Cliffs adds new coal mines in W. Virginia

Cliffs Natural Resources’ (CLF-N) US$757-million acquisition of INR Energy, a private equity firm with producing metallurgical and thermal coal mines in West Virginia, is part of the company’s long-term belief in metallurgical coal as a scarce mined commodity and “probable choke point” for global steel production, president and chief executive Joseph Carrabba told mining analysts and investors on a recent conference call.

“We believe this scarcity is going to result in met coal pricing for all grades staying strong for at least the intermediate term,” he said. “Nowhere is this trend becoming more evident than our current North American coal business, where a strong pricing environment is expected to produce well over US$100 million of sales margin for Cliffs in 2010 and assuming a price rollover and our expansion plans, possibly triple that in 2011.”

INR Energy’s operations in southern West Virginia consist of the Toney Fork No. 2 thermal coal open-pit mine and the Powellton and Chilton-Dingess Branch underground metallurgical coal mines. Two other underground metallurgical mines are under development. In addition, there is the Saunders wash plant (4 million short tons per year built at a cost of about US$42 million) and the Elk Lick load-out facility, which accesses the CSX railroad. The coal could be transported by rail to the port of Norfolk, Va., or trucked to a wholly-owned river-loading facility on the Big Sandy River and barged along the Ohio River system to the port of New Orleans for export.

“Over the last several years, we’ve communicated to our shareholders and the investment community our desire to grow as a diversified mining company by expanding our steel-making raw materials portfolio,” Carrabba said, adding that the company’s coal acquisitions since 2007 bring “a suite of products to sell throughout the steel cycle as different grades of coal fall in and out of demand.”

Cliffs’ initial foray into seaborne coking coal came in January 2007 with its purchase of a 45% stake in the Sonoma coal project in Australia. Situated in the northern limit of Queensland’s Bowen basin coalfields, the project is owned by privately-held QCoal, an Australian coal company. Under that deal, Cliffs agreed to invest about US$109 million to build a wash plant and acquire mining assets and rights. Cliffs operates and owns 100% of the wash plant and 8.3% of the mining leases, bringing its total economic interest in the project to 45%. Production is an equal mix of hard coking coal and thermal coal.

That investment was followed in June 2007 with the purchase of PinnOak Resources, a privately owned U.S. producer of high-quality, low-volatile metallurgical coal. Cliffs acquired the operations for US$450 million in cash plus about US$150 million in debt. Pinn-Oak consists of two complexes comprised of three underground mines — the Pinnacle and Green Ridge mines in southern West Virginia and the Oak Grove mine near Birmingham, Ala. Pinnacle has been in operation since 1969. The Green Ridge mine opened in 2004, while the Oak Grove mine has been in operation since 1975.

The latest coal acquisition brings with it new customers and further exposure to the seaboard market. More than half of INR Energy’s coal production last year was exported.

What’s more, the purchase did not involve “taking on a legacy of liabilities” that can be typical in acquisitions of coal mines, management emphasized. Production began in 2008 after an INR Energy investment of US$200 million.

“INR acquired these assets in 2007 so everything here is new,” says Donald Gallagher, president of Cliffs’ North American business unit. “We’re coming into a mine that is greenfield and what you see is what you get, no legacies. There is no tail on this. . . so we’re pretty confident on this one.”

In addition, a significant amount of permitting work has been done already. Says Carrabba: “About one-third of reserves are under permit so that gives us plenty of time to start permitting processes that are five year’s out.”

The purchase will be financed with cash on hand and the company’s US$600-million credit facility.

While the acquisition “is slightly dilutive to 2011-2012 valuation,” says Mark Liinamaa of Morgan Stanley, Cliffs “is an interesting value play on a recovery of steel fundamentals we see beginning in 4Q.”

Liinamaa points out in a research note that INR’s met coal mines produce a mix of about one-third “A” quality high volume and two-thirds “B” (lower) grade, and that the deal “expands Cliffs’ met coal footprint to as much as 8 million tonnes per year by 2012 from a previous projection of 5.6 million tonnes.” He estimates Cliffs’ earnings before interest, taxes, depreciation and amortization (or EBITDA) from its coal segments increases to 21% of total 2012 EBITDA from 18%.”

Cliffs forecasts that the volume of INR Energy’s high-volatile metallurgical coal in 2011 will reach 1.7 million tons, of which 200,000 tons are committed and priced at US$100 per ton FOB (free on board) mine. Total 2011 production of thermal coal is expected to reach 1.2 million tons, of which 500,000 tons are committed and priced at US$66 per ton FOB mine.

“Assuming current market pricing of about US$140 and US$75 per ton FOB mine for uncommitted high-volatile metallurgical and thermal coal production, respectively, and expected cash costs of about US$70 per short ton, the acquisition is expected to contribute significantly to Cliffs’ revenue and EBITDA,” the company outlined in a statement announcing the acquisition.

In 2011, Cliffs expects the business will raise about US$300 million in revenue and US$100 million in EBITDA, and that those numbers will rise to over US$400 million in revenue and about US$175 million in EBITDA in 2012.

Cliffs will expand INR Energy’s production of high-volatile metallurgical coal to 2.4 million tons by 2012, increasing the company’s total global equity coal production in the future to nearly 11 million tons split between 8 million tons metallurgical and 3 million tons thermal. INR Energy’s reserves bring Cliffs’ total global reserve base to more than 175 million tons of metallurgical coal and over 57 million tons of thermal coal.

Tony Robson, who covers Cliffs for BMO Nesbitt Burns, believes the impact of the acquisition is mixed. “BMO Research estimates Cliffs paid a full price for the INR assets, with net present value increasing by only US$80 million or US59¢ per share,” he wrote in a note to clients. “The acquisition logic appears to be highly dependent on strong met coal prices going forward, as FOB cash costs are estimated by BMO at a relatively high US$94 per tonne for thermal coal and US$116 per tonne for met coal. Cliffs, however, does gain export capacity through INR’s rail and port access, reducing its dependence on the North American market.”

Robson asserted that the INR acquisition is “generally neutral” to the company’s valuation, which increased by less than 1% to US$82.69 per share from US$82.10 per share. “A more accretive transaction,” he continued, “would be to buy back its own heavily discounted stock.”

Robson has a one-month target price on the stock of US$90 per share. At presstime, Cliffs was trading at US$51.14 apiece. Over the last year, the Cleveland-based company has traded between a low of US$19.91 (July 13, 2009) and a high of US$76.17 (April 6, 2010).