Which Iron Ore Players To Buy For Huge Upside?

Includes: BHP, CLF, RIO, VALE
by: Smart Equity

The iron ore markets have been suffering lately from the consistent oversupply, along with the depressed demand for the commodity. The latter is a direct consequence of the poor demand for steel (which uses iron ore as a key raw material) in China - the largest steel consumer in the world. Although an iron ore rebound is not evident in the near term as the global economy continues to grow at a sluggish pace, the stocks of the mining companies are enormously cheap and are set to give investors huge returns in the long term.

Cliffs Natural Resources (NYSE:CLF) and Vale S.A. (NYSE:VALE) are our favorite stocks to play a rebound in the iron ore industry. CLF offers a dividend yield of more than 5%, and its major exposure is in iron ore and metallurgical coal, both of which are used as raw materials in steel production. Thus, the company is a pure-play on macroeconomic recovery, in general, and steel's rebound in China, in particular. VALE has a lean cost structure, and a cheap forward price-to-earnings ratio. In addition, the company has responded smartly to the turmoil in its industry by selling off non-value adding businesses, which have helped it to release funds for other high-yielding projects.

Vale - Earnings Review

World's second largest producer of iron ore, Vale S.A. 's disappointed investors in the recent quarter earnings by reporting a 66% decline in the profits on a year-over-year basis. However, the results were inevitable considering the depressed iron ore prices, a combined result of weak market fundamentals and global macroeconomic meltdown.

The Brazilian company is the world's largest producer and exporter of iron ore and iron pellets in addition to being the world's second-largest nickel producer. The company's primary market is China considering the fact that the country is the largest consumer (as well as producer) of the iron ore. It is also noteworthy that iron ore constitutes the bulk of Vale's profit, as the company derives almost 90% of its net income from its iron ore operations.

The company's quarterly results were the worst in the past three years. It reported net income of $1.67 billion, way short of last year's $4.94 billion figure and the analysts' estimate of $1.92 billion. The poor operating performance has forced the Rio de Janeiro - based company to delay the expenditures related to major mining projects, shut down operations and consider cutting investments and even dividends.

The company is considering selling businesses to concentrate more on value-enhancing projects. According to the company, "The sale of assets that do not add value will improve the allocation of capital and free up funds to help finance world-class investments."

Previously, Vale has announced closing operations at three iron ore pellet plants in Brazil. Now, the company has also added Zogota mine at Simandou, Guinea, to that list.

However, I feel that all these measures will help Vale emerge out of the problems the iron ore industry is facing currently. In addition, being one of the "BIG 3" iron ore giants, Vale has substantial control over the commodity prices, which gives it an advantage over its peers.

Cliffs Natural Resources - Earnings Review

Cliffs Natural Resources Inc. also suffered from low iron ore prices and high costs, which resulted in an 85% drop in its year-over-year profits.

Recently, in its earnings release, the Cleveland-based company reduced its full-year expectation for the production of Chinese crude steel to 715 million tons from its previous guidance of 730 million tons. It also decreased its expected sales volumes for both North American iron ore and coal.

According to Reuters, iron ore prices have dipped by about 22% during the July-September period this year, decimating profits of the producers significantly. CLF also suffered from an increase in mining, maintenance and labor expenses, which further deteriorated its profits.

Still, with a dividend yield of more than 5% and a forward price-to-earnings ratio of 8x, I feel that the stock is an inexpensive buy. Meanwhile, its exposure in both iron ore and metallurgical coal makes it the best stock to play a turnaround in the steel industry, which uses both these commodities as raw materials.

The following table is a brief summary of essential things to consider from the perspective of valuations; the table includes Vale, CLF, BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) .

Source: FINVIZ.com, Google Finance

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.