Cleveland-Cliffs Inc. 10-Q Summary: Period Ended September 30, 2007
Business Context and Reporting Period
Cleveland-Cliffs Inc. (Cliffs) is an international mining company and the largest producer of iron ore pellets in North America. The company also supplies metallurgical coal and operates iron ore assets in Australia. This report covers the quarterly period ended September 30, 2007. During this period, Cliffs executed a major strategic shift by acquiring PinnOak Resources, LLC (a U.S. metallurgical coal producer) on July 31, 2007, and significantly expanded its international footprint through investments in the Amapa iron ore project in Brazil and the Sonoma coal project in Australia.
Key Financial Metrics
| Metric (in millions) | Three Months Ended Sep 30, 2007 | Nine Months Ended Sep 30, 2007 | Nine Months Ended Sep 30, 2006 |
|---|---|---|---|
| Total Revenues | $619.6 | $1,492.7 | $1,372.7 |
| Sales Margin | $107.3 | $298.7 | $316.6 |
| Operating Income | $81.9 | $242.7 | $282.1 |
| Net Income | $56.9 | $176.3 | $210.1 |
| Net Income Applicable to Common Shares | $55.5 | $172.1 | $205.9 |
| Diluted EPS | $1.08 | $3.37 | $3.87 |
| Cash and Cash Equivalents | $139.6 | $139.6 | $203.2 |
| Total Debt (Revolving + Term) | $590.0 | $590.0 | $0.0 |
| Net Cash from Operating Activities | N/A | $81.0 | $228.4 |
Material Changes vs. Prior Period
- Revenue Growth: Nine-month revenues increased 8.7% to $1,492.7 million, driven by the inclusion of PinnOak coal sales ($33.9 million) and higher freight reimbursements. However, North American Iron Ore sales volume decreased slightly due to customer blast furnace maintenance.
- Profitability Decline: Net income applicable to common shares decreased 16.4% year-over-year to $172.1 million. This was primarily due to higher interest expense ($8.2 million increase) related to debt financing for acquisitions, increased administrative costs, and a loss of sales margin in the newly acquired North American Coal segment ($15.9 million loss) caused by geological issues at the Pinnacle Mine.
- Balance Sheet Expansion: Total assets increased from $1,939.7 million to $3,061.8 million, reflecting the acquisition of PinnOak assets and investments in joint ventures (Amapa and Sonoma). Total liabilities rose to $1,761.5 million, including $390 million in revolving credit and $200 million in term loans drawn to fund growth initiatives.
- Cash Flow: Net cash provided by operating activities dropped significantly to $81.0 million from $228.4 million in the prior year, largely due to a $48.4 million increase in product inventories and lower net income. Investing activities consumed $713.7 million, primarily for the PinnOak acquisition ($343.8 million) and venture investments ($272.7 million).
Guidance, Outlook, and Risks
- Production Outlook: Cliffs expects 2007 North American Iron Ore production to approximate 35 million tons (22 million tons Cliffs share). Asia-Pacific production is expected to reach 8.1 million tonnes. North American Coal production for the remainder of 2007 is estimated at 0.7 million tons.
- Cost and Pricing: North American Iron Ore unit production costs are expected to rise ~1% in 2007. Revenue per ton is expected to increase ~2%. Asia-Pacific unit costs are expected to rise ~15% due to currency fluctuations and higher maintenance/labor costs, though revenue per tonne is expected to increase ~10%.
- Material Risks:
- Internal Controls: Management identified a material weakness in internal controls over financial reporting due to insufficient personnel with technical accounting knowledge. Remediation is ongoing but not yet complete.
- Regulatory/Safety: The Oak Grove coal mine faces a potential "Pattern of Violations" designation by MSHA, which could increase regulatory enforcement and costs. Portman faces potential loss of mining leases in Western Australia due to environmental reserve designations.
- Market Risks: Exposure to fluctuating energy costs (natural gas, diesel) and foreign currency exchange rates (AUD/USD). The company has hedged a portion of these risks.
- Unusual Items: The company recorded a $9.0 million pre-tax gain in Q2 2007 from a settlement with Wisconsin Electric Power Company (WEPCO). A $3.2 million casualty recovery was recorded in the first nine months of 2007 related to a 2003 flood.
Investor Verification Checklist
- Acquisition Integration: Verify the timeline for resolving geological issues at the Pinnacle Mine and the path to profitability for the North American Coal segment.
- Debt Servicing: Assess the impact of the new $800 million credit facility and the $590 million drawn balance on future interest expenses and liquidity.
- Internal Controls: Monitor the progress of remediation efforts regarding the material weakness in financial reporting controls.
- Regulatory Status: Track the outcome of the MSHA "Pattern of Violations" review for the Oak Grove mine and the status of Portman's mining lease disputes in Australia.
- Inventory Levels: Review the rationale for the significant increase in product inventories ($136 million increase year-over-year) and its impact on working capital.