Like many of its peers, mining company Cliffs Natural Resources is seeing a slump in demand from China create an oversupply situation – and trigger a freefall in raw material prices. That’s grim news for the company’s ability to measure up to analysts’ earnings expectations.

China’s economic slowdown is grabbing headlines around the world, and it is having a disproportionate impact on resource companies of all kinds. For years, the explosive growth of the Chinese economy has supported demand for commodities ranging from copper to iron ore, and helped keep prices high. In the case of iron ore, China has become the world’s largest consumer. Now, as demand from Chinese markets for iron ore slackens, companies like Cliffs Natural Resources Inc. (CLF.N) are feeling the pain, not only on the demand side but also because of increased supplies. Australia’s iron ore mines expect to boost their output significantly in 2013 and China itself is seeking to increase its own production of the mineral. Unsurprisingly, iron ore prices have fallen steeply, from $185 per metric ton just a year ago to as low as $95 in early September before recovering slightly to $110 per metric ton today.

Despite the plunge in iron ore prices, Cliffs has continued to invest heavily in new projects, such as the expansion of is Koolyanobbing Mine in Australia. That is a pattern that we have seen with a number of mining and other resource companies of late: they developed capital spending plans when commodity prices were much higher, and haven’t yet scaled back those investments. In the absence of healthy cash flow, Cliffs may delay bringing these new mines online, but when they finally begin operation, they will simply exacerbate the oversupply situation that already exists today and curb any lasting or significant attempt by iron ore prices to rally.

Just 90 days ago, the I/B/E/S consensus estimate for the company’s third-quarter earnings stood at $2.45 a share; today, it stands at $1.21. But the StarMine SmartEstimate is lower still, at $1.08, giving the company a large negative Predicted Surprise of -13%. That’s a signal either that analysts haven’t finished cutting their earnings outlook – or that the company will announce earnings that are an even bigger disappointment. (The estimate revisions affect revenues as well; analysts today expect Cliffs to announce its revenues totaled $1.75 billion during the third quarter; that’s significantly below their previous estimate of $2.05 billion just 90 days ago.) Cliffs scores a mere 1 out of a possible 100 on the StarMine Analyst Revisions Model.

While the outlook for iron ore prices remains bleak and uncertain, what is certain is just how much Cliffs has spent on its various new projects. During the last two quarters, that capital spending has exceeded the cash the company has generated from its operations; during the second quarter, for instance, capital spending totaled $275 million while the company only generated $76 million from its operations. The company’s negative free cash flows is one reason analysts are so bearish about the company and its prospects. This is making Cliffs’ current dividend policy look unsustainably generous; it has a yield of 6.2% and is expected to have a payout ratio of more than 53% (based on analysts’ current forecasts for 2012 earnings), meaning that more than half of the company’s profits are consumed by its dividend policy.

The company’s management team is putting a brave face on the situation. “We believe China’s recent slowing growth rate … is temporary,” Joe Carrabba, the company’s chairman and CEO told investors during the second quarter earnings conference call. Certainly, any improvement in the company’s outlook will hinge on iron ore, and more specifically, on Chinese demand for imports of the mineral. For now, however, it will have to accept the reality: that analysts are becoming more bearish about the company’s prospects. At the end of the second quarter, the company could boast that there were 14 analysts who had “Buy” or “Strong Buy” recommendations on its stock, compared to only 10 suggesting that investors either hold or sell. Today, that ratio has been reversed, with 14 analysts urging their clients to either sell or simply hold on to the stock, as shown in the chart below.

As the third quarter draws to a close, the odds are that the company will continue to see downward pressure on its revenue and earnings, and struggle to control its costs and manage its margins in a hostile environment characterized by falling iron ore prices. Investors – already prepared for bad news when it comes to Q3 earnings – likely will scour the company’s quarterly earnings announcement on October 22 for some insight into just how gloomy management believes the future appears.

 
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