MANAGEMENT'S DISCUSSION AND ANALYSIS Exhibit 13(a)
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In 1998, Cleveland-Cliffs Inc ("Company") earned $57.4 million, or $5.06 per
share (references to per share earnings are "diluted earnings per share"), an
increase of $2.5 million, or $.26 per share, from 1997. Following is a summary
of results for the years 1998, 1997 and 1996:
1998 1997 1996
- -----------------------------------------------------------------------------------------------------------
Net income
- Amount (in millions) $57.4 $54.9 $61.0
- Per share (basic) $5.10 $4.83 $5.26
- Per share (diluted) $5.06 $4.80 $5.23
Average number of shares (in thousands)
- Basic 11,248 11,371 11,594
- Diluted 11,336 11,456 11,678
1998 VERSUS 1997
- ----------------
Revenues were $503.9 million in 1998, an increase of $47.8 million from 1997.
Revenues from product sales and services totaled $444.1 million in 1998 compared
to $391.4 million in 1997. The $52.7 million increase was due to higher sales
volume and average price realizations. North American iron ore sales were 12.1
million tons in 1998 compared to 10.4 million tons in 1997. Royalty and
management fee revenue in 1998, including amounts paid by the Company as a
participant in the mining ventures, totaled $49.7 million, compared to $47.5
million in 1997, primarily reflecting higher production at the Tilden mine.
Net income for the year 1998 was $57.4 million, or $5.06 per share, an increase
of $2.5 million, or $.26 per share, compared to 1997 earnings of $54.9 million,
or $4.80 per share. The increase in earnings was mainly due to increased North
American sales volume and price realization, a lower effective income tax rate,
increased royalties and management fees, and higher capitalized interest. Partly
offsetting were non-recurring 1997 Australian earnings and higher ferrous
metallics and international development expenses.
Earnings attributable to the Savage River Mines ("Savage River") in Australia,
which produced its last iron ore pellets in December, 1996, were $6.3 million in
1997 including an after-tax credit of $3.2 million from the reversal of
closedown obligations. Net income in 1997, excluding Australian earnings, was
$48.6 million, or $4.25 per share.
Earnings in 1998 and 1997 include tax credits of $3.5 million and $5.6 million,
respectively, that reflect a reassessment of current and prior years' income tax
obligations resulting from audits of prior years' tax returns. The lower
effective tax rate in 1998, relative to 1997, also reflects the absence of the
higher Australian statutory tax rate and the increased benefit of depletion
allowances.
27
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
1997 VERSUS 1996
- ----------------
Revenues were $456.1 million in 1997, a decrease of $62.0 million from 1996.
Revenues from product sales and services in 1997 totaled $391.4 million, a
decrease of $60.3 million from 1996, mainly due to the planned termination of
Savage River operations and lower North American sales volume. North American
iron ore sales were 10.4 million tons in 1997 compared to 11.0 million tons in
1996. Savage River's sales in 1997 were .3 million tons as compared to 1.7
million tons in 1996. Royalty and management fee revenue in 1997, including
amounts paid by the Company as a participant in the mining ventures, totaled
$47.5 million, a decrease of $4.0 million from 1996, mainly due to lower volume.
Net income for the year 1997 was $54.9 million, or $4.80 per share, compared to
net income for the year 1996 of $61.0 million, or $5.23 per share. The $6.1
million decrease in 1997 earnings was mainly due to the termination of Savage
River operations, lower North American sales volume, and higher mine operating
costs, partly offset by a lower effective income tax rate, including a $5.6
million tax credit resulting from settlement of prior years' tax issues. Savage
River earnings in 1997 were $6.3 million, including a $3.2 million reversal of
closedown obligations, versus $12.9 million in 1996. Savage River terminated
production as planned in December, 1996 and shipped its remaining inventory in
the first quarter of 1997.
CASH FLOW AND LIQUIDITY
- -----------------------
At December 31, 1998, the Company had cash and cash equivalents of $130.3
million. In addition, the full amount of a $100 million unsecured revolving
credit facility was available. No principal payments are required until 2005
when the Company's $70 million senior unsecured notes mature.
Following is a summary of 1998 cash flow:
(In Millions)
-----------------
Cash flow from operations:
Before changes in operating assets and liabilities $75.1
Changes in operating assets and liabilities 17.0
-----
Net cash from operations 92.1
Capital expenditures (31.7)
Investment in Cliffs and Associates Limited (19.7)
Dividends (16.3)
Repurchases of common shares (11.5)
Other 1.5
-----
Increase in cash and cash equivalents $14.4
=====
The $17.0 million decrease in working capital primarily reflected lower trade
receivables of $13.1 million due to lower December sales. North American iron
ore inventory investment at December 31, 1998 was $43.4 million, a decrease of
$1.2 million from December 31, 1997.
28
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
Following is a summary of key liquidity measures:
At December 31 (In Millions)
---------------------------------
1998 1997 1996
---------------------------------
Cash and cash equivalents $ 130.3 $ 115.9 $ 165.4
Marketable securities 4.0
-------- -------- --------
Total cash and temporary investments 130.3 115.9 169.4
Long-term debt 70.0 70.0 70.0
-------- -------- --------
Net cash $ 60.3 $ 45.9 $ 99.4
======== ======== ========
Working capital $ 170.7 $ 174.0 $ 195.3
======== ======== ========
Ratio of current assets to current liabilities 2.9:1 2.9:1 2.9:1
Additionally at December 31, 1998, the Company had a long-term investment of .8
million shares of The LTV Corporation Common Stock with a value of $4.8 million.
NORTH AMERICAN IRON ORE
- -----------------------
The six North American mines managed by the Company produced a record 40.3
million tons of iron ore in 1998, compared to production of 39.6 million tons in
1997. The Company's share of the North American production was a record 11.4
million tons in 1998 versus 10.9 million tons in 1997. The increases were mainly
due to higher production at the Tilden and Wabush mines. The Company and its
steel company partners have elected to start the year 1999 operating the mines
at near capacity levels. However, production rates are subject to change during
the year.
Labor contracts at the five Company-managed mines, in which all bargaining unit
employees are represented by the United Steelworkers of America, will expire in
1999. The three year Wabush contract in Canada will expire March 1, 1999. Six
year agreements at the Empire, Hibbing, and Tilden mines and a five year
agreement at LTV Steel Mining Company will expire on August 1, 1999.
Steel production in the U.S. and Canada declined significantly in the second
half of 1998 due to a surge in unfairly traded steel imports, adversely
impacting order rates, capacity utilization rates, shipment volumes and profits
of the North American steel industry. Steel inventories have increased, causing
cutbacks in steel production. Industry analysts are projecting 1999 steel
production to be lower than 1998 which could affect iron ore production.
Given the state of the North American steel business, the Company expects 1999
iron ore pellet sales volume will be lower than 1998 record sales. The Company's
sales capacity is largely committed to multi-year sales contracts, which expire
in various years starting in 2000. Maintenance of sales volume is dependent on
the renewal or replacement of such contracts and the demand for iron ore
pellets. The Company has consistently demonstrated its ability to sustain sales
volume through renewed or new contracts. Year 1999 international iron ore price
negotiations are currently taking place, and with the weakness of the Asian and
European steel
29
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
markets, a price decrease is expected. A decline in the international price
would impact prices in certain of the Company's multi-year sales contracts.
The major business risk faced by the Company is the potential financial failure
and shutdown of one or more of its significant customers or partners, with the
resulting loss of ore sales and/or royalty and management fee income. If any
such shutdown were to occur without mitigation through replacement sales volume
or cost reduction, it would represent a significant adverse financial
development to the Company. The iron mining business has relatively high fixed
costs. Therefore, loss of sales volume due to failure of a customer or other
loss of business (e.g., foreign competition) would have a greater impact on
earnings than revenue.
On September 28, 1998, Acme Metals Incorporated and its wholly-owned subsidiary
Acme Steel Company (collectively "Acme"), a partner in Wabush and an iron ore
customer, petitioned for protection under Chapter 11 of the U.S. Bankruptcy
Code. The Company had a $1.2 million pre-petition trade receivable from Acme,
which has been fully provided in the allowance for doubtful accounts. Since its
filing, Acme has maintained operations with debtor-in-possession financing and
has continued its relationship with Wabush and the Company. Sales to Acme in
1998 and 1997 represented less than 5 percent of total sales volume.
The Company and its mining venture partners have made substantial capital
expenditures in recent years to reduce operating costs and maintain production
rates. The following table summarizes 1998 and estimated 1999 capital equipment
additions and replacements, including equipment acquired through lease, for the
six mining ventures and supporting operations in North America.
CAPITAL INVESTMENT
(In Millions)
----------------------------------------
Company's
Share Total
------------------- -------------------
Actual 1998:
Total* $42.5 $ 113.7
===== =======
Capital $33.0 $ 64.0
===== =======
Estimated 1999:
Total* $36.0 $ 142.0
===== =======
Capital $22.1 $ 60.2
===== =======
* Includes equipment acquired through leases, which are largely non-recourse
to the Company.
FERROUS METALLICS
- -----------------
The Company's strategy includes extending its business scope to produce and
supply ferrous metallic products to an expanded customer base, including
electric arc furnace steelmakers.
30
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
Cliffs and Associates Limited, a joint venture in Trinidad and Tobago, is
completing construction of a facility to produce premium quality hot-briquetted
iron ("HBI") to be marketed to the steel industry. The venture's participants,
through subsidiaries, include the Company, 46.5 percent; The LTV Corporation,
46.5 percent; and Lurgi AG of Germany, 7.0 percent, with the Company acting as
manager and sales agent. Project capital expenditures through December 31, 1998
were $141.1 million (Company share - $65.6 million). Currently estimated total
capital expenditures of $151.0 million (Company share - $70.2 million) do not
include construction claims of $16.0 million (Company share - $7.5 million),
which are being contested. The Company believes the claims are largely without
merit; any payments on these claims are expected to be partially offset by
recoveries from contractors and suppliers. No project financing has been used
during construction. Construction of the facility is near completion, and
commissioning activities are currently in progress. Plant startup is currently
scheduled for March, with HBI production increasing on a planned production
curve. At design, the facility is expected to produce 500,000 metric tons
annually. Full year production volume will depend on market demand.
The Company continues to evaluate an investment in a plant at the Company's
wholly-owned Northshore mine in Minnesota to produce premium grade pig iron.
While progress has been made in a number of areas, uncertainty over market
conditions and timing of state environmental permitting has postponed a decision
on the project.
STRATEGIC INVESTMENTS
- ---------------------
The Company is seeking additional investment opportunities, domestically and
internationally to broaden its scope as a supplier of iron units to the steel
industry, including investments in iron ore mines or ferrous metallics
facilities. In the normal course of business, the Company examines opportunities
to increase profitability and strengthen its business position by evaluating
various investment opportunities consistent with its business strategy. In the
event of any future acquisitions or joint venture opportunities, the Company may
consider using available liquidity, incurring additional indebtedness, project
financing, or other sources of funding to make investments.
CAPITALIZATION
- --------------
Long-term debt of the Company consists of $70 million of senior unsecured notes
payable to an insurance company group. The notes bear a fixed interest rate of
7.0 percent and are scheduled to be repaid on December 15, 2005. In addition to
the senior unsecured notes, the Company, including its share of mining ventures,
had capital lease obligations at December 31, 1998 of $5.4 million.
The Company also has a $100 million revolving credit agreement. No borrowings
are outstanding under this agreement, which was amended in the second quarter
1998 to extend the expiration date from March 1, 2002 to May 31, 2003.
The Company has purchased 1,130,500 of its Common Shares at a total cost of
$46.7 million through December 31, 1998 under its authorization to repurchase up
to 1.5 million Common
31
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
Shares in open market or negotiated transactions. The shares will initially be
retained as Treasury Stock.
COMMON SHARE REPURCHASES
Common Cost
Shares (In Millions)
------------------------- -------------------------
1995 284,500 $10.8
1996 495,800 19.5
1997 113,100 4.9
1998 237,100 11.5
--------- -----
Total 1,130,500 $46.7
========= =====
Average cost per share $41.28
======
The repurchase program's cumulative effect on earnings per share was $.41, $.33
and $.24 in 1998, 1997 and 1996, respectively.
ACTUARIAL ASSUMPTIONS
- ---------------------
As a result of a decrease in long-term interest rates, the Company re-evaluated
the interest rates used to calculate its pension and other postretirement
benefit ("OPEB") obligations. The discount rate used to calculate the Company's
pension and OPEB obligations was decreased to 6.75 percent at December 31, 1998
from 7.25 percent at December 31, 1997. The change in the discount rate
assumption did not affect 1998 financial results; however, in 1999 and
subsequent years, the changes are projected to increase pension and OPEB expense
by approximately $.4 million.
The Company makes annual contributions to the pension plans within income tax
deductibility restrictions in accordance with statutory requirements. In 1998,
the Company contributed $2.8 million, including its share of associated
companies' funding, a decrease of $.3 million from 1997. In 1999, the Company
plans to contribute $1.4 million, including its share of mining ventures'
funding.
ENVIRONMENTAL COSTS
- -------------------
The Company has a formal code of environmental conduct which promotes
environmental protection and restoration. The Company's obligations for known
environmental conditions at active and closed mining operations, and other sites
have been recognized based on estimates of the cost of investigation and
remediation at each site. If the cost can only be estimated as a range of
possible amounts with no specific amount being most likely, the minimum of the
range is accrued in accordance with generally accepted accounting principles.
Estimates may change as additional information becomes available. Actual costs
incurred may vary from the estimates due to the inherent uncertainties involved.
Potential insurance recoveries have not been reflected in the determination of
the financial reserves.
32
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
At December 31, 1998, the Company had a reserve for environmental obligations,
including its share of the environmental obligations of ventures, of $21.5
million ($22.7 million at December 31, 1997), of which $2.0 million was current.
Payments in 1998 were $.9 million (1997 - $2.4 million).
On March 25, 1997, the remaining assets of Savage River and all related
environmental and rehabilitation obligations were transferred to the Tasmanian
government. The release from these obligations includes previously identified
environmental and rehabilitation obligations and from any such obligations that
may be asserted in the future, whether presently known or unknown.
YEAR 2000 TECHNOLOGY
- --------------------
Year 2000 compliance is a major business priority of the Company and is being
addressed at all operations. A Company-wide Year 2000 Compliance Program
("Compliance Program") is underway with a dedicated team headed by a Project
Executive, with representation from Internal Control, Information Technology and
Process Control, including functional project leaders from the Company's
ventures. Additionally, two outside engineering firms and one information
technology service firm have been engaged to support and assist in process
control compliance activities. The status of the Compliance Program is reported
regularly to the Year 2000 Compliance Steering Committee, consisting of the
Chief Executive Officer and other Officers of the Company, and to the Company's
Board of Directors.
The Compliance Program has been divided into five phases: 1) inventory, 2)
assessment, 3) renovation, 4) unit testing, and 5) system integration testing.
The Company has substantially completed the inventory, assessment, renovation
and unit testing phases in 1998. Renovation and unit testing on a limited number
of items have been delayed into the first half of 1999 pending availability of
vendor technical resources, replacement equipment and software. System
integration testing is scheduled to be completed during the third quarter of
1999.
A substantial portion of Year 2000 information technology compliance will be
achieved as a result of the Company's Information Technology Plan ("IT Plan").
The IT Plan, initiated in 1996, involves the implementation of a purchased,
mining-based, Year 2000 compliant, software suite to replace legacy programs for
operations and administrative mainframe systems servicing most domestic
locations. In addition to avoiding any potential Year 2000 problems, the IT Plan
is expected to result in improved system and operating effectiveness. Following
is a summary of the IT Plan total project cost estimate and costs incurred to
date:
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
(In Millions)
--------------------
COMPANY'S
SHARE Total
------- -------
Total project:
Capital $ 15.3* $ 16.5
Operating 2.4 8.5
------- -------
Total $ 17.7 $ 25.0
======= =======
Incurred through December 31, 1998:
Capital $ 9.2* $ 10.1
Operating .8 2.8
------- -------
Total $ 10.0 $ 12.9
======= =======
* Includes amounts reimbursable by mining ventures of $12.9 million
for the total project and $7.6 million through December 31, 1998.
The Company is charging to operations current state assessment, process
re-engineering, and training costs associated with the IT Plan. For legacy
programs and locations not included in the IT Plan, modifications and/or
replacement of existing programs are underway for achieving Year 2000 compliance
with an expected cost of $1.0 million.
In addition to addressing software legacy program issues, the Year 2000
Compliance Program is addressing the impact of the date change with respect to
the Company's mainframe computer system, technical infrastructure, end-user
computing, process control systems, environmental and safety monitoring, and
security and access systems. Emphasis has been placed on those systems which
affect production, quality or safety.
The Company has also included investigation of major suppliers' and customers'
Year 2000 readiness as part of the program. Major suppliers and customers of the
Company have been requested to complete a Year 2000 compliance questionnaire.
For those which the Company considers critical to its operations, on site
verifications are being performed as required. Interruption of electrical power
supplied to the Company's ventures has been identified as having the greatest
potential adverse impact. Failure of electric power suppliers of the Company's
mining ventures to become Year 2000 compliant could cause power interruptions
resulting in significant production losses and potential equipment damage. The
Company's wholly-owned Northshore and managed LTV Steel Mining Company mines are
equipped with electric power generation facilities capable of providing nearly
all of their power requirements.
The incremental expense of achieving Year 2000 compliance on systems not covered
by the IT Plan and other software legacy programs is estimated to be $4.0
million for the Company and its ventures. Completion of this program is targeted
for mid-1999. The Company has completed internal audits at various operations to
verify that progress is on schedule toward timely completion of the Compliance
Program.
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
The Company is developing specific contingency plans at each location to
mitigate year 2000 compliance failures, of the Company or any of its key
suppliers or customers. The contingency plans involve specific actions designed
to maintain employee safety, production and quality. The contingency plans
include a range of actions, including low technology or manual alternatives to
current automated processes. Alternatives for key suppliers are being
identified, and, where alternate suppliers do not exist, other actions (e.g.,
increased inventory) are being considered. While focused on continuing
production, by necessity the plans include procedures for reducing production or
orderly temporary suspension of operations, if required to protect employees,
property and the environment. Initial contingency plans are expected to be
completed at all sites in the first quarter of 1999. Contingency plans will
continue to be refined throughout 1999, incorporating assessments of areas where
risk is greatest.
The Company expects to be Year 2000 compliant; however, statements with regard
to such expectations are subject to various risk factors which may materially
affect the Company's Year 2000 compliance efforts. These risk factors include
the availability of trained personnel, the ability to detect, locate and correct
system codes, the evaluation of the wide variety of IT software and hardware,
failure of software vendors to deliver upgrades or make repairs as promised, and
failure of key vendors to become compliant. Although the Company has taken
actions that it believes are appropriate and reasonable to determine the
readiness of third parties, it must in part rely on third party representations.
The Company is attempting to reduce these risks and others by utilizing an
organized approach, conducting audits and extensive testing, identifying
alternative sources of supply and other contingency plans.
MARKET RISK
- -----------
The Company is exposed to a variety of risks, including those caused by changes
in the market value of equity investments, foreign currency fluctuations and
changes in interest rates. The Company has established policies and procedures
to manage such risks.
The Company's investment policy relating to its short-term investments
(classified as cash equivalents) is to preserve principal and liquidity while
maximizing the return through investment of available funds. The carrying value
of these investments approximates fair value on the reporting dates.
The value of the Company's long-term equity investment in Common Stock of The
LTV Corporation is subject to changes in market value as reflected in the
trading price. This investment has been classified as an available-for-sale
investment, and accordingly, changes in value have been recorded in
Shareholders' Equity. If the market price of the stock at December 31, 1998,
were to increase or decrease 10 percent, the value of the investment would
change approximately $.3 million after-tax.
A portion of the Company's operating costs are subject to change in the value of
the Canadian dollar. Derivative financial instruments, in the form of forward
currency exchange contracts, are used by the Company to manage its risk of
operating costs at its Canadian venture. Forward exchange contracts are hedging
transactions that have been entered into with the objective of managing the
impact of exchange rate fluctuations of the Canadian dollar on the Company's
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
operating costs. The Company's normal procedure is to use forward contracts to
fix the cost in U.S. dollars of a portion of the annual Canadian dollar
requirements. The Company does not engage in acquiring or issuing derivative
financial instruments for trading purposes. At December 31, 1998, the notional
amount of the outstanding forward currency exchange contracts was $13.9 million
with a market value of $13.9 million based on the December 31, 1998 forward
rates. If the Canadian dollar forward rates were to change 10 percent from the
year-end rates, the value and potential cash flow effect would be approximately
$1.4 million.
The Company currently has $70 million of long-term debt outstanding at a fixed
interest rate of 7 percent due in December, 2005. A hypothetical increase or
decrease of 10 percent from year-end interest rates would change the fair value
of the debt by $1.8 million.
FORWARD-LOOKING STATEMENTS
- --------------------------
The preceding discussion and analysis of the Company's operations, financial
performance and results, as well as material included elsewhere in this report,
includes statements not limited to historical facts. Such statements are
"forward-looking statements" (as defined in the Private Securities Litigation
Reform Act of 1995) that are subject to risks and uncertainties that could cause
future results to differ materially from expected results. Such statements are
based on management's beliefs and assumptions made on information currently
available to it. Factors that could cause the Company's actual results to be
materially different from the Company's expectations include the following:
- Changes in the financial condition of the Company's partners
and/or customers. The potential financial failure of one or
more significant customers or partners without mitigation
could represent a significant adverse development;
- Unanticipated changes in the market value of steel, iron ore
or ferrous metallics;
- Substantial changes in imports of steel, iron ore, or ferrous
metallic products;
- Development of alternate steel-making technologies;
- Displacement of steel by competing materials;
- Displacement of North American integrated steel production
and/or electric furnace production by imported semi-finished
steel or pig iron;
- Domestic or international economic and political conditions;
- Major equipment failure, availability, and magnitude and
duration of repairs;
- Unanticipated geological conditions or ore processing changes;
- Process difficulties, including the failure of new technology
to perform as anticipated;
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued
- Availability and cost of the key components of production
(e.g., labor, electric power, fuel, water);
- Labor contract negotiations;
- Weather conditions (e.g., extreme winter weather, availability
of process water due to drought);
- Timing and successful completion of construction projects;
- Failure or delay in achieving Year 2000 compliance by the
Company or any of its key suppliers or customers;
- Changes in tax laws (e.g., percentage depletion allowance);
- Changes in laws, regulations or enforcement practices
governing environmental site remediation requirements and the
technology available to complete required remediation.
Additionally, the impact of inflation, the identification and
financial condition of other responsible parties, as well as
the number of sites and quantity and type of material to be
removed, may significantly affect estimated environmental
remediation liabilities;
- Changes in laws, regulations or enforcement practices
governing compliance with environmental and safety standards
at operating locations; and,
- Accounting principle or policy changes by the Financial
Accounting Standards Board or the Securities and Exchange
Commission.
The Company is under no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise.
37