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Does Cliffs Natural Resources’ High Debt Mean More Trouble Ahead?

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Jan. 26 2016, Updated 7:35 a.m. ET

Liquidity

Cliffs Natural Resources (CLF) ended 3Q15 with $270 million in cash and cash equivalents. At the end of the third quarter, the company didn’t have any borrowings on its asset-based lending facility, which has a borrowing limit of about $255 million.

The company’s management mentioned during the earnings call that liquidity would remain the key focus, particularly as the company headed into the winter months. During the winter, inventory usually builds up as the Great Lakes area is frozen.

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Debt remains high

At $2.4 billion, Cliffs Natural Resources’ (CLF) net debt remains high. This implies a net debt–to-forward-EBITDA (earnings before interest, tax, depreciation, and amortization) ratio of 10x, which is very high in a depressed commodity price environment.

CLF has been buying back its bonds, which has led to a marginal reduction in its net debt. However, the company’s operational cash generation will need to be substantial to have any meaningful impact on its debt position.

FCF generation not enough

Cliffs Natural Resources’ consensus EBITDA estimate is $240 million, and its EBIT (earnings before interest and tax) estimate is $113 million for 2016. With these figures and assuming the effective tax rate for 2015 to be 2.1% and maintenance capital expenditure to be $90 million, we arrive at a FCF (free cash flow) of $148 million for 2016. This assumes all other variables remain constant before interest expenses. The company’s cash interest expenses for 2015 were $205 million. With this in mind, the FCF for 2016 should be -$57 million.

In the current commodity price environment, CLF’s cash generation doesn’t seem to be enough to make a dent in its debt. The company needs higher iron ore prices to reach any significant level of FCF.

It will be interesting to hear management’s comments on the efforts to reduce debt to restore investor confidence in the company.

Other companies with high financial leverage, including ArcelorMittal (MT), AK Steel Holding Company (AKS), and United States Steel Corporation (X), could be under pressure in 2016. Investors looking to diversify the risk of investing in a single security can consider the SPDR S&P Global Natural Resources ETF (GNR). Almost 25% of GNR’s holdings are invested in steel and other metals companies. Nucor Corporation (NUE) forms 1.7% of GNR’s portfolio.

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