The global supply of iron in 2013 was about 2 billion tons. China, which consumes two-thirds of the world's iron supplies, is projected to grow demand at 3% to 4% annually. With Chinese urbanization expected to reach 77% by 2050, strong demand from growth in cities and infrastructure is likely to create immense demand for this commodity.
Yet, iron ore prices have plunged 47% in the last three years.
Iron Ore Spot Price (Any Origin) data by YCharts
The cause of this collapse has been a steady increase in iron ore supply, which is expected to grow at 3.5% annually through 2018. Throw in record-high iron inventories in Chinese ports and iron prices are unlikely to recover anytime soon.
Yet this cyclical downturn serves as a lesson on a key Foolish investing principle -- buying great companies when the market hates them most.
Buying at the bottom of a cycle
Iron ore miners such as Cliffs Natural Resources (CLF -0.49%), Rio Tinto (RIO -0.53%), and Vale (VALE -2.51%) have been hammered by the collapse of iron prices and are trading at a 40%, 41%, and 30% respective discounts to their historical valuations.
However, despite these low prices only two of these miners are a good long-term investment.
| Company | Yield | 10 Year Annual Projected Earnings Growth | 10 Year Annual Projected Dividend Growth | 10 Year Projected Annual Total Return |
| Cliffs Natural Resources | 4.10% | 4% | 2.39% | 0.50% |
| Vale | 6.10% | 59% | 32.06% | 64.60% |
| Rio Tinto | 4.20% | 16.80% | 13.40% | 23.10% |
Sources: S&P Capital IQ, Yahoo Finance
As seen in the table, analysts are predicting Cliffs Natural Resources to be dead money for the next decade while Vale and Rio Tinto are expected to perform spectacularly. Why the stark difference?
Cliffs Natural Resources' problems are due to a combination of high debt and managerial ineptitude. At the peak of iron prices in 2011, it spent $4.9 billion to acquire the Bloom Lake iron mine in Canada and proceeded to invest into it $1.5 billion. This was a part of a larger $9 billion diversification program into things such as metallurgical coal whose prices have plunged 65% since 2011.
Today that $9 billion contributes nothing to earnings, and Cliffs Natural Resources is hemorrhaging cash to the tune of $220 million annually. Wells Fargo recently put out a report warning that Cliffs will have to cut its dividend unless iron prices rise and stay above $100/ton-$110/ton.
Unfortunately, Morgan Stanley is predicting iron prices will drop to $90/ton in 2015 and that Cliffs debt/EBITDA ratio will reach 4.0 by the end of 2014. This would put it in breach of its debt covenants and might put the company into bankruptcy. At the very least the dividend is likely to be cut and after the 76% dividend cut Cliffs executed in early 2013 shares will likely plunge to Wells Fargo's price target of $7-$10 -- representing a 33%-50% decline.
With Deutsche Bank predicting Cliffs Natural Resources' earnings will drop 84% by 2016 after already falling 46% this year, investors should look to Vale and Rio Tinto for long-term iron mining profits.
Vale and Rio Tinto: Best of breed iron miners
Long-term income investors should look to Rio Tinto and Vale for three main reasons: economies of scale, diversification, and superior cost controls.
Rio Tinto and Vale are diversified, both geographically and into non-iron products. For example, Rio Tinto produces aluminum, copper, and diamonds while Vale mines nickel, copper, coal, and makes fertilizer.
Most importantly, both Vale and Rio Tinto have superior economies of scale and can mine iron far cheaper than Cliffs Natural Resources. In fact, Rio Tinto was able to cut costs at its Pilbara mine by 11% in 2013 to just $20.80/ton.
This is why, despite declining iron prices, both Vale and Rio Tinto are planning on expanding production 7% in 2015 for Vale and 66% from Rio Tinto's Pilbara mine by 2017.
Both Rio Tinto and Vale are also masters at controlling costs. For example, Rio Tinto's Pilbara mine's most recent expansion came in four months ahead of schedule and $400 million under budget.
Meanwhile Vale was able to cut its administrative costs by 39% in 2013 with exploration costs down 45%.
Vale is planning on slashing capital expenditures by 42% from 2011 to 2016 while still increasing production.
Rio Tinto's cost cutting is even more impressive. From 2012 to 2015 it will cut capital spending by 55% while still expanding production and investing in efficiency technology such as automated dump trucks and trains. These trains will save the company 3.6 million kilometers of annual travel.
Foolish bottom line
The coming decades will see demand for iron soar and the best iron miners will grow rich and shower long-term income investors with capital gains and fast growing dividends. Vale and Rio Tinto are two examples of best-in-breed iron miners with access to superior technology, economies of scale, and diversified assets that can ride out cyclical downturns. Cliffs Natural Resources lacks these attributes and its exposure to iron and metallurgical coal means its turmoils are likely to continue. Investors should buy Vale and Rio Tinto at these prices but avoid Cliffs Natural Resources, whose discount is well earned and likely to continue.
