Tue,10 May2011
by Morningstar Credit Committee
We are lowering our issuer rating for Cliffs Natural Resources CLF to BBB- from BBB in anticipation of the acquisition of Consolidated Thompson for $4.9 billion in cash. While the deal affords additional exposure to the presently lucrative seaborne iron ore trade, the additional debt Cliffs will assume to consummate the deal and the higher cash flow volatility associated with seaborne iron ore pricing make the acquisition a credit negative, in our opinion.
Cliffs entered 2010 with $1.7 billion in gross debt, roughly 1.0 times the $1.6 billion in EBITDA generated for the year (strong, but not especially so relative to mining peers). We expect the $4.9 billion deal will add about $2.25 billion more debt to Cliffs' balance sheet, putting pro forma 2011 debt at $3.96 billion. We assume Cliffs will finance the deal with proceeds from $1.25 billion in term loans, $1.0 billion in senior unsecured notes issued in March, and $1.0 billion in new equity. Cash on the books (including proceeds from September 2010's $1 billion note issuance plus accumulated free cash flow) would fund the remainder. While the term loan and notes portions were nailed down after the deal's January announcement, Cliffs has not yet finalized the amount of the new equity it will issue, saying only that it would size the offering with an eye toward retaining its Baa3/BBB- ratings with the nationally recognized statistical rating organizations.
Assuming iron ore prices remain elevated, we expect Cliffs to have little difficulty paying down the new debt should management wish to do so. If we see continued strength in iron ore over the next few years and management directs free cash flows to debt retirement, we will revisit our rating for potential upgrade. But it's worth recalling just how exceptional today's price levels are. In only two of the past seven years were seaborne pellet prices materially above Cliffs' current cost of production in North America ($72 per ton including depreciation expense): $153 per ton in 2010 and $146 per ton in 2008. In the remainder of those years (hardly a bad time to be an iron ore producer), seaborne pellet prices averaged $69 per ton.
In assessing the credit implications of the deal, we think it's important to note that, in contrast to Cliffs' existing North American operations, which sell almost exclusively to North American steel producers at prices set by a volatility-reducing three-part mechanism, Thompson's eastern Canada Bloom Lake sells to the seaborne market at prices set by a quarterly mechanism based on the trailing spot price in China. At present, this means Bloom Lake can garner much higher FOB realizations than Cliffs can earn on its existing North American operations. But in weaker markets for seaborne iron ore, the reverse is typically true. In fact, that's one of the factors that had underpinned our BBB issuer rating for Cliffs: While the North American pricing arrangement effectively prevents Cliffs from realizing price increases commensurate with those garnered by seaborne iron ore producers when times are good, it also mitigates the risks associated with dramatic declines in the spot market for iron ore. The addition of Bloom Lake and recent management actions to move away from the three-part mechanism in its existing operations increase Cliffs' aggregate exposure to the vagaries of the seaborne market, for good or for ill. While potentially a brilliant move for shareholders, we view this as a negative development from a credit perspective.
Looking at Cliffs' outstanding bonds, we don't think prevailing spreads adequately compensate investors for the risk associated with a decline in seaborne iron ore prices. Cliffs' 2020s currently trade at Treasuries plus 135 basis points and the 2040s at T+175, quite a bit tighter than we think appropriate. For context, the average BBB issue in Morningstar's corporate bond index offers a spread of 157 basis points above Treasuries (average term of 11.5 years) and the average BBB- trades at T+202 (average term of 9.5 years).
We think bonds of mining peer Southern Copper SCCO (rating: BBB+) are a much better play at the moment. With the lowest cash cost of any large copper miner, Southern Copper is unusually well insulated from a drop in commodity prices. In contrast to peers that were forced to tap the market for additional capital in the dark days of early 2009, Southern Copper's mines were generating enough free cash flow for the company to proceed with expansion plans and buy back shares. Southern Copper's 2020s trade at T+187 and 2040s at T+242, well wide of Cliffs' comparably dated notes, despite offering, in our view, superior credit quality. (Morning Star)
by Morningstar Credit Committee
We are lowering our issuer rating for Cliffs Natural Resources CLF to BBB- from BBB in anticipation of the acquisition of Consolidated Thompson for $4.9 billion in cash. While the deal affords additional exposure to the presently lucrative seaborne iron ore trade, the additional debt Cliffs will assume to consummate the deal and the higher cash flow volatility associated with seaborne iron ore pricing make the acquisition a credit negative, in our opinion.
Cliffs entered 2010 with $1.7 billion in gross debt, roughly 1.0 times the $1.6 billion in EBITDA generated for the year (strong, but not especially so relative to mining peers). We expect the $4.9 billion deal will add about $2.25 billion more debt to Cliffs' balance sheet, putting pro forma 2011 debt at $3.96 billion. We assume Cliffs will finance the deal with proceeds from $1.25 billion in term loans, $1.0 billion in senior unsecured notes issued in March, and $1.0 billion in new equity. Cash on the books (including proceeds from September 2010's $1 billion note issuance plus accumulated free cash flow) would fund the remainder. While the term loan and notes portions were nailed down after the deal's January announcement, Cliffs has not yet finalized the amount of the new equity it will issue, saying only that it would size the offering with an eye toward retaining its Baa3/BBB- ratings with the nationally recognized statistical rating organizations.
Assuming iron ore prices remain elevated, we expect Cliffs to have little difficulty paying down the new debt should management wish to do so. If we see continued strength in iron ore over the next few years and management directs free cash flows to debt retirement, we will revisit our rating for potential upgrade. But it's worth recalling just how exceptional today's price levels are. In only two of the past seven years were seaborne pellet prices materially above Cliffs' current cost of production in North America ($72 per ton including depreciation expense): $153 per ton in 2010 and $146 per ton in 2008. In the remainder of those years (hardly a bad time to be an iron ore producer), seaborne pellet prices averaged $69 per ton.
In assessing the credit implications of the deal, we think it's important to note that, in contrast to Cliffs' existing North American operations, which sell almost exclusively to North American steel producers at prices set by a volatility-reducing three-part mechanism, Thompson's eastern Canada Bloom Lake sells to the seaborne market at prices set by a quarterly mechanism based on the trailing spot price in China. At present, this means Bloom Lake can garner much higher FOB realizations than Cliffs can earn on its existing North American operations. But in weaker markets for seaborne iron ore, the reverse is typically true. In fact, that's one of the factors that had underpinned our BBB issuer rating for Cliffs: While the North American pricing arrangement effectively prevents Cliffs from realizing price increases commensurate with those garnered by seaborne iron ore producers when times are good, it also mitigates the risks associated with dramatic declines in the spot market for iron ore. The addition of Bloom Lake and recent management actions to move away from the three-part mechanism in its existing operations increase Cliffs' aggregate exposure to the vagaries of the seaborne market, for good or for ill. While potentially a brilliant move for shareholders, we view this as a negative development from a credit perspective.
Looking at Cliffs' outstanding bonds, we don't think prevailing spreads adequately compensate investors for the risk associated with a decline in seaborne iron ore prices. Cliffs' 2020s currently trade at Treasuries plus 135 basis points and the 2040s at T+175, quite a bit tighter than we think appropriate. For context, the average BBB issue in Morningstar's corporate bond index offers a spread of 157 basis points above Treasuries (average term of 11.5 years) and the average BBB- trades at T+202 (average term of 9.5 years).
We think bonds of mining peer Southern Copper SCCO (rating: BBB+) are a much better play at the moment. With the lowest cash cost of any large copper miner, Southern Copper is unusually well insulated from a drop in commodity prices. In contrast to peers that were forced to tap the market for additional capital in the dark days of early 2009, Southern Copper's mines were generating enough free cash flow for the company to proceed with expansion plans and buy back shares. Southern Copper's 2020s trade at T+187 and 2040s at T+242, well wide of Cliffs' comparably dated notes, despite offering, in our view, superior credit quality. (Morning Star)
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