Cliffs Natural Resources: Broken Business Model Makes Dividend Cuts Inevitable

Investing for income has never been more popular. With volatility levels remaining elevated and fixed-income offering limited returns, interest in dividend investing has never been stronger. The S&P 500 has rallied hard since the summer lows of last year. Still, while the U.S. indexes have rallied hard of recent, the best performing stocks have consistently been many leading dividend stocks in the consumer staple sector such asProcter & Gamble Co. (PG), AT&T Inc. (T), and Altria Group, Inc. (MO).

Still, not all dividends are created equally. While many consumer staple companies have grown earnings and raised dividend payouts fairly consistently over the past several years, companies in more volatile industries have also been increasingly been trying to significantly increase dividend payouts as well.

Cliffs Natural Resources Inc. (CLF) is an iron ore and metallurgical coal producer that is heavily leveraged to the Chinese real estate and construction markets. While the company had strong profits over the past couple years when the Chinese real estate market was growing at a record pace, Cliffs Natural Resources' earnings and cash flow have deteriorated significantly in the last year as iron ore prices have crashed.

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I recently wrote that while copper stocks would likely hold-up fairly well, despite the weak growth outlook in China because of severe supply-side constraints, many iron ore and metallurgical coal stocks would likely continue to sell-off. The primary reason why I continue to believe that copper stocks will likely stay fairly strong even as iron ore and metallurgical coal companies continue to sell-off is because the iron ore and metallurgical coal markets face no significant supply issues.

While demand for copper remains weak, major copper producers such asFreeport-McMoRan Copper & Gold Inc. (FCX) continue to face labor and issues and problem with unstable and corrupt governments, and copper prices have held up well over the last several months. Just in the past couple months, there have been repeated stories of buyer defaultsin the iron ore market, as well as news of significant steel dumping by Chinese companies in countries that don't have strong tariffs.

Still, with many iron ore producers, such as Cliffs Natural Resources, Rio Tinto plc (RIO), and BHP Billiton Limited (BHP), trading at or near their fifty-two week lows, I think it is interesting to see if these companies are likely undervalued today.

Cliff Natural Resources rose to around $120 a share in 2008, and recovered nicely after the 2008 financial collapse and subsequent recession to reach $100 a share in early 2011. The stock currently trades at just 4x trailing earnings, and less than 5x average estimates for next years likely earnings. Many traders and investors are now beginning to become bullish on this company.

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The share price of Cliffs Natural Resources and other iron ore and mining companies heavily levered to the Chinese real estate and construction markets have essentially crashed over the last year. While many iron ore and metallurgical coal companies have stabilized for short periods of time, leading companies in this sector, such as Rio Tinto and BHP Billiton, are still down over 30% in the last six months.

Cliffs Natural Resources is a nearly $5-billion dollar company based in Cleveland, Ohio. The company has significant exposure to the seaborne iron ore market through its acquisition of the Austrialian company Portman's, and the company's mines in Brazil and other countries. Cliffs Natural Resources has a strong operational record over the past decade, and the company has performed very well during stronger economic times. Still, management has a very poor track record of trying to use capital to maximize shareholder returns.

Cliffs Natural Resources' current dividend policy is totally unsustainable, and the company raised its dividend by over 125% in the last several months as iron prices continue to crash. Cliffs Natural Resources raised the company's dividend when the stock was trading at around $60 a share, and the current dividend of $2.50 a share represents a nearly 50% payout of estimates for next year's likely earnings. The company's current dividend payout would also use over 80% of next year's projected cash, and analysts are projecting revenues and cash flow to drop significantly over the next several quarters.

While Cliffs Natural Resources may be able to sell assets and borrow to maintain the dividend, the management of this company is leveraging a weak balance sheet at the wrong time. Cliffs Natural Resources' last major decision to leverage the companies balance sheet was an ill fated $128 a share bid for Alpha Natural Resources, Inc. (ANR), a metallurgical coal company now trading at $7 a share. While few industry insiders foresaw the financial collapse and subsequent recession in 2008, this company still made a $128 dollar offer for a company that is today trading at $7 a share.

Cliffs Natural Resources' current dividend policy is both unsustainable and dangerous. With revenue and free cash flow likely to remain weak for some time, the company's high payout ratio will keep management from having the flexibility to look at better ways to maximize long-term shareholder value with buybacks or acquisitions.

Cliffs Natural Resources and other leading iron ore and metallurgical coal companies have seen record profits over the last several years, but the weak balance sheets of many companies in this industry and the housing bubbles in commodity-based economies such as Australia and Brazil, suggest that many industry insiders significantly overestimated long-term demand in these industries. While price to earnings ratios and historical price ranges of iron ore and other bulk metals are usually good valuation metrics for mining companies, it is also likely that recent bulk metal prices were significantly inflated from what these commodity prices are likely to trade at in coming years.

With the Federal Reserve continually initiating significant quantitative easing efforts, while the Chinese government and Chinese Central Banks financed a $4 trillion dollar real estate and infrastructure build-out, steel demand in the U.S. and China will likely remain very weak over the next several years. Companies such as BHP Billiton recently announced significant cutbacks in future capital expenditure plans, and many experts are also suggesting that cash flow in the mineral industry will likely bevery limited moving forward.

To conclude, while iron ore prices are at the lowest levels, this mineral has been priced at in two-and-a-half years; mineral prices are unlikely to return to previous levels for years. With the Chinese government and Chinese Central Bank increasingly unwilling to pursue new fiscal and monetary initiatives, and regional banks in China laden with debt, the iron ore and metallurgical coal markets will likely remain oversupplied for some time. While companies such as Cliffs Natural Resources have sold-off hard over the last several years, China and the U.S. are unlikely to pursue significant new stimulus policies in the near term.