Brazilian mining sector braces for downturn

The February 12 announcement that Aluminum Corp of China was set to invest $19.5 billion to get access to some of the best iron ore and copper assets of Rio Tinto, highlighted the perils facing indebted mining companies, now facing insufficient cash flow to cover interest payments. Rio Tinto had been desperately seeking to divest assets, shelving a more than $2bn mining investment in Brazil.

Frenzied start-up activity and rumours of new projects til mid-2008 have been replaced by talk of project delays, sales and lay-offs in Brazil. The steel industry, too, has been hammered by huge drops in car manufacturing. Who will survive in this brutal environment and will it be conducive to consolidation?

Mining sector slump sparks M&A speculation

After a period of relentless mergers and acquisitions (M&A) activity and tales of bigger deals to come, the puff has gone out of miners’ bellows worldwide. The 85% price increases achieved in long-term iron ore contracts with the Chinese last year helped catalyse a number of new deals at prices that raised eyebrows even then. The latest rumours suggest that the Chinese are looking for 40% reductions from iron ore suppliers this year and that any conclusion to talks is likely to be protracted with the upper hand firmly with buyers.

The drop in global demand for iron ore has hit big mining countries from Australia to Brazil hard. In recent months, things have got worse still, thanks to ever-more depressed steel prices, and the desire by miners to hoard cash. That has dampened appetite for planned developments. Rio Tinto postponed a $2.15bn development of a mine in Corumbá in Brazil for the foreseeable future in January and has announced it is cutting 14,000 jobs.

That is a sign of tougher times to come. A large number of projects, even at companies with significant cash, have already been put on the back burner, including ground-breaking deals that would have helped integrate the steel and mining sectors. In mid-January, Brazil’s Companhia Vale Rio Doce SA (Vale) announced that it was cancelling plans to build a steel-slab plant with China’s Baosteel Group Corp, thanks in part to the global recession. The company also blamed difficulty in obtaining environmental permits, now a common explanation for delaying projects in Brazil. It is difficult to evaluate the truth of the explanation as cumbersome laws and bureaucratic decision-making have slowed project roll-outs for years.

A slew of newcomers that paid top dollar for assets are no longer keen to develop them in the current economic environment. Anglo American paid $5.5bn for 51% of a complex of mining assets in the south-east of Brazil, the Minas-Rio complex, and 70% of MMX Amapá, in the far north of the country. Many analysts said even then the deal over-valued the assets, although Anglo American insisted that it made sense. Since then, its shares have slid by more than 60%.

In November, the mining giant announced that it would delay developing Minas-Rio iron ore mine as it had not obtained a local environmental permit, insisting that its reasons were not commercial. Anglo American also acknowledged “significant” delays in reaching full capacity at its Amapá iron-ore mine, which will come on stream at the end of this year, representing a full year’s delay.

Acquisitive Brazilian miner MMX, which had been vocal in its desire to expand its footprint, has fallen remarkably quiet too. Instead, the company has been accelerating payments on recent acquisitions, obtaining discounts of 11.7% on the final price to buy iron ore producer AVG by anticipating instalments that had been slated to run over one and a half years and closed a similar deal for the Bom Sucesso deposit.

The emphasis today is on maintaining cash and postponing what can reasonably be delayed. Companies are going to need to work to break even in this environment, says Carol Cowen, mining analyst at Moody’s in New York.

Deal Stimulus

The question analysts are asking is whether cash-rich mining companies will look to keep spending to a minimum or use the opportunity to pick up competitors cheaply.

Cowen sits firmly among those who expect M&A activity to slow considerably. Mining companies simply don’t have transparency on prices going forward, she argues. Prices for metals are extremely low, it’s difficult to see a recovery and, with so much uncertainty, it’s very difficult to value mining entities.

The negotiations between the Chinese and their suppliers over iron ore prices could be more protracted than usual and unfold over months, she says. “Everything is so uncertain and steel demand is dead in the water. We won’t get much transparency until we have stability in financial markets and credit markets that are more open.” That should further deter merger and acquisition activity as it’s difficult to value mining entities with so little predictability of forward pricing.

Others believe that for a bold company this year could be the perfect time to pounce on a target. Roger Downey, metals and mining analyst at Credit Suisse in São Paulo, believes that because shares have been so pummelled, conditions may soon be in place for further M&A activity at more reasonable prices. If you have the opportunity today, it’s cheaper to buy than to build up, says Downey. He predicts that those mining companies that have the funds will look to acquire. That will heat up the market for M&A with a number of deals possible this year, he says.

The best positioned companies are those that have strong cash positions and the size and clout to continue making investments, Downey believes. Sellers and those with tight cash positions will naturally be the laggards.

Size and cash position help to explain much of the discrepancy in share price performance in Brazil. Shares in giant Vale were down 40.1% over 12 months to January 19, which may seem a miserable performance, but smaller, less well capitalised rivals have done worse. MMX was down a frightening 78.2% over the same period, for example.

For now, Vale is eschewing grandiose plans. The company announced in October that it would spend $14.2bn this year to support existing operations and expand research and development. Managers went out of their way to scotch talk that they would use Vale’s enviable cash position to snap up a weaker rival, saying organic expansion was the clear priority. Vale is in the enviable position of having $12.2bn in cash thanks to a recent issue of shares, long-term credit lines of $10bn provided by government institutions as well as $1.9bn in medium-term debt plus an investment grade rating.

That cash hoard should help the company’s finances hold up despite the negative outlook for the industry, says Cowen. The weak outlook doesn’t necessarily translate to a bad outlook for the ratings, particularly as Vale has a footprint across different metals, she adds.

Rumours that the firm would buy Xstrata, the Anglo-Swiss giant, that were doing the rounds last year, should not be dismissed in this new environment, Downey believes. Although Vale already has interesting projects in Australia, Africa and Latin America to develop, especially in coal and copper, and might need additional financing to take over Xstrata, the attractive valuation of Xstrata means that it still represents an interesting target, he says. The share price of Xstrata is down over 79% over the 12 months to January 20. Meanwhile, the company has continued to carry out smaller acquisitions, including assets of Cemento Argos in Colombia.

Vale faces constraints in its ability to spend cash on foreign assets at a time when it is shrinking at home. As a state-owned entity, it is particularly constrained from making staff cuts and this could prove a ball-and-chain as the global economy worsens. The firm was in the dog-house with the government when it announced a total of 1,300 job losses last November.

When Vale President Roger Agnelli tested the waters with the idea of temporary lay-offs, with workers keeping a connection to the company but receiving temporary aid from the government, he met with a strong rebuff from President Luiz Inácio Lula da Silva. Lula suggested that companies that had made sizeable profits in the boom years should use that cash as a cushion for their workers now. Vale rushed out a splashy media campaign to show that it had ended 2008 with 5,000 more workers (62,000) than it started the year, trumpeting the extra hires through full-page announcements in the national press. Political pressure on state-owned companies to retain workers will no doubt intensify as other companies in industries affected by the recession step up lay-offs.

Vale has two longer-term disadvantages that might make it harder for the miner to raise money even if bond markets return. Vale is determined to hang on to its investment grade rating, which means that raising significant sums of money through debt markets needs to be undertaken with care. It could also raise money through non-voting shares but that might put it into conflict with the Novo Mercado market and its rules on tag-along rights.

If Vale is a predator, MMX, the mining company of prolific entrepreneur Eike Batista, is an interesting target for international mining companies. Batista has repeatedly divested assets, albeit usually at a large profit, points out Downey. Although the share price is depressed, the company has said that it will continue to push ahead with plans to develop mines and should make some $165m in earnings before interest, tax, depreciation and amortisation (EBITDA) this year and double that next year. Furthermore, MMX has strong infrastructure, good resources and projects and a strong management team, he says. “MMX is top of the list and one of the most attractive operations today for steel mills looking for iron ore assets,” Downey believes.

At a time when investors are putting particular emphasis on transparency and understanding future plans, Brazil’s Companhia Siderúrgica Nacional (CSN), the steel company with iron ore and other mining assets, has been the hardest of all to read in terms of its future strategy. Its structure is made more complex thanks to its wide range of interests.

CSN successfully divested part of its huge mine Casa de Pedra late last year when it agreed to sell a 40% stake in Nacional Minerios to a group of Asian companies for $3.12bn. It was a deal that raised eyebrows at the time thanks to the high price paid at a time of rapidly-declining forecasts for the sector. CSN announced later that it would seek to bring the unit’s sales up to 39m tonnes in 2015 from 18.2m this year with a $2bn investment.

CSN may also look at a hot rolling plant in the United States, where it already owns a cold rolling plant, to fill in a missing piece of its jigsaw, says Downey. Other options include a purchase in Europe, he adds.

CSN is unusual in its appetite for developing mining assets at a time when the logic behind much-vaunted plans to develop vertically integrated coal-steel companies has been removed thanks to weak prices in both industries, posing a double whammy threat.

The steel sector, which was booming on the back of buoyant demand for cars and access to cheap iron ore, has gone into a funk. Miners are praying that the Chinese construction industry maintains some strength and that the global automobile industry does not fall any further.

Until the last months of last year, Brazil had been relatively strong in car sales, offering some protection for its local car makers. However, industrial production figures announced at the end of the year showed just how rapidly the economy is sliding downhill. Production fell 5.2% month-over-month in November after a 2.8% fall in October. Worse still, two of the leading lights of the economy last year, automobile and machine production, were down a whopping 22.6% and 11.9%, respectively.

Cowen is pessimistic about the sector and has a negative outlook for base metal prices. She reasons that any recovery will be extremely slow. Downey is more optimistic. Although iron ore fell from $180 per tonne to $60, it has gradually inched back up to about $80, he points out. Furthermore, an unusual gap has opened up between the spot and contract market with the implied price of contract iron ore trading at a large discount to spot prices, even though the former is better quality and guaranteed supply. That would suggest prices should firm from here, reasons Downey.

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