Affect Cliffs?
We have represented the iron ore sold by Cliffs to ArcelorMittal as a separate driver contributing to Cliffs' value in our analysis, given the potential impact changes to ArcelorMittal's policy can have on Cliffs.
Although we had factored in a reduction in the iron ore sales in our analysis based on ArcelorMittal's announcement to be self-sufficient in its iron ore production, there is a significant downside to this number. If the sales actually decline by one-half by the year 2015, this would reduce our price estimate for Cliffs' from $103 to less than $99 - implying downside of more than 4%.