Cliffs May Take Over Walter; Vale Also A 'Buy'

| About: Cliffs Natural (CLF)

For investors bullish on the rise of the industrial economy, Cliffs Natural Resources (NYSE:CLF) and Vale (NYSE:VALE) offer a high risk / high reward opportunity. They have a volatility that is, as an average, double that of the broader market. The Street currently rates both firms and, based on my multiples analysis and review of the fundamentals, I find meaningful upside for Cliffs especially should it make strategic takeovers.

From a multiples perspective, the two are dirt cheap. Cliffs trades at a respective 5.3x and 7.1x past and forward earnings while Vale trades at a respective 5.7x and 6.6x past and forward earnings. To put this introspective, consider that Cliffs is currently valued at 37% of its historical 5-year average PE multiple.

Much of the reason for the depression-level multiples is due to uncertainty in end market demand. At the recent fourth quarter earnings call, Cliffs' management addressed disappointing earnings performance by focusing on 2011 as a whole:

Cliffs delivered an exceptional performance in 2011, a year highlighted with the transformational acquisition of Consolidated Thompson. With a significant organic pipeline of growth in both iron ore and metallurgical coal, Cliffs is well positioned for continued momentum in 2012 and beyond.

The company faced production difficulties at Wabush and goodwill impairment charges. But perhaps the biggest disappointment has come from 2012 outlook. Capex is targeted at $1B, up 25% from 2011 and trends are looking worse in the near-term. To help turn over a new leaf, management should consider buying out Walter Energy (NYSE:WLT). Some time back, Cliffs tried, and failed, to acquire Alpha Natural Resources (ANR). Purchasing Walter would help Cliffs gain greater exposure to met coal and excite investor entry. The trick is to structure financing so that it does not cause a downgrade in the firm's investment rating.

Consensus estimates for Cliffs' EPS forecast that it will grow by 51.5% to $11.35 in 2011, decline by 10.6% in 2012, and then grow by 23% in 2013. Assuming a multiple of 8x and a conservative 2013 EPS of $12.70, the rough intrinsic value of the stock is $101.60, implying 45.3%.

Vale has had difficulties of its own. It first declared force majeure on iron ore interests in Espirto Santo, Rio de Janeiro, and Minas Gerais and then suspended it two weeks later. Average iron ore prices have been weak, falling 7% m-o-m in January. Despite the weakness and supply chain difficulties, management has announced that it will pay out at least $6B worth of dividend distributions. Moreover, steel production is looking to consistently improve sequentially up until the third quarter of 2012 when it hits 2 mtpy.

Consensus estimates for Vale's EPS forecast that it will grow by 39.3% to $4.50 in FY2011, decline by 12.9% in FY2012, and then grow by 0.8% in FY2013. Assuming a multiple of 8x and a conservative FY2012 ESP of $3.88, the rough intrinsic value of the stock is $31.04, implying 20.5% upside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.