Can Cliffs Natural Resources Be Fixed?

Cliffs Natural Resources has been under significant pressure from activist hedge fund Casablanca Capital over the past few months. Casablanca, which holds a 5.2% stake in Cliffs Natural Resources, has outlined a strategy for the struggling company. The hedge fund believes that if its strategy is implemented, Cliffs Natural Resources could create long-term value for shareholders. Cliffs Natural Resources management on the other hand believes that the hedge fund is only looking at the short-term and its strategy would in fact destroy shareholder value. With the battle between the activist hedge fund and the mining company heating up, the big question for shareholders is whether Cliffs Natural Resources can be fixed?

Weak iron ore market
As I have discussed in several articles here, the outlook for the iron ore market is bearish due to concerns over a significant supply glut. Iron ore majors such as BHP Billiton and Rio Tinto have been ramping up production. However, as increasing supplies hit the seaborne iron ore market, demand from China, the biggest consumer of the bulk commodity, is expected to slow down. Not surprisingly, iron ore prices have tumbled this year and are expected to fall to around $80 per ton.

Indeed, the bearish outlook for the seaborne iron ore market is a major worry for Cliffs Natural Resources as well as for iron ore majors such as BHP Billiton and Rio Tinto. But, BHP Billiton and Rio Tinto have significantly lower costs, and as a result both companies can easily sustain even if prices were to remain at around $80 per ton for a long time. Cliffs Natural Resources on the other hand will struggle unless the company decides to exit the seaborne iron ore market, which is what Casablanca has proposed.

Exiting seaborne iron ore market
In a recent presentation, Casablanca noted that Cliffs Natural Resources is too small to compete head-to-head with the iron ore majors. Indeed, the likes of BHP and Rio will not really mind weaker iron ore prices as it will drive away many of the smaller players and allow the mining giants to increase their market share in the long term albeit at the cost of lower cash flows in the medium term.

Casablanca wants Cliffs to exit seaborne markets in the most efficient way possible. Exiting the seaborne iron ore market would shield Cliffs from weak iron ore prices, given that the company's core U.S. iron ore business has long-term supply contracts and therefore is not exposed to the volatile spot prices.

In fact, what Casablanca is proposing is not very different from what mining giants such as BHP and Rio did after the boom in the commodity markets ended in 2011. Both companies' strategy now is to focus on core business, reduce costs, and divest noncore assets.

Cliffs also has some noncore assets, including coal, which if divested could help the company strengthen its balance sheet. According to Casablanca, Cliffs' noncore assets are a distraction and a drag on the balance sheet.

Fixing Cliffs
While weakness in the iron ore and met coal markets has hurt Cliffs, the company's problems are more deep-rooted. Cliffs expanded at the peak of the commodity boom like many other mining companies, including majors such as BHP and Rio, and now finds itself in a down cycle. Cliffs cannot sustain in the seaborne iron ore market at the existing price level. The best bet for the company is to exit noncore operations and focus on the U.S. iron ore business as Casablanca has proposed. Indeed, in the battle between management and Casablanca, shareholders should back the latter as the activist hedge fund's plan offers the best chance to create value. 

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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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