May. 7, 2014

Summary

• The earnings outlook in Metals And Minerals looks soft due to volatility in prices and an imbalance between supply and demand.
• Cliffs Natural Resources has adopted the right strategy to create profitability.
• Vale S.A. appears to be in a better position to generate profits.
• It is not wise to invest in companies that are facing price volatility in their main product line.

The Industrial Metals and Minerals industry remains cyclical and very price-competitive. It has an imbalance between supply and demand due to the economy, the housing markets, vehicle sales, and other industrial industries that impact this business.

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Vale seems to be on the right track with its business plan of generating higher production from existing assets. In the past year, it generated record sales volumes of iron ore and pellets (305.6 Mt), copper (353,000 t), gold (297,000 oz) and coal (8.1 Mt). In the first quarter of this year, iron ore production reached a record (71.1 mt), coal production reached (1.8 mt) and nickel production reached the record level of (67500 t). However, due to lower iron, copper and coal prices, revenue growth was sluggish when compared to past quarters.

Due to the uncertain commodity prices, Vale is aggressively cutting its operational costs and other expenses to maximize profitability. Last year, it reduced the cost of products by $972 million, SG&A expenses by 40% and R&D by 45%. In the first quarter of this year, it continued its cost-cutting efforts, and SG&A costs decreased 20%, pre-operating and stoppage costs decreased 33% and R&D costs decreased 15%. Consequently, Vale's net earnings were higher sequentially, but lower on a year-over-year basis.

Where Does Cliffs Natural Resources Stand?

Cliffs Natural Resources was a bit slow in responding to the uncertain commodity prices, because it was working on mergers and acquisitions to expand its asset portfolio. Thus, with the drop in commodity prices, Cliffs' profits went down substantially. In 2012, it experienced a loss of $6.32 per share. However, after a management change that included a new CEO, in the second half of 2013, the company reshuffled its business strategy. It is currently cutting operational and management costs. In addition, the company has suspended its aggressive growth strategy and stopped making acquisitions and mergers. It is now looking to expand production from existing assets, while disposing of non-core low-performing assets. Although it was late in responding to the shift in business challenges, it appears to be on the right track, concentrating on organic growth and enhancing financial strength.

As a result of changes in business strategy, the company moved back towards profitability in 2013. It reduced costs of goods sold and decreased selling and general administrative expenses by 18%. It also reduced capital spending, which in turn resulted in positive free cash flow. In 2014, Cliffs continued its strategy of reducing costs, lowering capital expenditures, right-sizing its asset portfolio and enhancing production from existing assets. In the first quarter, it reduced COGS by 3%, SG&A expenses by 30% and reduced capital expenditures by 55%. Despite the cost reductions, as a result of the drop in iron ore and metallurgical and coal prices, its revenue fell on a year-over-year basis. Further, $39 million of expense-related Wabush-related costs led it to post a loss of $70.7 million.

Are Vale and Cliffs Natural Resources Good Buys?

Currently, both companies are working on similar business plans. They have both reduced capital spending, and have plans to reduce costs as much as possible. However, Cliffs Natural Resources remains slow in making changes. In addition, uncertainty in iron, copper and coal prices is expected to continue, which I think, will further hinder its financial situation.

On the other hand, Vale was quick in responding to the new business challenges. Thus, it is currently in a better position than Cliffs. The company has been getting record productions from its existing assets, while lowering operational and management costs. Vale has also lowered capital spending, and is reducing debt and improving liquidity.

Amid all this, I do not recommend initiating a position in any company that must sell its main product line at prices that that leave it with very slim margins. Both companies are being hurt by low commodity prices, and that is having a negative impact on their cash flow and top and bottom line growth. Furthermore, the outlook for Metals and Minerals prices looks dismal. Hence, I recommend that even though the stocks of these companies are cheap, investors should stay away from them until Metal and Minerals prices stabilize.

Source: Are Vale S.A. And Cliffs Natural Resources Good Investments?