Time To Buy Cliffs Natural Resources: An Undervalued Dividend Stock

| About: Cliffs Natural (CLF)

Cliffs Natural Resources Inc. (NYSE:CLF) is a coal and iron ore mining company with mines in Alabama, Michigan, Minnesota, West Virginia, and parts of Canada. It also has mines located in Asia and Australia. In North America, CLF is by far the largest producer of iron ores. What's most exciting for growth is CLF's 30% stake in an iron ore project in Brazil and its increasing investment in renewable energy through acquisitions.

This company is extremely undervalued because of a recent bear rally starting in mid-April. At a price-to-book ratio of 1.02, it's a steal. Investors get the chance to pay $1.02 for every $1 in assets that CLF holds. This essentially means they would be paying $0.02 for its business value. Compare this with the mining industry average price-to-book of 6.10, which means investors pay $6.10 for every dollar of assets a company owns.

It's well accepted that free cash flow is a good indicator of the financial health of a company. For mining companies like CLF, investors typically pay about $53.00 for every dollar of free cash flow. At its current share price of $42.23, CLF investors are paying only $38.00 for every dollar of free cash flow. These numbers beg the question, why is a company with a market cap of $6 billion so severely undervalued?

The simple answer to that question is that quarter-over-quarter revenue is down 10%. Earnings per share when compared to last year are also down 10%. The industry average EPS for the same time is down only 5% - which means CLF was hit harder by the sloth-like global economy. This shouldn't surprise anyone since CLF has large exposure to North America where growth has been largely non-existent. In fact, it provides a great entry point for new investors.

Not only is CLF undervalued, but it pays a hefty dividend also. Its yield of 5.50% is more than twice the industry average of 2.50%. Its payout ratio, on the other hand, is less than half of the industry average (14.6% for CLF compared with 48.9% for the industry. The payout ratio is important because it indicates how much of the free cash flow a company has goes towards paying investors dividends. The less a company is paying out to investors, the more room it has for dividend growth in the future without taking funds away from expansion projects.

CLF's most recent twelve months return on investment is 13.71% compared to a measly 7.70% for the industry. While some investors typically disregard the metric, I find revenue per employee a good measure of how efficient a company is when compared to its peers. CLF brings in a working revenue of $904,000 per employee, while the industry average is less than half at $441,000. While the definition of 'employee' varies from company to company, it's a good approximation of efficiency.

The price of CLF shows relatively strong correlation with its revenue (surprisingly, revenue GROWTH isn't showing a strong correlation). The chart below shows that the price tends to lead the revenue by about half a quarter. This means that by the time the company reports a good earnings quarter, the market will have already priced it in (barring any unexpected movements in the company or the macro environment that would through analyst expectations way off). This is partly why I suggest buying into CLF now rather than waiting for an absolute bottom or a swing low.

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Technical investors may look for CLF to break the $45.00 resistance level (previously a support level). However, the MACD has crossed the signal line. The price has also crossed above the 14-day exponential moving average. The RSI indicator, as well as the Ultimate indicator show downtrend territory, but not oversold. Because of the mixed signals from indicators, it's difficult to predict if we've already seen the swing low or if we have yet to witness it.

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If I haven't convinced you that CLF is a good investment, I'd like to point your attention to its current Graham valuation and the Reverse Discounted Cash Flow (RDCF) valuation. The well-known Graham valuation method is good for established companies where growth can be predicted fairly accurately. If I use a projected growth rate of 0% for CLF, it's current valuation is $151.75, well above its current stock price.

The RDCF valuation is handy for figuring out what kind of growth the market expects in a company's free cash flow to justify it's current share price. This method gives me a calculated growth rate of -9%. This means that to justify current share price, CLF should shrink by 9%. I'm not arguing that revenue won't be down 9% year over year. What I'm saying is that this a company with solid fundamentals and its simply hit a rough patch due to slowed global economic growth - which has created an absolutely perfect opportunity for new, long-term investors to jump in.

Disclosure: I am long CLF.