Why Cliffs Natural Resources Is Our Favorite Stock To Play Iron Ore's Turnaround

Sep.14.12 | About: Cliffs Natural (CLF)

There have been constant chats of a possible bottom in iron ore. After China approved more than $157 billion of infrastructure spending last Sunday, the country's data showed increased iron ore imports in terms of tonnage. However, speculations were not met, as investors realized that as long as steel's demand doesn't improve, especially in China (the biggest iron ore and steel consumer), such short-lived spurs are unlikely to cause a major turnaround. Meanwhile, the Big 3 iron ore companies, which include BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), and Vale S.A. (NYSE:VALE), have announced considerable cutbacks in capital expenditure plans for 2013, following the vulnerable condition of the iron ore market.

The Federal Reserve's announcement of further monetary stimulus measures yesterday was also bullish for iron ore, but we still remain cautious in the near-term, and wait for markets to bottom this year. However, for long-term investors, we remain bullish on iron ore mining companies in general, and Cliffs Natural Resources (NYSE:CLF) in particular.

Latest Developments

  • Management Change - CLF

Cliffs Natural Resources has recently disclosed a set of key changes in its executive management. The most important change is the transition of Chief Financial Officer Laurie Brlas to the president of the company's global mining operations. According to Chief Executive Joseph Carrabba, "As we transition Cliffs' strategic focus from M&A activities to executing organic growth projects, these executive changes will drive excellence in project execution, ensure operational stability and provide for a more disciplined approach to capital allocation and cost management."

  • QE3

The Fed is desperately trying to uplift the U.S. economy from one of its worst phases after the global financial crisis. In one such measure, the Federal Reserve announced the latest phase of quantitative easing (QE3) yesterday, which specifically acted as a catalyst for the energy and basic material sectors. Coal mining companies were one of the big gainers, with Alpha Natural Resources (ANR) augmenting by as much as 12%. CLF also rose by more than 6%, as iron ore prices resumed their early-week upward trajectory following two days of consecutive declines.

Bullish Factors

  • High iron ore exposure, but not a big mining giant

The company has two major segments, iron ore and metallurgical coal, unlike big iron ore giants like BHP and RIO, whose operations are much more diversified. CLF will be one of the biggest gainers following a potential iron ore rebound. VALE S.A. too is also a good investment for the long-term, due to its cheap valuations and high iron ore exposure. RIO's iron ore exposure is much higher than BHP, which makes us prefer it over the latter. Still, we remain bullish on all these companies in the long-term.

While BHP and RIO have the advantage of operating at relatively lower levels of the cost curve, a mid-sized company like CLF is not going to have a downward impact on global prices of the metal, if it increases its production. In fact, increasing production would reduce CLF's marginal costs of production, but if mega-miners do the same, they will suffer from margin squeezes.

  • Cheap Valuations

The company is the most inexpensive stock relative to its peers. This is because its forward P/E ratio of 6x trails those of its peers.

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Source: Google Finance, Yahoo Finance

Bearish Factor - Possible Dividend Cut

CLF's current dividend yield of 7% seems unsustainable if the company doesn't delay the required capital expenditure for its Chromite project and/or obtains a waiver on its debt covenant. However, given the consensus estimates of its upcoming quarter's earnings of $1.3-$1.4, and its 2Q dividend of $0.625, dividend cuts are unlikely in this quarter. Please read our previous article for a detailed scenario analysis on the company's dividend in response to different iron ore prices.

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

Business relationship disclosure: The article has been written by Qineqt's Basic Materials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.