At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.
At Cliffs, it could be a long way down
Tic-tac-toe, make it three in a row for downgrades at Cliffs Natural Resources (NYSE: CLF ) . Last week, a single day saw Cliffs hit with simultaneous downgrades from both UBS and Longbow. As iron prices continue to slump, this week it's Goldman Sachs piling on, and warning that "higher cost assumptions ... and a weaker pricing outlook for iron ore" are bad news for this "relatively high cost producer."
As you may recall, UBS held out a faint hope that iron ore prices would "re-rate higher in 4Q," helping to salvage profits (and the stock price) at Cliffs. China's announcement of a new $150 billion plan to build infrastructure, and boost its economy, is adding further hopes for higher prices. Goldman, however, is dashing these hopes with a comment that "CLF requires a higher iron ore price than we are currently forecasting." So, even if things improve for iron miners, they're unlikely to improve enough to save the stock. Result: Goldman pulls its "buy" rating and downgrades Cliffs to "neutral."
Is that the right call?
There's trouble all over
Earlier this year, Deutsche Bank waved investors away from the iron mining sector, warning that costs have been rising for Brazilian and Australian producers such as BHP Billiton (NYSE: BHP ) , Rio Tinto (NYSE: RIO ) , and Vale (NYSE: VALE ) . Despite their "geological advantages," said Deutsche, the companies have been pressured by "rising local currencies, labor costs and higher royalties."
Cliffs, which operates primarily in the U.S., has not been immune to cost inflation either. Despite H1 2012 sales coming in 3.3% lower than H1 2011, the cost of goods sold at the company are up a frightening 28.5%. That's been enough to cut gross profit at the company nearly in half, and take a big chunk out of the company's bottom line.
Bad as that sounds, though, it pales in comparison to the damage wreaked upon Cliffs' cash flow statement. Already, operating cash flow at the company has reversed from last year's H1 $725 million, becoming a cash outflow of nearly $33 million in H1 2012. Adding to its woes, Cliffs' spending on capital improvements has more than doubled, with the result that free cash flow at the firm now runs negative to the tune of $550 million -- an annual rate of $1.1 billion cash-burn, if things continue as they're now going.
Foolish final thought
All of this is bad news for Cliffs, and suggests UBS, Longbow, and now Goldman Sachs are right to downgrade the stock. But what does it mean for investors elsewhere in the commodities markets? At AK Steel (NYSE: AKS ) , for instance, bulls have been cheering the fact that low iron ore costs are keeping AK's input costs in check, and giving the company a shot at earning its first full-year profit since 2008 (and its first significant profit since 2007).
Don't get too excited about this prospect, though. Remember: Cycles have downs as well as ups. If iron ore prices are low today, and if this forces miners like BHP, Rio, and Vale to cut back on their production, it could dry up supply enough to raise ore prices in the future. Similarly, if Cliffs should fail to survive through this cycle (I don't mean to alarm anyone, but with more than $4 billion net debt, and no cash coming in the door, things sure don't look good), then the removal of a significant player from the market would similarly act to push up ore prices for AK and its brother steelmakers.
So how does an investor ever make money in the topsy-turvy world of commodities production? Just like with any company -- by keeping an eye on the balance sheet, and making sure your company isn't digging itself too deeply in debt to survive a downturn. In steel, that means investing in something like Nucor (net debt, 21% of market cap) rather than AK (net debt -- 193%). And in mining, stick to companies resembling the one we just profiled in our latest report on the gold mining sector: "The Tiny Gold Stock Digging Up Massive Profits." Read it here for free today.