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Cliffs is the largest producer of iron ore pellets in North America, a major supplier of direct-shipping lump and fines iron ore out of Australia and Canada, and a producer of metallurgical (met) coal. Based on the location of the company's reserves in North America, we consider Cliffs a high-cost producer of both iron ore and met coal relative to global competitors.
Although the company has significant customer concentration in the North American iron ore business, as its top five customers account for about 85% of revenue, the long tenor and predictability of these contracts make switching to an alternative producer less likely. In addition, its proximity to its customers, combined with the prohibitive freight costs for imported iron ore, support the company's leading competitive position in North America.
Cliffs is highly exposed to the cyclical steel industry, which we estimate accounts for more than 85% of revenue. As a result, operating results fluctuate with economic cycles, albeit to a lesser extent than other parts of the industry, given the contract-driven nature of the iron ore business. While the longer-term outlook for the worldwide steel industry remains relatively positive, given the expected increase in demand as emerging regions continue to develop, steel remains a commodity, and both iron ore and coal prices will fluctuate in the short-term depending on steel industry fundamentals.
We view Cliffs' liquidity position as "strong." Our view of the company's liquidity profile incorporates the following expectations:
-- Liquidity sources (including balance sheet cash and availability under the company's $1.75 billion revolving credit facility) over the next 12 months will exceed uses by at least 1.5x.
-- Sources of cash would continue to exceed uses even if EBITDA were to decline by 30%.
-- The company would remain in compliance with financial maintenance covenants if EBITDA dropped 30%.
As of June 30, 2012, Cliffs had total liquidity of about $1.6 billion, comprising about $160 million in balance-sheet cash and borrowing capacity of $1.4 billion on its $1.75 billion unsecured revolving credit facility due 2016.
We expect Cliffs to generate at least $400 million to $450 million in free operating cash flow in 2012 and 2013, compared with about $1.4 billion in 2011, as a result of higher capital expenditures to fund mine expansions in the U.S. and eastern Canadian iron ore segments. However, if low iron ore prices were to persist, we believe Cliffs would match capital expenditures to cash flow generation and rationalize its capital expenditure program (which we estimate will exceed $1 billion in 2012 and 2013). We estimate maintenance capital spending of about $300 million annually. We expect the company to pay annual dividends of approximately $355 million, and we factor in modest annual increases into the rating. Cliffs has authorized a share repurchase plan for up to four million of its outstanding common shares; we don't expect any repurchases in the coming months.
Financial covenants governing the company's bank credit facility include a maximum debt to EBITDA requirement of 3.5x and a minimum EBITDA to interest ratio of 2.5x. As of June 30, 2012, Cliffs was in compliance with its financial covenants. We expect the company to remain compliant for at least the next 12 months, based on our operating expectations.
Cliffs' nearest maturity is 2013, when its $270 million of private placement notes mature. We expect that Cliffs will address the maturity in a timely fashion.
The stable outlook reflects our view that, in spite of lower iron ore prices, Cliffs' operating performance over the next few years should remain within our expectations for the rating. We expect debt-to-EBITDA to remain between 2x and 3x, and for FFO-to-debt to exceed 30%. In addition, the company's strong liquidity provides support for the rating.
We could lower the rating if, as a result of weakening in market conditions, operating performance deteriorates, weakening credit measures. Specifically, we could lower the rating if Cliffs maintains total debt-to-EBITDA greater than 3x for an extended period, which could occur if iron ore prices decline significantly.
A positive rating action seems less likely in the coming months as Cliffs continues to further develop its recently acquired assets into sustainable diverse cash flow streams. We could raise the rating if Cliffs continues to execute its growth strategy within our expectations.
Related Criteria And Research
-- Issuer Ranking: North American Metals And Mining Companies, Strongest To Weakest, July 10, 2012
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Key Credit Factors: Methodology And Assumptions On Risks In The Metals Industry, June 22, 2009
-- Business Risk/Financial Risk Matrix Expanded, May 27, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008