What To Do About Steel Uncertainty

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Uncertainty in Europe, coupled with a weaker-than-expected stimulus in China, has sent jitters in the iron, steel & coal markets. Volatility in commodity pricing makes production planning very difficult--Cliffs, for example, is still compiling its 2013 business plan. It is important that investors back basic material companies that either have the financial or operational flexibility to weather uncertain markets.

Cliffs Natural Resources (NYSE: CLF)

The nightmarish descent continues to haunt Cliffs--it has lost more than half of its value over the last 12 months. But the iron ore & metallurgical coal producer now trades at just 9x forward earnings with a PEG ratio of 0.66x. EPS turnaround has also been dramatic over the past decade, and it is forecasted to be $3.92 next year and grow at a 8.3% annual rate into the near future. This would make Cliffs a $47 stock next year at a 12x multiple, or $42.76 in present terms. Accordingly, the stock looks around 20% undervalued. Analysts currently put the price target at $48.50.

On the other hand, the company has had operational challenges. In the most recent quarter, Cliffs produced EPS of $0.61, which was 41.9% below expectations. Weaker spot pricing in coal has caused the company to lower its revenue guidance to $120 - $125 per ton. Instead of generation $600 million in cash from operations, Cliffs generated only $308 million--well below the $821 million that was generated in 3Q 2011. And while the chromite project is a significant catalyst, management has had to "review its timeline" in light of rough iron ore pricing--pushing production as much as beyond 2017. Management has still been successful in lowering cash costs per ton, and operations will receive a nice boost once the Phase II expansion at Bloom Lake is completed.

Investors may be tempted into buying the company for its 7.1% dividend yield, but this may be challenged in coming days by creditor assessment of the company's ability to sell core assets. China has also seen slower-than-expected growth, and it is a major player in iron ore with 65% of market consumption. This uncertainty should be enough to preclude investments from day-to-day traders.

Vale (NYSE: VALE) & ArcelorMittal (NYSE: MT)

Vale and ArcelorMittal have been similarly hit badly by the poor iron ore market. Their stock prices have fallen 33.5% and 20%, respectively, during the past 12 months. ArcelorMittal and Vale, which I believe are both strong investments, trade at a respective 8.4x and 7.1x forward earnings. Analysts are currently more bullish on the former, so let's see if that preference is warranted.

ArcelorMittal has performed absolutely terribly even for the poor market conditions. In 3Q 2012, it was forecasted for EPS of $0.06. Instead, it lost $0.31 per share. Although this came after a 93.9% beat in 2Q 2012, investors have been weary of operations particularly since 1Q 2012 when the company was $0.13 under expectation with an EPS of $0.09. Vale, however, has been more consistently weak. Earnings have come in below expectations in all of the last 5 quarters with an average miss of nearly 20%.

It is particularly disconcerting that Vale has spent around $2 billion building mega-ships to transport iron ore over to China, only to be refused. After a drastic drop in income mid-last year, management has started scaling back production. The cut back in the Moatize coal project has particularly been a wet blanket for the bulls. Just like with China, Vale was expected so much for so little--it had already built a railroad for hauling coal in Africa.

With ArcelorMittal showing a strong recovery in free cash flow generation--going from -$302 million in 2Q 2011 to $4.7 billion in 3Q 2012--I am optimistic about its future. This represents more than a 20% yield against the market cap, which more than supports the 5.1% dividend yield. The "buy" rating on the Street is thus justified.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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