Could Cliffs Natural Resources Really Go Bankrupt?

Iron ore futures prices from CME Group Globex
Cliffs' stock prices from Google Finance

Cliffs Natural Resources' stock price has dropped an astounding 85% since its peak of $100 per share in 2011. With no end in sight for iron ore's free fall, the future looks hazy for this iron producer. As a potential investor, should you strike while the iron's hot, wait for a rebound in iron ore prices, or run for the hills?

Background on recent performance and debt covenants
Cliffs posted its first-quarter earnings report on April 25, 2014. The sales margin for its U.S. iron ore segment was $95 million, Eastern Canadian iron ore sales margin was a nasty -$49.7 million, while Asia Pacific iron ore sales margin was $66.3 million. Because of weak coal prices, North American coal's sales margin was $-48.4 million. The sales margin for the company as a whole was $63.2 million.

Despite operating losses in two of its four operating segments, things don't seem too dire yet. Cliffs still has ample liquidity for its operations. The company had $364 million in cash and cash equivalents and access to a 1.7 billion revolving credit line at the start of the second quarter.

The cause for concern in the near future is iron ore prices. If they continue falling, Cliffs could start experiencing dangerously low EBITDA. If its EBITDA continues dropping, this could cause the company to violate its debt covenants, meaning severe liquidity problems, and possibly even bankruptcy. 

Let's take a look at the two debt covenants associated with Cliffs' line of credit:

• Debt to earnings ratio as of the last day of each fiscal quarter cannot exceed 3.5 to 1.0. (Note that "debt" means total funded debt, or long-term debt. It does not include short-term financing. Also, "earnings" refers to the sum of the preceding four quarter's adjusted EBITDA.)
• Minimum interest coverage ratio for the preceding four quarters must not be less than 2.5 to 1.0 on the last day of any fiscal quarter.

Cliffs was compliant with both covenants in the first quarter. Its EBITDA for the four quarters preceding March 31, 2014 was $1.3 billion, and its total long-term debt was $3.13 billion as of March 31. That makes a debt to earnings ratio of 2.40 to 1.

Now, let's look at Cliffs' interest coverage ratio. As discussed in the previous paragraph, Cliffs' adjusted EBITDA for the trailing four quarters was $1.3 billion. Its total interest expense for the 12 months preceding March 31 was $172.7 million. That makes a healthy interest coverage ratio of 7.55 to 1.0.

How close is Cliffs to violating its debt covenants?
Let's look for the magic number that would cause Cliffs' credit line to be revoked. 

Remember that the debt covenants are based on the 12 months preceding the final day of a given quarter. Cliffs' total adjusted EBITDA for the last three quarters was $819.27 million. Let's say its total debt stays at $3.13 billion throughout Q2. At $3.13 billion in funded debt, Cliffs must maintain a minimum trailing 12 month adjusted EBITDA of $894 million. That means Cliffs must generate at least $74.73 million adjusted EBITDA in the second quarter. The question is, will Cliffs make the cut?

What will Q2 look like?
To get a decent idea of where adjusted EBITDA will be come July 21 (projected quarterly earnings release), let's compare market and operating conditions of the first quarter to those of the second quarter thus far.

First of all, the weather has been a lot nicer. Weather conditions affect Cliffs' ability to generate revenue. Historically, Cliffs' first-quarter earnings and revenue lag behind the other three. So, we should see much better sales volume in Q2. Secondly, iron ore prices have plummeted. This will negatively affect the amount of revenue/ton Cliffs will receive. 

We could spend all day going through each financial statement and attempting to accurately forecast every number, but let's just stick to ballparking Q2 EBITDA. Since we are only focusing on EBITDA and debt, we don't need to worry about non-cash expenses such as depreciation, taxes, amortization, and LCM adjustments (thankfully). 

Using the Realized Revenue Sensitivity Guide (below) supplied by Cliffs' management in a recent presentation, we can get a feel for what sales and operating costs might end up being for Q2. 

Chart from Cliffs' 10-Q from 3-31-2014

We also need a few other things: a sales volume forecast, a freight and venture partners cost reimbursements forecast, a cash-cost forecast, the average price of iron ore since March 31, a forecast for selling general and administrative expenses, and an exploration costs forecast. Luckily, the company has offered guidance on all of the above except freight and venture partners cost reimbursements. But that's an easy one, too. Usually freight and venture partners cost reimbursements are about 9% of total revenue, so we'll call it 9% of total revenue for Q2. 

*Q2 EBITDA forecast completed by Michael Nielsen.

Our rough adjusted EBITDA estimate for Q2 was $247.02 million. Remember the minimum EBITDA to stay within the boundaries of the debt covenant is $74.73 million. So, it looks like the company has a decent amount of wiggle room. There are certain things that could happen, or have already happened, in Q2 that could lower this number. However, odds are, Cliffs will come in with an adjusted EBITDA for the quarter that is well above $74.73 million.

So should investors buy now, wait, or run for the hills?
If you're an investor in Cliffs Natural Resources, you should feel a little better knowing Cliffs isn't in immediate danger of bankruptcy. However, you should definitely keep an eye on iron ore prices. If prices don't bounce back within the next year or so, Cliffs' credit line could eventually be depleted or revoked. Both cases could result in bankruptcy. 

If you're comfortable with risk, it might make sense to buy a few shares of Cliffs. If iron ore does bounce back, you could easily be looking at a two-bagger. 

But if you're risk-averse, you should probably run for the hills. There is no real way to know where iron ore prices will be a year from now, but there is a real risk that Cliffs will go bust. 

It may be wise to wait and see how iron ore prices move in the next few months. The only risk is that the stock price jumps before you have a chance to buy at a discount.