Casablanca Capital Banking on Change at Cliffs Natural Resources

Updated from 2:17 p.m. ET with updated share prices and calculations of initial investment.

NEW YORK (TheStreet) - Cliffs Natural Resources (CLF) shares are virtually unchanged since Casablanca Capital, a little-known investment fund run by a team of former Lazard (LAZ) investment bankers, unveiled a proposal to split up the company, spinning its international iron ore businesses to shareholders, while converting its North American assets to a master limited partnership (MLP). However, it may be worthwhile to re-visit the nature of the newest activist investment to hit Wall Street.

Casablanca Capital's 5.2% stake in Cliffs Natural Resources is not the ordinary investment. The firm's co-founders Donald G. Drapkin, chairman, and Douglas Taylor, CEO, don't have long histories managing money on Wall Street and the Casablanca's holding Cliffs Natural Resources shares isn't part of a larger portfolio. In fact, the firm's only other publicly disclosed deal came nearly three years ago when it took an activist stake in Mentor Graphics (MENT).

In some respects then, it is then no surprise that Casablanca's recommendations for change have received a lukewarm reaction by stock analysts and investors.

Credit Suisse analyst Nathan Littlewood recommended investors use Casablanca's Jan. 28 disclosure to establish fresh short positions in Cliffs Natural Resources, a company he rates 'underperform' with a $10 price target. Analysts at Bank of America Merrill Lynch, BMO Capital Markets and Clarkson Capital Markets expressed doubts that Cliffs Natural Resources' international iron ore assets have the longevity and financial strength to stand on their own. 

Casablanca is undeterred. CEO Douglas Taylor characterized the fund's unique structure and history as a "comparative advantage" in a Jan. 28 interview with TheStreet as it tries to turnaround the struggling commodity producer. Taylor stressed that Casablanca Capital has the experience with corporate transactions, board dynamics and the shareholder community to pull off its Cliffs Natural Resources proposal.

The investment appears to be off to a poor start.

Based on a filing from Casablanca, the value of fund's stake in Cliffs has fallen significantly since it began buying shares in mid-November. Casablanca appears to have acquired Cliffs shares at an average price in excess of $25 apiece, putting its overall investment at just above $200 million.

Cliffs shares were falling less than 2% in Monday trading at $18.95. At current share prices, the over 7.5 million holding in Cliffs shares that Casablanca disclosed would be worth less than $140 million. After one of the worst weeks for stock markets in the last 12 months, shares in Cliffs are also lower than prior to when Casablanca disclosed its activist proposal.

The fund, however, values Cliffs at over $50 a share if its plan were to be executed.

If Casablanca's co-founders Mr. Drapkin and Mr. Taylor are relatively obscure in the world of active money managers, they are well-known on the transactional side of Wall Street.

Mr. Drapkin was a long-time top lieutenant to Ronald Perelman and helped the buyout billionaire's holding company McAndrews & Forbes structure some of its biggest acquisitions such as the takeovers of Marvel comics, Revlon (REV) and AlliedBarton Security Services. Prior to his 20-year career at McAndrews & Forbes veteran, Drapkin was a partner in the M&A department at law firm Skadden, Arps, Slate, Meagher & Flom. Between 2007 and 2010, Drapkin was vice chairman of Lazard International and was chairman of the firm's investment committee.

At Lazard, Drapkin met Mr. Taylor, a long-time banker at the firm who was also one of Bruce Wasserstein's first hires after he became CEO of the boutique investment bank in the early 2000s. While at Lazard, Mr. Taylor set up Sapphire Industrials Corp., an $800 million special purpose acquisition company that was liquidated shortly before he and Mr. Drapkin set off on their own with Casablanca Capital. Some of Casablanca's partners such as Gregory S. Donat, also trace their roots to Lazard.

The Proposal

Last Tuesday, Casablanca disclosed that it has met twice with Cliffs Natural Resources CEO James F. Kirsch and had additional conversations with members of the mining firm's executive team. Casablanca's plans for Cliffs, which has seen its shares fall by nearly 50% in just the past 12-months, are ambitious.

Casablanca wants Cliffs to spin off its Bloom Lake iron ore mine in Eastern Canada alongside the company's assets in the Asia Pacific region. Since buying Bloom Lake for $4.9 billion in 2011, Cliffs has seen delays and spiraling costs in developing the mine, and at a time when falling iron ore prices depress the asset's long-term value. So far, according to Casablanca Capital, Cliffs has spent a total of $8 billion on development projects such as Bloom Lake that have only contributed marginally to the company's earnings profile. 

The fund says Cliffs is "drowning in Bloom Lake" and believes the mine is currently shaving $2 billion off of the company's stock market value. Its solution is to spin the mine alongside Cliffs Asia Pacific assets so as to create a viable standalone company that will deliver some shareholder value for Bloom Lake. "By including Cliffs' Asia Pacific division in Cliffs International, the new company would gain mature assets that should provide sufficient credit support and cash flows to complete Bloom Lake," Casablanca said.

It believes Cliffs International will attract some investors who want to gain exposure to a possible recovery in iron ore price. The fund believes Cliffs International would be worth $15 a share to current investors.

Removing Bloom Lake and Cliffs' seaborne iron ore businesses might also uncover value in the company's legacy North American iron ore business, which has an over 100-year presence in the Great Lakes region. Casablanca said it believes Cliffs' remaining businesses - called Cliffs USA - would attract a dividend-seeking institutional investor base, which would warrant a conversion of its assets to a master-limited-partnership structure.

"We envision that Cliffs USA would become a separately traded, parent-level GP holding company, with the U.S. assets distributed in a public offering to MLP investors, either immediately or in stages," Casablanca said.

Their plan also stipulates a divestiture of Cliffs logistics assets, a focus on reducing costs across the company and a doubling of its dividend. Cliffs shares initially surged on the news of Casablanca's investment and its proposals, however, they have since lost all of their gains. That's no surprise given the reaction from Wall Street. 

Negative Feedback

Analysts generally questioned whether Cliffs seaborne assets would have the longevity to support continued investment in Bloom Lake. Meanwhile, some challenged the logic of a sale of logistics assets or a doubling of the company's dividend. Other proposals such as expense reductions are already in progress.

However, there is a prospect that Wall Street has been too dismissive of Casablanca's proposal.

Over its six-week engagement with Cliffs, Casablanca has proved it has management's ear. Cleveland-based Cliffs said in a Jan. 28 press release it "has held productive preliminary conversations": with the fund and "looks forward to continuing the dialogue to better understand their assumptions, projections and overall views."

Cliffs has also followed through on one recommendation by Casablanca in hiring JPMorgan (JPM) as its financial advisor and Wachtell, Lipton, Rosen & Katz as legal counsel.

Mining for Opportunity

As with many successful recent activist investments, Cliffs may also already have the wheels in motion on significant change.

As Casablanca noted in its letter, the company's board of directors has already turned over significantly after years of criticism. Meanwhile, analysts are already forecasting expense reductions that could bring costs at Cliffs in line with industry peers.

Casablanca, for its part, would welcome an investment that takes little prodding. "Our favorite outcome is to have an engaging and constructive dialogue," CEO Taylor said.

Maybe in an investment climate where activists are willing to become increasingly hostile with management, it might take the finesse of long-time M&A bankers to pull off a re-shaping of Cliffs Natural Resources.

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