The Business of Mining

“Vale, the world’s largest iron ore miner, reported record net profit for last year as demand remained strong in China and nickel volumes recovered. The company on Thursday said it earned net profit of $17.26bn in 2010, more than three times what it made a year earlier, as sales reached $46.48bn, nearly double the $23.94bn of revenue in 2009.

Observations:

• Revenue for 2010 is 21% higher than the previous record of 2008. EBIT, EBITDA and Net Earnings are up over 30% since 2008 as the EBITDA margin increased by 6%, mainly driven by higher iron ore prices. Earnings per Share of $3.25 are on the top side of analyst expectations.
• The company is working on iron ore expansion projects in Carajás (Northern Brazil) and the new Simandou deposit in Guinea. Apolo (Brazil’s Southeast system) and Carajás Serra Sul are further down the line of expanding production, planned to be delivered in 2014. Ferrous minerals accounted for 92% of adjusted EBIT over 2010, showing the company’s large dependence on iron ore prices.
• Expansion for non-ferrous commodities mainly takes place outside Brazil: Mozambique’s Moatize coal project; Zambia’s Konkola North copper project; Argentina’s Rio Colorado fertilizer project; and Peru’s Bayovar fertilizer expansion signify the increasing international presence of the company.

Implications:

• The improved gross margin of the company does not indicate it has costs under control, but mainly that prices were higher. Vale did not suffer from exchange rate fluctuations as much as its peers as most of its costs are incurred in currencies linked to the dollar, but it mentions cost pressures in the areas of depreciation (resulting from expansion of the equipment fleet) and in procurement.
• Cash position of $10bln at the end of 2010 and the outlook to beat last year’s cash flow from operations of $20bln in 2011 gives Agnelli a lot of flexibility in expanding. Vale will have to use the pile of cash to build a sustainable position among the supermajors even if iron ore prices come down. As the senior management indicates no major acquisitions will be done, the company will focus on organic growth (33 projects to be delivered by 2015) to achieve this objective.
• When presenting the results no mention was made of election of a new CEO for Vale. Reelection of Roger Agnelli when his current term ends in March is not fully certain as tensions with the government are mentioned. Henrique Meirelles, Brazil’s former central bank governor, and base metals chief Tito Botelho Martins would be potential candidates to succeed him. The decision will have to be made by the powers behind Vale: the Brazilian government, Pension fund Previ and Banco Bradesco, and Mitsui.

©2011 | Wilfred Visser | thebusinessofmining.com

The Economist published a strong article describing the rise of Vale:

“It is perhaps the biggest firm you have never heard of. The Boston Consulting Group says it has created more value than any other large firm in the world over the past decade. Yet few people know how to pronounce Vale’s name (it’s “vah-lay”).

Where the Economist is right:

• Vale has grown steadily organically and by small acquisitions from a state-owned local player to a state-backed global player.
• The company is still heavily depending on its iron ore production (65% of revenues, at times an even larger part of profits), diversifying into other metals mainly to hedge risks. Only the fertilizer business is set up to become a future star performer, but this might be frustrated by BHP’s Canadian plans.
• The capital expenditure of the company in the coming years will by far be superior to the competitors’ investments. Rio Tinto is bound to a $5bln capex for this year, while Vale is said to invest around $100bln in the next 5 years.

Where the Economist might be wrong:

• The vertical integration into transportation is more a necessary evil than a strategic asset. The company started the railway expansion because it could not trust the government to provide the infrastructure required for its operations and it bought bulk tankers mainly because its geographic locations makes ownership of the ships a better option than contracting the shipping. However, the ownership of a fleet might make Vale an interesting partner for various commodity trading houses that are looking to strengthen their upward ties.
• The pressure of the Brazilian government for local investments is certainly not on top of the management’s mind. Although the government should be kept satisfied to keep te current royalty structure, expansion abroad is crucial for the company’s success, which leads to increased international prestige and tax income for the government.
• The strong presence in the Brazilian iron ore market is a strategic asset rather than a hinderance. In the shadow of China, Brazil is developing an enormous appetite for steel. Vale is not only the most suitable cultural supplier; its domestic production ensures it is by far the lowest cost supplier to the developing Latin American market too.

©2010 | Wilfred Visser | thebusinessofmining.com

Roger Agnelli

What are the things the CEO of the world’s second largest mining company is worried about? What is Vale’s CEO Roger Agnelli doing to catch up with BHP Billiton? What is on top of his “To Do”-list?

An analysis of Vale’s latest annual and financial reports, investor presentations and the news about the company in the last months yields a list of 10 issues that are likely to be at the top of Agnelli’ list of priorities.

The list holds strategic, operational, financial and relational activities, each of which are scored in terms of importance and urgency. Priority 1 on the list is trying to prevent BHP’s acquisition of PotashCorp. Priority 10 is managing breakthrough innovation of copper processing in Carajás. Read on for the full list of priorities.

1. Assess opportunities to prevent BHP Billiton’s PotashCorp acquisition

BHP Billiton has made a hostile $39bln acquisition offer for PotashCorp, thus following Vale’s move of entering the potash business as a diversified miner. However, the potential changes to the market and to potash pricing (currently controlled by regional cartels) are likely to make Vale’s potash assets uncompetitive. Although the company has denied being in talks with PotashCorp to find alternatives, Agnelli will certainly devote a large portion of his time to finding a response to BHP’s offer.

2. Manage integration programs to reduce costs

Vale has grown rapidly partly because of a large number of acquisitions. Insiders comment that many of the acquired companies have never been integrated completely, creating operational inefficiencies and a lack of corporate culture. To sustain growth, Agnelli will be working hard on realizing the synergies from acquisitions by building global businesses. Part of this assignment is the carve-out of the aluminium business, which has been sold to Norsk Hydro this year.

3. Anticipate on Brazilian election results

Brazil will elect a new president, senate and governors on October 3rd 2010. Both economic policy and environmental policy on federal and state level could be impacted significantly by election results. Agnelli is certainly developing scenarios to react on post-election regulatory changes.

4. Study increase of gearing in order to accelerate growth

The company has traditionally grown by M&A, but is currently guarding its gearing carefully. However, in order to enable further acquisitions, Agnelli will be discussing increasing the gearing and accessing debt with the new CFO Cavalcanti, who took over from Fabio Barbosa at the end of June, and banking partners.

5. Compete for position in China

Compared to BHP Billiton and Rio Tinto, transportation distance poses a disadvantage to Vale in supplying iron ore to China. While Rio Tinto is creating strong ties with Chinese government via its partnerships with Chinalco, Vale will need to find alternative ways to improve relationships with clients and government in the country that is responsible for most of the growth in demand of its products.

6. Manage development of Guinean iron ore deposits

An important part of the growth of the iron ore production in the next decade should be coming from Guinea, where Vale will develop the Simandou South deposit. Vale will need to get infrastructure in place and start development soon in order to please the government, which recently took development rights away from Rio Tinto because the company was not proceeding fast enough.

7. Reduce iron dependence

Growing the copper business unit and building a fertilizer business are two of the ways in which Vale tries to reduce its dependence on iron ore. Although the iron ore business is a star business with solid growth perspectives, the volatility caused by the dependence on one single commodity will worry Agnelli. Diversification into other business units is crucial for the long-term stability of the company.

8. Gain access to coal in Latin America

Although a lot of iron ore is shipped to China, Brazil is booming too. In order to produce steel for the domestic market, Vale needs to develop coal capacity in Latin America, which will require strategic acquisitions and targeted exploration.

9. Manage employee relations after Vale Inco strike

The board will need to prevent repetition of strikes like they experienced at Vale Inco during the last two years in Canada. Reviewing and improving international employee relations is both crucial for the company’s productivity and to improve the image in labor market, where Vale still has difficulties to attract international management talent.

10. Manage technological processing innovation for copper in Carajás

The company is trying to scale hydrometallurgical copper processing technology to commercial level in the Carajás UHC plant. Success in this project would have significant profit impact and would position Vale with the current deposits in development as one of the most competitive copper producers globally.

Sources: Vale annual report 2009, Vale summary review 2009, Vale investor presentation February 2010

“Falling supplies and rising demand from manufacturers in Europe and Asia are pushing tin prices to their highest levels in two years.

Observations:

• Shortage of tin is expected as demand is increasing and no major new production is scheduled to start in the next year.
• Over two-thirds of both production and demand of tin are in China and Indonesia. However, as national production in China does not keep up with demand, international trade is picking up.
• The leading tin producing companies are Yannan Tin (China), PT Timah (Indonesia), Malaysian Smelting Corp. and MinSur (Peru)

Implications:

• None of the diversified international mining houses is active in tin production (as core product). Diversification into this space is unlikely, as tin mining methods are very specific. As efficiency gains could be achieved versus the incumbents, junior niche players are likely to enter the base metal market.
• Peru, Brazil and Bolivia have significant tin reserves, providing a potential for a surge of the tin market in Latin America. Solder, packaging and chemical applications would be the most likely demand source for the market.

©2010 | Wilfred Visser | thebusinessofmining.com

“Owners of dry bulk ships and tankers face sharp falls in profitability after rates for the largest ships at least halved since May on fears about ship oversupply and weak global demand.

The fall-off could revive fears about the finances of the weakest companies, some of which are struggling to finance significant orders of new ships.

The average rates paid to charter Capesize ships – the largest dry bulk carriers – on the short-term spot market have fallen from a peak of $60,000 a day in mid-May to $23,012 on Monday.”

Source: Financial Times, July 6 2010

Observations:

• Shipping costs are typically around 5-15% (Australia on low side vs. Brazil on high side) of the total cost of iron ore for Chinese steel makers.
• Iron ore bulk shipping is mainly contracted in long term agreements with globally operating shipbrokers.

Implications:

• The shipbrokers face very high capital costs and long lead times for their investments. They are fully relying on maximizing utilization of the carriers. As demand drops and capacity utilization decreases, transport price competition intensifies.
• If the demand drop in China leads to a structural overcapacity in the transport industry, this will improve the competitive position of Brazilian and West African iron ore producers in comparison to Australian producers.

©2010 – thebusinessofmining.com

“Japanese trading firm Sumitomo Corp. said Thursday it will pay 1.93 billion dollars to purchase a 30 percent stake in an iron ore mine from major Brazilian steelmaker Usiminas. The investment will boost Sumitomo’s access to iron ore by around 10 times to 10 million tons a year, the company said.

Observations:

• Sumitomo is a Japanese diversified industrial group, which activities include coal and metal mining. However, the firm is mainly active in the trading part of the miner’s value chain.
• Usiminas will most likely use the money to fund the expansion program of the mining complex in Serra Azul. Output should be increased from 7 to 30 mln tons per year.

Implications:

• The deal by Sumitomo demonstrates the increasing vertical integration and involvement by trading firms in the mining industry. Not only western traders (e.g. Glencore, Trafigura) are becoming more active in the upstream markets, but eastern firms try to secure access over resources too.
• Domestic demand in Brazil will increase strongly in the coming decade. The deal positions Sumitomo well to serve the Latin American market.

©2010 – thebusinessofmining.com

“…the company is spending $1.5 billion to create a new, low-cost bauxite mine. The aluminum maker hopes that by spending now it will be able to become a lower-cost producer once the economy finally stabilizes.”

Observations:

• Alcoa has developed a new high-grade bauxite mine in the middle of the Amazon rain forest. The development cost approx. $1.5 bln.
• Due to a 60% decrease in aluminium prices, net income of Alcoa has been negative for the past 2 fiscal years. However, the company has managed relatively well to bring operating costs down.

Implications:

• Vale recently sold its Brazilian aluminum operations to Norsk Hydro because of the high risk associated with energy price volatility. Alcoa will have to prevent being hit by high energy prices or black-outs by executing the energy-intensive aluminum production process in other parts of the world.
• Alcoa’s CEO Kleinfeld chooses to invest anti-cyclical, contrary to what many competitors are doing. If the balance sheet allows so, this is generally seen as a good strategy to capture market share. However, Alcoa has only some $1.5 bln in cash, which will make it hard for the company to continue the high level of investment.

©2010 – thebusinessofmining.com