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Debate at the Cliffs: to jump or not to jump?
Since hitting a recent low of $86 a ton in September, the price of iron ore has skyrocketed 57% in a matter of months, recently hitting $135 a ton. Unfortunately, this poses shareholders -- and potential shareholders -- of iron ore and coal miner Cliffs Natural Resources (NYSE: CLF ) with a bit of a quandary this week.
Is now the time to buy more stock, or to eat the 48% losses the stock has produced over the past year, and sell whatever shares you still have left? The answer depends on where you think ore prices are headed next.
If you ask investment banker Deutsche Bank, the sky's the limit for ore prices today. Or if not "the sky," necessarily, the banker does at least think we could see ore prices rise to $170 within a matter of "weeks." Yesterday, Deutsche put its reputation where its mouth is, switching from a neutral position on Cliffs stock and upgrading the stock to buy.
Deutsche argues that Cliffs will easily outperform the rest of the stock market in 2013, and with its value buoyed by buoyant metals prices, the shares will hit $48 -- 33% higher than today's prices -- within a year.
Sound good? Well hold on just one second. You haven't heard the bears' rebuttal yet. According to Deutsche rival Dahlman Rose, the opposite is actually true. Iron ore prices have risen too far, too fast, and are due for a "quick reversal." According to StreetInsider.com, which reported both analysts' ratings yesterday, Dahlman argues that investors should use the recent ore price movement as an opportunity to get out of Cliffs shares before any more damage can be done.
According to the analyst, the trend of rising ore prices simply cannot last, and when prices inevitably plunge, Cliffs is the iron miner "most vulnerable" to a reversal. Consequently, Dahlman's advice today is not to buy Cliffs, but to sell it instead. And there's something to that assertion.
While priced at a seemingly cheap 5.8 times earnings, Cliffs' stock valuation does come with some caveats. Caveat No. 1 would be the fact that most analysts seem to agree that Cliffs' earnings are currently at a near-term peak. Just about nobody (but Deutsche) expects to see more than 1% annual earnings growth at Cliffs over the next five years.
Caveat No. 2 is even worse: Even if Cliffs does find a way to keep earnings growing, these earnings may not be worth much, given that Cliffs continues to burn cash, and report negative free cash flow. Without real cash profits to back them up, it's hard to argue the company's GAAP "profits" have much worth to them at all.
Meanwhile, Dahlman has another good point when it says Cliffs is the iron miner "most vulnerable" to a downturn in ore prices. The natural question to ask when faced with such an assertion is: "Most vulnerable relative to whom?"
The answer, unfortunately, is "relative to everyone."
A relative lack of value
In contrast to Cliffs, two of its major competitors -- BHP Billiton (NYSE: BHP ) and Vale (NYSE: VALE ) -- currently sport sizable free cash flow margins. (A third rival, Rio Tinto (NYSE: RIO ) , is at least burning less cash than Cliffs is). In short, in a favorable pricing environment that finds Cliffs still unable to make buck, BHP and Vale appear to be doing just fine, while Rio is at least close to breakeven. Growth-wise, again, Cliffs lags two of its rivals -- BHP and Rio this time, while Vale trails behind.
In short, while Cliffs' rivals may currently cost more than it does on a P/E basis, the stocks of these rivals are arguably worth the premium -- because they're better businesses than Cliffs. So while an "iron bull" could conceivably argue that Cliffs will do well because iron ore prices will keep rising (and maybe they will), you still have to wonder whether Cliffs is the best way to play such a trend. There appear to be better plays on a strong market for iron ore.
On the other hand, if the iron bulls are wrong, and ore prices are due to reverse and resume diving, a prudent investor should probably want to be invested in one of the stocks that's generating cash, rather than in the one that isn't: Cliffs.
Cliffs Natural Resources has grown from a domestic iron ore producer into an international player in both the iron ore and metallurgical coal markets. It has performed well, relative to many competitors, in a very cyclical industry because of several factors that are likely to remain advantageous for Cliffs' management. For details on these advantages and more, click here now to check out The Motley Fool's brand-new premium report on the company.