The iron-ore producer's shares should be worth more if it merges with Alpha Natural Resources, is taken over by another company or remains a stand-alone miner. By David Landis, Contributing Editor August 19, 2008 The Cleveland Iron Company was founded in 1847 to explore for iron ore in neighboring Michigan. It's still in the same business today, but perhaps not for long. Now known as Cleveland-Cliffs (symbol CLF), the 161-year-old firm proposed last month to merge with Alpha Natural Resources, a coal-mining firm. Cleveland-Cliffs' largest shareholder, hedge-fund operator Harbinger Capital Partners, is actively opposing the deal and threatening to raise its stake in the company from 16% to as much as 33%. That has stirred speculation that Cleveland-Cliffs could find itself targeted for takeover by a larger mining firm or a steel company. With a shareholder vote on the merger not yet scheduled, it's unclear whether Cleveland-Cliffs will emerge from the brouhaha in tandem with Alpha (ANR); as a stand-alone iron-ore miner, as before; or as another company's prized catch. But in any of those scenarios, Cleveland-Cliffs' shares should be worth substantially more than their August 19 closing price of $93.83, says Amir Arif, analyst for Friedman, Billings, Ramsey. He rates the stock "outperform" and sees its price ranging from $124 to $144 in a year, depending on how events play out. Let's take a look at all three possibilities, beginning with the proposed merger with Alpha, a deal valued at $10 billion when it was announced July 16. Advertisement Cleveland-Cliffs is the nation's largest producer of iron-ore pellets -- a great business to be in, thanks to the global explosion in demand for steel, which is made from iron ore. Since 2002, Cleveland-Cliffs' revenues have grown by 370%, and its share price has quintupled. In the past year alone, its operating margin (operating profits divided by revenues) has nearly doubled, to 44%, as insatiable demand from China and India has lifted iron-ore prices to $140 a metric ton. Five years ago, iron ore fetched less than $40 a metric ton. The company produces about half the nation's iron-ore output and sells nearly all of it to a handful of U.S. steel makers. Under chief executive Joseph Carrabba, recruited from Rio Tinto, a mining company based in England, Cleveland-Cliffs has added mines in Brazil and Australia. But the bulk of its business is in the U.S., where the high cost of shipping ore puts competitors at a disadvantage. Industry analysts see global iron-ore prices peaking in 2010, as demand from China slows and new supplies come online. Looking ahead, Cleveland-Cliffs' management sees the deal with Alpha as a way to diversify its business in advance of a downturn. The company currently gets about 80% of its revenues from iron ore and most of the rest from metallurgical coal, a variety favored by the steel industry. In combination with Alpha, the largest U.S. supplier of metallurgical coal, Cleveland-Cliffs' revenue split would be 47% iron ore, 34% metallurgical coal and the remainder other types of coal. But whether this truly represents diversification is open to debate. Even though Cleveland-Cliffs' product base would be more spread out under the deal, the company would still be selling to the same end users: steel makers, primarily in the U.S. Advertisement Cleveland-Cliffs is offering $22.23 in cash plus 0.95 of one of its shares for each Alpha share. At the August 19 closing price, that amounts to $111.37 per share. Alpha shares closed at $90.95, a 19% discount to the offer price, indicating a high degree of skepticism among investors that the deal will go through. But if Cleveland-Cliffs walks away, it will owe Alpha a $350 million breakup fee. The fee falls to $100 million if shareholders from either company vote down the deal. Given the new shares Cleveland-Cliffs would have to issue to fund the deal, the company would not see any increase in earnings per share until 2010, says Arif. (That could change if there's an unexpected spike in iron-ore or metallurgical-coal prices.) Otherwise, Arif estimates, the shares of the combined firm would be worth $124 in a year, the lowest value that would arise from the three possible outcomes. On the other hand, Arif says, as a stand-alone firm, Cleveland-Cliffs is a generator of massive amounts of free cash flow, which is the cash left over after a company pays its debt and funds capital expansion. But Cleveland-Cliffs has relatively little debt and capital-investment requirements. Arif estimates that the company will generate more than $20 a share of free cash annually by the end of 2010. He sees Cleveland-Cliffs shares hitting $130 in a year under this scenario, and as much as $200 a share in two or three years. The third possibility, that Cleveland-Cliffs could be acquired, brings the highest estimated short-term value, Arif says. He sees a potential takeout price of $147, a 10% premium to his estimate of the company's stand-alone value. Cleveland-Cliffs' shares are well below their June peak closing price of $119. The stock closed at $111 the day before the offer for Alpha was announced on July 16. That suggests that a clearer picture of Cleveland-Cliffs' future, no matter what the outcome, would be good for the shares.