Brazil Mining: Into the Pits

Large Brazilian metal producers are well capitalized and scouting opportunity. Incremental, opportunistic asset purchases by deep-pocketed firms look likely.

Vale’s decision at the end of January to unleash $1.6 billion in acquisitions of Rio Tinto assets – including $750 million for an iron ore pit and associated logistics in Brazil and $850 for Argentine potash assets – could typify the kind of M&A deal that gets done this year. The firm paid with cash from reserves – it raised $12.2 billion last year with equity and credit lines through commercial and state-owned banks – and the potash deal suggests a willingness to consider asset types opportunistically.

As commodity prices trend lower, bankers expect M&A to be selective, opportunistic and smaller in size. Cash rich companies will pick off assets from indebted ones. But bankers disagree about first half volume.

José Olympio, head of investment banking at Credit Suisse in São Paulo, believes that flow will continue and points to the successful conclusion of CSN’s Namisa deal in the teeth of the downturn. The steel and iron ore conglomerate finalized the sale of a 40% stake in integrated iron ore complex Namisa to a consortium of Japanese companies last October.

The $3.12 billion sale valued the entire complex at $7.8 billion, implying a far greater value for CSN than its market capitalization would have suggested. “That deal took place in the midst of all the uncertainties and suggests that other deals can get done at attractive valuations. I don’t believe that this was a one-off,” Olympio says. He cautions, however, that most transactions will not be of the same caliber as Namisa nor deals seen in the boom years of 2006-07. “We’re not talking about large commitments of money. Investments will be of the magnitude of up to $1 billion,” he concludes.

Poor Visibility, Smaller Size
João Roberto Teixeira, executive VP at Banco Santander, reckons the dust will have to settle on price negotiations for iron ore, which start in February and usually conclude in March or April, before firms venture too far. He points to difficulties in making operational forecasts: analysts and bankers have wildly differing predictions for contract negotiations that suggest a drop of 20%-40% in prices versus 2008.

Companies are re-assessing the world and will delay plans for the next 3-6 months, agrees Jean-Marc Etlin, executive vice president at Banco Itaú BBA in São Paulo. In every downturn, you see a lag before people re-adjust valuation expectations, he adds.

But bankers remain sanguine about prospects for deals on a 12-month horizon. “We will see a large number of small transactions this year,” focused on piecemeal takeovers of assets, mines and projects, predicts Teixeira.

Others are more pessimistic. Carol Cowen, VP and senior credit officer at Moody’s in New York, expects little M&A. Prices of iron ore are extremely low and it is difficult to see when recovery may come. She adds that valuation will be challenging. “Companies are going to need to work hard just to break even,” she believes. That makes finding money for deals difficult, she adds.

Iron ore prices will be key for larger Brazilian acquirers and divestors. Roger Downey, metals and mining analyst at Credit Suisse in São Paulo, notes that having hit bottom at $60 in China from a peak of $140 per ton in May-June last year, iron ore has gradually inched back up. Spot prices were just under $85 mid-February. Downey talk of price drops of 20%-40% as overdone and believes that a 10% discount from last year’s contract level is more realistic.

Output Slumps
If ore prices do stabilize, it will happen too late to stop Rio Tinto exiting its Corumbá mine and a slew of projects from being mothballed. For the first time since 1999, Vale’s production fell last year, albeit by just 0.5%. But the last quarter of 2008 was much more dramatic: Vale produced 63.3 million metric tons of iron ore in that quarter, down 26.3% from the previous quarter, marking a 21% year-on-year drop.

Vale laid off 1,300 employees in November and December and gave collective vacations to another 5,000, incurring the wrath of unions in Minas Gerais. The company needs to tread very carefully in closing down production with the consequent loss of jobs, say analysts, pointing out that government-linked Brazilian pension funds and investors control Vale through Valepar. The firm has already been slapped on the wrist by the government for suggesting the latter could provide benefits for temporary lay-offs.

“Vale completely mismanaged the communications of its layoffs. It made a big, very public announcement right in the middle of the crisis,” says a senior banker. That could make it politically disastrous for the firm to make an expensive overseas acquisition at the same time as it lets go of workers, agrees another. Vale declines to comment.

Anglo American, which paid MMX $5.5 billion for Minas-Rio and Amapá, has meanwhile seen slippage. Its two Brazilian projects are “progressing, albeit on adjusted timetables,” the firm acknowledges. The Minas-Rio iron ore project is expected to begin production in late 2011 or early 2012, a delay of one year.

Anglo was very late to jump in to acquisitions in Brazil and now it may be wondering if this is the right time to expand mines anyway, says a senior investment banker. “They overplayed their hand completely. They were looking for a price rise for iron ore from the Chinese as late as July,” he adds.

Others suggest that miners are keeping mum about planned expansions. “It may represent a negotiating tactic. It’s the middle of price negotiations and miners don’t want to send a signal that capacity is going to expand,” argues another senior banker based in São Paulo.

Steel Saviours
With miners proving cautious, steel companies will be looking to capture iron ore assets and achieve a more vertically-integrated structure, adding some puff to the M&A bellows, bankers agree. “Steel makers realized in the last cycle that they were in the pockets of iron ore companies,” says Olympio. The steel industry is intent on upward integration to secure supply, agrees Downey.

CSN has enjoyed a significant competitive advantage for years thanks to its giant Casa de Pedras iron ore mine, while Usiminas relies on Vale iron ore, Olympio says. The desire to break this dependence led Usiminas to conclude a deal to buy J Mendes, Somisa Siderurgica Oeste de Minas and Global Mineração for $925 million in 2008, giving it immediate access to five million tons in iron ore production. The firm plans to step up production to 29 million tons by 2013.

Steelmakers, particularly Asian ones, watched with interest. They were angry with Vale for what they saw as unnecessarily elevated price rises over the previous two years, often done at the last minute, according to a São Paulo-based mining banker, who declines to be identified. ArcelorMittal bought London Mining South America for $764 million and took on $46 million of debt for its iron ore reserves, points out Olympio. Still, there are few mid-sized companies with large reserves left to buy, analysts agree.

There have been wobbles too, including the decision by Vale and Chinese steelmaker Baosteel to cancel plans to build a steel-slab plant together. The firms blamed difficulty in obtaining environmental permits for putting the kibosh on Siderurgica Vitoria, a joint venture to build a $3.6 billion mill to produce five million metric tons of slabs annually. The recession was also a key factor, say analysts.

Iron Ore Consolidation?
Steel players must prepare for competition from miners, will selectively add assets. Companies with competitive advantages in costs and logistics will look to buy from companies that need to deleverage, says Teixeira.

The ideal targets are firms that have interesting resources but lack funds to develop them. They include smaller mines in Bahia, northern Minas and Ceará state that have the potential to produce 10-20 million tons per year each, according to a mining banker.

There is little consensus on tactics of key individual firms, however, such as the rump of MMX and whether it will be sold or built up. Since the sale of the Rio-Minas complex and Amapá to Anglo American, the firm is left with relatively small assets in Corumbá and the Southeast, which may encourage an exit, says a senior investment banker in São Paulo.

MMX will generate $165 million in Ebitda this year and double that in 2010, predicts Downey. Management plans to develop assets to build a 40 million ton per year iron ore business, he says. MMX produced 4.3 million tons from its Southeast operations last year and does not provide a figure for Corumbá, but states that the plan is to produce 6.3 million tons per year. Downey says a sale is possible as the firm has attractive mine and logistics, and has in Eike Batista an entrepreneurial owner.

Gauging CSN’s strategy in the wake of the sale of Namisa is extremely tough, say bankers. It is in a very comfortable financial position, has fantastic assets and owner Benjamin Steinbruch is a prolific deal-maker, says a senior São Paulo-based investment banker. But managers there are concerned about steel demand, which continues to slide, he says.

CSN still lacks a hot rolling mill in the US, a missing link in the flow sheet. But it is more likely that CSN will be cautious on steel and willing to look at new opportunities as they arise. CSN did not return calls.

And until the Corumbá acquisition, Vale had been ignoring smaller opportunities in iron ore. Rumors that it may finally swallow heavily-indebted Anglo Swiss miner Xstrata continue. The market capitalization of Xstrata is down at a manageable $10 billion from a peak of some $62 billion in May last year, making a deal more affordable. A transformational acquisition by Vale is always under discussion, thinks Downey.

The official message – the company says it is focusing on organic growth and will look at acquisitions opportunistically – is designed to make shareholders at ease that Vale is focusing on existing competitive projects. But the firm is still considering all options, says Downey. Still, the decision by BHP Billiton not to press ahead with a takeover of Rio Tinto has alleviated some pressure on Vale to respond.

One São Paulo-based senior investment banker sees an Xstrata deal as a remote possibility. After all, Vale does not need to buy more iron ore assets as it is developing the extensive southern system of its giant Carajás mine. More likely, Vale is likely to look overseas at individual projects. It is already working in coal mines in Mozambique, Australia and Colombia and has the world’s largest nickel reserves. It is interested in copper and will pay particular attention to Africa, LatAm and Australia, notes the banker.

Brazilian companies are sitting pretty compared to international peers: they are well capitalized and have access to iron ore at low costs and efficient logistics, adds Teixeira. Opportunities will abound as many overseas companies ran up significant amounts of debt that need to be refinanced and might be looking to divest assets, adds another banker.

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