Wall Street Overreacted to Cliffs Natural Resources' Third-Quarter Loss

The first assumption that many investors may have had when shares of Cliffs Natural Resources (NYSE: CLF) fell sharply after announcing earnings was that something went very wrong that will impact the future of the business. Sure, Cliffs' earnings did slide back into the loss column during the third quarter, but other aspects of the earnings release suggest that it is set up rather well for next year, and maybe beyond.

Let's take a quick glance at why those third-quarter numbers weren't that bad, and why investors should be encouraged for the coming years.

Image source: Getty Images.

By the numbers

Results Q3 2016 Q2 2016 Q3 2015
Revenue $553.3 $496.2 $593.2
Operating income $34.7 $74.7 $29.2
Net income ($27.8) $12.8 ($15.0)
Earnings per share ($0.12) $0.07 ($0.10)

All numbers in millions, except per-share data. Data source: Cliffs Natural Resources earnings release.

There are a couple things baked into the decline in earnings that make the numbers look a little worse than the overall situation at the company. The first is that the company took a loss on the extinguishment of some of its debts. This was one of those temporary hits that a company should take, because the payoff lowered annual interest expense payments by $17 million annually, and it means that the next-term notes due aren't until 2020. This gives the company lots of time to improve its profitability before any more debts come due.

Another thing that lowered earnings this quarter were some costs at its U.S. Iron Ore operations related to the restart of one of its United Taconite mines. These costs will likely be worth it, as Cliffs anticipates it will need production to meet increasing demand in 2017.

EBITDA = earnings before interest, taxes, depreciation, and amortization. Data source: Cliffs Natural Resources earnings releases. Chart by author.

The news that should be encouraging to investors is that the company is increasing its sales guidance for 2017. According to management, customer demand has already fully subscribed to its annual production levels, and it will likely draw down on iron-ore inventories.

Management's path forward

When CEO Lourenco Goncalves was brought on to run Cliffs a few years ago, the company was in rough shape. It had an extremely bloated balance sheet and a bunch of unprofitable assets that were dragging down the business. These past couple years, Goncalves has shed these assets and has reduced the company's debt load. With much of that work having an impact on the bottom line, Goncalves highlighted where he sees the company going from here:

The point about electric-arc furnaces and their future in the American market can't be overstated. Not only do these types of furnaces figure in a large majority of the steelmaking process in the U.S., they are also a much more profitable method of making steel. The companies that use traditional blast furnaces have been barely treading water these past five years, while those companies that focus exclusively on electric-arc furnaces have remained mostly profitable this whole time.

What a Fool believes

Cliffs will likely need to incur some capital costs to upgrade its iron-ore pellets such that they are suitable for electric-arc furnaces. In the long run, though, this is clearly the direction the company needs to move if it wants to supply American steel producers, because it's where the industry is heading.

This negative turn in earnings for the quarter was a bit of a bummer, but some of the reasons for that slide look to be temporary. Things are certainly looking up, as the company plans to increase production and draw down inventories in 2017. If Cliffs can continue to keep its costs low, then investors should expect a return to profitability, as well as further extinguishment of debt that will make the company much better positioned to withstand the ups and downs of the commodity market. All this seems to suggest that investors shouldn't take Cliffs' big stock slide after earnings as a bad sign.

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Tyler Crowe owns shares of Cliffs Natural Resources.You can follow him at Fool.comor on Twitter@TylerCroweFool.

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