CVRD (Companhia Vale do Rio Doce) is facing a rapid transformation as a booming steel industry is leaving it flush with cash. Until now, it has remained highly dependent on iron ore mined in Brazil for its profitability. But the company is using the tailwind of high prices to ramp up its international expansion programme. It has a lot to play for. If the move is successful, the Brazilian giant might boost its credit ratings, broaden its appeal to investors, ensure a less cyclical future and launch it as one of those rare things: a truly global player from a low cost, developing country. If its programme falters, it will remain a domestic giant and a strong exporter, but remain highly dependent on its turbulent home country for raw materials and at the whim of the unpredictable steel market.
In one crucial way, CVRD is highly global. Only 27% of its revenues are derived from Brazil. Its main rivals, Australians BHP Billiton and Rio Tinto, have a far more domestic customer bent: BHP sources just over 40% of its EBIT from Australia and Rio Tinto more than 60% from Australia and New Zealand. But with its Rio de Janeiro headquarters, state-owned past and focus on extraction in Brazils Minas Gerais state, CVRD remains in many ways resolutely Brazilian. It is also very dependent on iron ore with some 80% of its business derived from iron mines in Brazil.
CVRD has lower geographic and product diversification and financial flexibility relative to some of its global diversified mining peers, laments Reginaldo Takara, the São Paulo-based analyst for Standard & Poors. BHP is an industry leader not only in iron ore but in aluminium, coal, copper, manganese, uranium, nickel, silver and titanium minerals, and has substantial interests in oil, gas, liquefied natural gas and diamonds. Rio Tinto mines for aluminium, copper, diamonds, energy products, gold, industrial minerals and iron ore. Both mine in many countries.
The Brazilian firm is working hard to change its spots, by diversifying its sources of extraction and the minerals it takes out in order to close the gap on its rivals. To get there, CVRD has set up the Mineral Project Development Department in Santa Luzia, Minas Gerais. The dedicated team there is responsible for areas such as mineral prospecting, technological development and creating new mineral projects. It is moving the company into areas such as copper, coal, gold and nickel and exploring opportunities on an opportunistic basis across the world.
Roger Downey, mining analyst at Credit Suisse in São Paulo, sees the team as professionally managed. It is rigorous in checking the fundamentals of each project before it goes in to develop them, he says. He believes the expansion is being undertaken at a sensible pace. Generally its modus operandi is to dip its toe in the water by working on a number of projects at the same time, approaching each with some caution. Often the company ties up with a local expert and commits itself to just the pre-feasibility study with an option for later commitment if all goes well. This has been the case in its first ventures in Australia. It has started mineral exploration in the Belvedere project there with Aquila Resources Ltd. and AMCI Holdings Australia. It will put in an initial $5 million commitment with the option to acquire an interest for $90 million.
The firm has also invested in a potassium project in Argentina, with a commitment to
spend $15 million over 24 months, is involved in phosphate exploration in Peru, and has projects in China, Venezuela, Gabon, Angola and Chile.
Typically, when it gets serious on a new prospect, it opens an office in the relevant country so that it has an on-the-ground presence. Recently, it opened up in Ulaanbaatar, Mongolia where it will focus on exploration for copper, gold and coal and in Brisbane because of a number of interests in the Australian market. These projects will certainly help it to become more international. Still, most projects have remained small beer and if CVRD wants to catch up with its two rivals, it has to think bigger.
Putting Together Deals
Two recent jumbo projects suggest that this is exactly what it is doing and give vital clues to its future direction.
The first is in Mozambique where CVRD won the international bidding to explore coal deposits in the Moatize region. It won against stiff competition that included a bid by arch-rival BHP Billiton. CVRDs victory is all the more prized as the company has next to no experience of developing coal fields and BHP is one of the worlds largest players. The winning bid was $122.8 million (it has a partner in American Metals and Coal International, but that firm has just a 5% stake) with an eye-watering $1 billion of investments likely to be needed. The project also gives CVRD access to what is likely to prove the largest unexplored coal province in the world with an estimated 2.4 billion tons of reserves. As the company proudly states, the project is a milestone in its initiative to enter the coal business. It fits in well with the existing portfolio, enabling it to supply to the Brazilian steel industry.
The successful bid is likely to encourage CVRD to look at other projects in the developing world. That focus could be an advantage. After all, as Downey explains, most of the resources in the developed world have been mapped and exploited. Those that havent are typically in no go zones: beneath cities or places like Yellowstone National Park. Emerging markets have many of the characteristics with which CVRD is familiar. It is an expert in transportation logistics with extensive net of railways, ports and maritime terminals in Brazil. This expertise will prove invaluable in developing its Mozambique project. It is also used to negotiating bureaucracies, especially with its history as a state-owned company, and is familiar with the political risk and financing complications that bedevil companies headquartered in the developing world face.
Of course, Mozambique is not only an emerging market but a lusophone country and that is likely to have helped CVRD win the bid and indicates that CVRD is likely to be especially successful in other Portuguese-speaking nations, such as mineral-rich Angola. Still, projects in emerging markets are more prone to difficulties that include everything from mapping and exploration through transportation via unstable politics. Mozambique only emerged from a civil war in 1992.
The other major project is very different in two key ways. Last years purchase of Canico of Canada sees CVRD acquire a company in a developed market with an existing portfolio. CVRD paid C$940 million for the acquisition of Canico and its development will demand investments of US$1.1 billion. To secure the company, CVRD had to sweeten its initial offer by 19%, to C$20.80 from C$17.50, representing a premium of approximately 53% over the share price after its initial bid was rejected by the board. Canico is developing the Onça Puma nickel laterite project in Pará, Brazil with the capacity eventually to produce 57,000 tons of nickel per year with production slated to start up in 2008. But although it gives CVRD a developed market partner, the acquisition doesnt do much for geographical diversification as the mine is located slap bang next to one of CVRDs own projects. At the conclusion of the deal, CVRDs share price hardly moved, turning up by under a quarter of a percent. That may mean that CVRD overpaid for the acquisition.
The China Factor
Even if it did overpay for the Canadian deal, given the current good times that iron ore extractors are enjoying because of the steel boom, CVRDs spending spree is certainly not going to break the bank. The companys fundamentals could hardly look rosier, at least for now. Traditionally steel has been viewed as highly cyclical, the classic boom-bust industry where price rises in commodities or economic slow-downs choked off growth and led to a rapid collapse in iron ore prices. That dynamic has changed because demand from East Asia and especially China is driving a fundamental re-assessment. Global production rose by nearly 6% last year with production in China increasing by a whisker under 25%, making it responsible for over 30% of world production.
Given the speed of Chinas growth, analysts are scrambling to re-evaluate the dynamics of the market. In 2005, many were predicting a significant cool down in the price rises of iron ore. Thats not the case any more. Goldman Sachs January 10 report on iron ore prices typifies this change of heart. We have revised our 2006 iron ore price forecast to an 18% increase for 2006 from our previous 10% increase due to strong iron ore import trends in China, tight market conditions CVRD has seen no sign of weakness in iron ore demand despite press articles suggesting a slowdown in Asian steel production. Furthermore, CVRD has 100 years of iron ore reserves and Downey points out that mining companies dont usually bother to invest in further drilling to prove up resources they will only use in the distant future shareholders arent particularly interested in time periods longer than that. Better still, the giant domestic mines provide high quality iron ore at a very low cost.
These boom times have led to an amazingly rapid improvement in CVRDs fundamentals. The figures speak for themselves. CVRDs share price has risen at an annual average rate of more than 31% in US dollar terms over the last four years. Cash generation leapt from $1.78 billion in 2002 to $5.8 billion in the 12 months to the last quarter of 2005. The company has been generating cash at a rate that even its voracious appetite for capital spending cant keep pace with. Its capital expenditures rose from $4.3 billion in 2002 to $8.5 billion in 2004.
For now, the acquisition programme seems the way to go for a company that is rapidly generating more cash and whose customers cant get enough of its product. And yet although the price of steel is riding high and iron ore miners cant meet demand, there is a significant risk that the good times will not last. There are any number of plausible scenarios for a downturn for the bubbling steel industry. Chinas authoritarian government may decide to slow the supply of steel and it already seems intent on concentrating capacity in larger players. And although Chinese demand is huge, sales to Europe, which account for some 30% of CVRDs iron ore shipments are growing only marginally, while sales to the US and Japan have actually fallen. The market may prove to be as fickle and cyclical as it has in the past. If China suffers a government-led or market-driven downturn, the rest of the world will be in no position to mop up all the steel coming to market. And the steel industry is consolidating globally with moves afoot by the biggest players to vertically integrate in order to reduce dependence on the three big iron ore miners. Indeed, Goldman Sachs predictions for 2007 are for a fall in iron ore prices. The firm sees a 10% price decrease in 2007 alone.
Furthermore, although its location in an emerging market may give it a more sympathetic hearing in bids in other developing countries, CVRD suffers from all the typical disadvantages associated with being in an emerging market. As Takara puts it, the Brazilian location subjects CVRD to Brazilian risks including regulatory risk, tax risk, currency appreciation risk, domestic economic conditions and exchange control risk, including export repatriation schemes. That holds down its rating, even though it has leapfrogged the speculative grade of the Federal Republic of Brazil. CVRD is rated BBB by Standard & Poors whereas BHP and Rio Tinto both have an A+ long-term rating.
CVRDs laudable plan to diversify further away from iron ore will take years to mature and for now the company remains highly dependent on the mineral for its profitability. But the early signs are relatively encouraging. The firm has won a significant bid in Mozambique which will see it gain experience in coal and is starting to make inroads in the mining of a host of other metals. With its low cost base and deep reserves of iron ore, BHP and Rio Tinto are likely to have a good run for their money.