Poor Visibility Spells Trouble For Steel Producers

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you are willing to take on the risk, coal and iron may be attractive investments right now. Producers are trading at low multiples and, in many instances, yielding substantial free cash flow. However, I encourage carefully backing companies that have solid operations in place that can capitalize on improving market conditions. With this in mind, I review several basic material stocks below.

Cliffs Natural Resources (NYSE: CLF)

This producer of met coal and iron ore has lost more than half of its value for the year to date. As staggering as this sum is, it is reflective of the underlying fundamentals, which have gone downhill. Analysts are forecasting negative growth of around 70% for the fiscal year and negative growth of 13.5% in FY2013. Despite these bearish assumptions, Cliffs has missed expectations in 3 of the last 5 quarters, with an average miss of ~25%. At this point, however, one wonders whether Cliffs is at its basement price. It trades at only 4.8x past earnings and 0.69x book value. Still, analysts have been downgrading the stock in the last few months.

The main concern for many investors at this point is whether the dividend, currently yielding 8.1%, will be cut. In my view, it is not a question of whether the dividend will be cut but whether it will be removed entirely. BMO Capital expects it to be cut from its "unsustainable" distribution of $0.625 per share to $0.28 per share. But I think it could be much worse in light of operational setbacks. Management, for example, announced that it will delay parts of Phase II Bloom Lake Mine development, idle 50% of lines at Northshore Mining, and temporarily idle Empire Mine. At a time when prices are weak and cash costs are rising, this alternative scenario isn't much better. After missing third quarter EPS by 48 cents on EPS of $0.61, management guided for lower Chinese crude steel production.

While the company is still creating some value with a 2011 return on invested capital ("ROIC") of 14.3%, it is creating less than it was in 2012 when the ROIC was 17.3%. Meanwhile free cash flow has plunged into negative territory on a TTM-basis after peaking at around $1.6 billion in 3Q11. When you consider that the average annual FCF generated over the last 5 years would yield around 12.1% today, however, there is a reason to be optimistic if you are a high risk investor. However, I only see short-term deterioration from here.

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

Vale and ArcelorMittal are two other basic material producers--more specialized in coal--that look cheap at first glance but are "value traps" to many. Vale trades at 7.2x past earnings while ArcelorMittal trades at 9.7x forward earnings (it lost $0.51 per share over the TTM). The one advantage to ArcelorMittal is that it offers a 5% dividend yield, which I believe is relatively stable given that free cash flow is still positive--$4.7 billion was generated in the TTM ending 3Q12. Put differently, ArcelorMittal's current free cash flow pays off all of the equity holders in just half a decade! At a price-to-book ratio of 0.42x, management should also consider increasing share repurchases to drive EPS accretion.

In contrast to ArcelorMittal, Vale has been forced to "do more with less" as a result of its financial crunch. While management's suggestion that it will increase investments despite a lack of capital boosts my confidence in the underlying fundamentals, the near-term picture won't see any of those returns resulting from the expenditures. The market should theoretically price future activity into the stock and understand that a dollar spent today means more than just that--it is investment in the future. But, investors are fixated on the volatility, and Vale is making promises without specifics. Moreover, the company faces a major headwind from China, which has restricted use of huge cargo vessels for iron ore--an investment that Vale has thrown $2 billion of its resources at. On the other hand, the company recently gained a major license to expand its railroad tracks so that it links a major northern Brazilian port to the largest iron ore mine in the world.

In short, as attractive as these stocks may be in the long-run, I don't believe that now is an attractive entry point.

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!

blog comments powered by Disqus