Why Cliffs’ Bloom Lake acquisition hurts its earnings and shares

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Jul. 25 2014, Updated 12:00 p.m. ET

Cliffs Natural Resources acquires Bloom Lake  Mine

Cliffs (CLF) acquired Consolidated Thompson in 2011 for $4.9 billion. The main asset from this deal was the Bloom Lake Mine in Eastern Canada. The company expected this mine to provide long-term growth by increasing volumes and reducing operating costs per ton.

But capital expenditure and operating costs both exceeded expectations at the time of the acquisition. This dragged on already depressed earnings due to decreasing prices. Production also lagged to 5.6 million tons against expectation of 8 million tons.

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As a result, Cliffs has put on hold Phase II (double the initial ramp-up to 14 million tons) of the project. The company’s looking for strategic alternatives. Phase I (the initial ramp-up to production of 6 million to 7 million tons per year) is continuing—but on a reduced tailings capital plan. The company could also decide to idle this phase if prices remain under pressure for an extended period.

Exploring options

Cliffs is talking to a number of parties about Bloom Lake. Possibilities include a partnership, the sale of part or all of the operations, or closure.

According to management, the value proposition for Bloom Lake is its high iron ore content of concentrate, which is 66%. The benchmark iron content, by comparison, is 62%.

But there’s a catch. The party that shows interest in Bloom Lake Mine can’t just go ahead with standalone Phase I. To achieve economies of scale and full benefits, it will have to go for developing Phase II. Phase II will entail substantial capital and operating costs.

Also, Cliffs had entered into a take-or-pay rail contract. This contract would cost $64 million for Phase II and $150 million if Bloom Lake operations shut down completely.

Outlook

One thing is clear. The mine continues to drain the company’s resources. So it remains a key risk for the company’s share price going forward.

The chart above shows you the share price reaction to announcements regarding Bloom Lake. You can see that Cliffs’ share price reached a five-year high due to expectations building around Bloom Lake and how this outlook was beaten down after capital and operating costs escalated.

Key investments

Cliffs Natural Resources (CLF) will have to fix this issue before its share price can come out of its downward spiral.

Meanwhile, peers like Rio Tinto (RIO), BHP Billiton (BHP), and Vale SA (VALE) could give you exposure to the iron ore sector with fewer uncertainties.

The SPDR S&P Metals & Mining ETF (XME) also offers exposure to the sector. Cliffs forms 3.46% of this ETF.

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