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Message: An Alternative To Cliffs Natural Resources Common Stock

The following article would be interesting reading for those who are LONGs on Cliffs or those following it because Cliffs’ important role in the development in Northern Ontario’s Ring of Fire.

Good reading!

Cheers,

durban1

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Mar 14 2013, 06:58 | 8 comments by: Maltzberger | about: CLF

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Last week, I published an article (here) that advocated a wait-and-see outlook in Cliffs Natural Resources (CLF) before stepping and trying to catch a bottom. While that may be a fine strategy if you are not already invested, what do you do if you are holding depreciated shares of the company?

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Perhaps you had purchased the stock last year and were counting on not only some capital appreciation, but a nice juicy dividend to fatten your wallet while you waited for the eventual rise in the stock price. But all that evaporated when the management announced a reduction in the quarterly dividend from $.625/share to a measly $.15/share AND issued millions of additional common and depository shares as part of a capital raise which further diluted the value of your shares.

Things May Get Worse Before They Improve

What do you do now? Wait and see? Maybe, but it's likely that things are going to continue to get worse for Cliffs before they start getting better. In fact, management announced Wednesday that by the end of the second quarter, it plans to suspend operations at its Wabush Pointe Noire iron ore pellet plant in the province of Quebec (see full story here). The move, which will idle the 165 employees at the plant, is seen as necessary by the company in order to preserve resources until such time as iron ore prices stabilize perhaps in 2H 2013… or maybe later. So the "wait and see" approach might be a lot more of the "waiting" and a whole lot less of the "seeing" for the foreseeable future.

Making Lemonade Out of Lemons

Instead of just waiting, an alternative strategy for shareholders who are interested in maintaining exposure to Cliffs Natural Resources, is to consider selling CLF common stock (yield 2.5%) and purchasing some of the 7% 2/16/2016 Mandatory Convertible Preferred (CLV) securities that were recently issued as part of the aforementioned capital raise.

CLV is a surrogate for CLF. By that I mean, like the common stock, holders of CLV will share in both the upside and the downside of the security. Although the actual market prices will differ, CLV will trade more or less in tandem with the price of CLF. However, instead of just collecting the 2.5% dividend that the common now yields, holders of CLV will receive a 7% dividend, paid until maturity. Then upon maturity (2/1/2016), there is a mandatory conversion back into the CLF common equity, so you are pretty much back where you started. "Pretty Much" except that you've collected a LOT more in dividend income during the preceding 3 year timeframe.

Also "Pretty Much," because the conversion of CLV back into CLF is based upon a conversion ratio which is dependent upon the price of the common at the time of the conversion.

It Works Like This

There are two sets of conversion prices and ratios that are associated with CLV:

  • The Maximum Conversion Rate of .862 applies if the price of CLF is $28.99 or lower on the conversion date. So, if at conversion, the price of CLF is below $29/share, you will convert each share of CLV into .862 shares of CLF.
  • The Minimum Conversion Rate of .7037 applies if the price of CLF is $35.5265 or higher on the conversion date. So, if at conversion, the price of CLF is above $35.5264/share, you will convert your shares into .7037 shares of CLF.
  • Within this range (28.99-$35.5256), the applicable conversion ratio is determined by dividing the par value of the stock by the stock price. So if the price of CLF is, say, $32/share on conversion, your ratio would be calculated like this: $25(par value)/$32(stock price) = .78125 (conversion ratio)
  • Further, at any time prior to the mandatory conversion date (2/01/2016), holders of CLV may elect to convert into CLF at the minimum conversion rate (.7037)

It's Not That Complicated

While all this may seem at first, to be a bit convoluted, it's really pretty simple. If you are holding CLF, you now have a choice. You can hold and hope, or you can trade out of the stock and into the Mandatory Convertible Preferred CLV, and collect a 7% yield while waiting for it to convert back to the same CLF common stock in which you were originally invested.

To my way of thinking, it's a pretty clear and simple choice: Sell the common and buy the preferred (CLV).

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Comments (8)
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  • To the Author,

    as a shareholder, and a suffering one, of CLF, I appreciate your article. I look forward to more. What gives me anxiety is the recent news out of China about housing curbs and too much iron ore production and not enough demand. With so many different stories and opinions out there on China and their commodity demands, I would like to hear your opinion. Thank you.
    14 Mar, 07:08 AMReply Like 0
  • China makes me jumpy. I'm not sure what I can believe or not believe coming out of that region. First housing is up, then it's down, next they are taking steps to ease expansion, the they are being more accommodative. Half the time I think they just make numbers up over there, depending on what they need. I think CLF is trying to become less dependent on the Chinese economy and the Chromite mine is one way to do that. As the US economy (hopefully) continues to mend and Europe starts coming out of it's funk, CLF should benefit somewhat.
    14 Mar, 09:15 AMReply Like 0
  • I have been watching CLF and the iron business for sometime; given the high production costs of all of CLF's operations relative to Vale, Rio and BHP and the CLF financial constraints would you anticipate that CLF might seek a partner for the Ontario Chromite? Or would you anticipate continued attempts to diversify and an attempt to retain 100%? An additional question to you and any one else that might comment at what price would you consider buying CLF?
    14 Mar, 07:44 AMReply Like 0
  • My off the cuff answer to your question about partnering with regard to the Chromite is that management seems very pragmatic. If they can go it alone they will do so but the Chromite is their ace in the hole and if they need to monetize it by partnering up then then will do so. I think their efforts to lower operational costs across the board and to raise capital is an attempt to avoid that scenario.
    I stand my be original position of 'wait and see" before taking a position. However, current investors don't have the luxury and so the CLV 7% preferred might be a viable option - at the right price.
    14 Mar, 09:09 AMReply Like 0
  • How much is the premium of the convertible? Usually this stuff trades at very large premium with low coupon but if it is reasonable it may be a nice opportunity.
    14 Mar, 08:39 AMReply Like 0
  • The convertible is trading at 21.29 as of yesterday's close. Par is 25 but remember this is not like a regular preferred that, at some point is either called or matures at par. This is pegged to the common, which is trading at 22.73 as of market close yesterday. So, CLV is trading at about a 94% conversion ratio to CLF. Since the highest conversion ratio at maturity is .862 I'd say, yes, it's trading at a premium, most likely due to the 7% it'll yield for the next three years.
    14 Mar, 09:03 AMReply Like 0
  • There is one flaw in your argument. Were the common to rise from its current price of $22.73 to $35.52(a 50+%) increase, the converted preferred would rise from $21.29 to $25(a 17% increase). Even if you add the additional approximate $3.50 in additional dividends, your return would be only 33% compared to more than 50%. Of course, if the stock continues to decline as it has since these preferred were issued you are still exposed to the downside. So I think you have traded a significant portion of the upside while retaining the downside risk in exchange for a small percentage increase in dividend income. I think there are a lot better choices than this.
    14 Mar, 09:26 AMReply Like 0
  • The analysts at Credit Suisse have been one group that have predicted the fall in CLFs stock ahead of all the others I follow.

    8 months ago they were writing about the 1B write down CLFs should/would be taking regarding the Consolidated Thompson acquisition, and when CLFs reported this huge loss last Quarter the stock fell from the mid 35 area to its current price of $22 - a loss of another 35% in price.

    Here's are CS estimates for 2013 -0.53
    2014 -4.19
    2015 -5.00
    If CS is right with these estimates, CLFs stock will probably will trade below $20 a share - ultimately.
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