As market surges, 2 commodity stocks slump

There are bargains to be found in gold and coal even as the major indices hit new highs.

By StreetAuthority Mar 7, 2013 2:10PM
Elevated view of freight cars with coal copyright Joseph Sohm-Visions of America, Photodisc, Getty ImagesBy David Sterman                                                                                                                                  As the major indices post multi-year highs, many investors credit the invisible hand of the Federal Reserve. 

The Fed's pump-priming quantitative easing (QE) has acted as a key source of liquidity for a range of investment classes, from small-cap stocks to junk bonds to the leading blue chips.

The Fed's moves were also expected to boost various commodities -- and the stocks that are pegged to them -- but this entire asset class has started to lag stocks by a widening margin in recent quarters. The still-slow global economy is just one of factors affecting them.

But as the global economy stirs to life, demand for commodities could strengthen, boosting pricing. Here are two commodity producers that have fared badly in recent years, but now hold deep value and upside when the global economy firms up.

1. Barrick Gold (ABX)
This is the world's largest gold producer in terms of production and market value, and is a poster child for the key issue plaguing the gold-mining sector: rising costs.

In 2009, Barrick mined gold (on a cash basis) for less than $500 an ounce -- this figure is expected to exceed $630 an ounce this year. In light of the drop in gold prices, from about $1,900 an ounce in the summer of 2011 to a recent $1,575, Barrick's profit margins have steadily narrowed. That helps explain why shares hit fresh two-year lows with each passing week.



Yet thanks to a series of new lower-cost mines that are gearing up for production, Barrick's mining costs are finally set to reverse course as we head into mid-decade. Merrill Lynch's analysts see Barrick's mining costs falling below $600 an ounce by 2015. Assuming gold prices remain constant, Barrick's margins and operating cash flow will likely begin to rebound. (Every $50 per ounce in gold prices in either direction is expected to have a $350 million effect on annual cash flow).

For many investors, Barrick's aggressive spending has been a major concern. Massive amounts of capital expenditures (CapEx) have led to negative free cash flow. For example, the company's 60%-owned Pueblo Viejo gold mine in the Dominican Republic cost $4 billion to develop, thanks to cost overruns. Meanwhile, the company's Pascua-Lima mine in the border of Chile and Argentina will likely have consumed $8 billion by the time production ramps up in 2014. (As a silver lining: Pueblo Viejo's cash costs are expected to be below $350 an ounce for the next five years, while Pascua-Lima's cash costs will likely be even lower).

Developing those two massive mining complexes greatly damaged the company's balance sheet. Barrick generated a $7.3 billion free cash-flow loss in 2011, a nearly $1 billion free cash-flow loss in 2012, and free cash flow will likely be less than $300 million this year.

That poor financial performance led the company's board to replace Barrick's CEO in June 2012, but the promotion of Chief Financial Officer Jamie Sokalsky to the corner office signaled investors that free cash flow will be the priority in the years ahead.

Free cash flow is expected to exceed $2.5 billion by next year, and $5 billion by 2015, according to Merrill Lynch's analysts. Their $44 stock price target represents more than 50% upside from current levels. Citigroup, Credit Suisse and UBS also have price targets in the low- to mid-$40s, and their analysts also cite the looming surge in free cash flow as a key reason for their bullishness.

2. Alpha Natural Resources (ANR)
For many investors, coal stocks have doled out ample pain in recent years, as surging natural gas prices and stricter environmental regulations have led to a share slump in coal demand and pricing. This company's stock has really taken it on the chin, plunging 80% since early 2011.



In light of coal's long-term headwinds, it's hard to see how this stock will return to the mid-$60s. Still, at about $8, shares possess deep value, with perhaps 50% upside from here.

The key catalyst won't be a heady rebound in coal prices, but a more constrained cost structure. You can already see the effect of Alpha Natural's cutback of 1,200 employees in its quarterly results. The company posted a net loss of $128 million the fourth quarter of 2012, compared with a $793 million net loss in the fourth quarter of 2011. Though the red ink is likely to continue, Alpha's operating cash flow looks healthier, at about $217 million in the most recent quarter.

Despite coal's dirty reputation in our nation's electric utility industry, it has paths to growth elsewhere. Many steel mills around the world burn a high grade of coal known as metallurgical coal (or "met coal"), and as the global economy rebounds in the next few years, demand for met coal is expected to strengthen. Alpha Natural is the nation's largest producer -- and exporter -- of met coal.

It will take several years for investors to gain better visibility into Alpha Natural's capability to generate cash flow, so in the near-term, analysts at UBS say it's wiser to value shares on a price-to-book basis. Although UBS analysts don't see shares rising up to book value of $22 a share, they say shares could rebound to $13 -- or more than 50% above current levels -- once investors recognize that coal pricing and demand dynamics have at least stabilized and are no longer worsening.

Analysts at Barclays believe that imminent catalysts are indeed in place for a rebound. "The near-term outlook for ANR shares primarily depends on the next move in met coal prices, and we maintain our position that the next move will likely be higher as 2013 progresses." They see shares trading up to $12.

Risks to Consider: A slowdown in the global economy in coming quarters would limit upside for commodity prices -- and these stocks.

Action to Take: Both of these companies are restraining spending to generate improving cash flow, even if the commodity prices fail to rally. They remain deeply out of favor, though they look poised for a rebound if the global economy builds a head of steam in 2013 and 2014. If you're in search of deep value in the commodity space, then any of these two stocks fit the bill.

David Sterman does not personally hold positions in any securities mentioned in this article. 

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