Joel Smolen is the Managing General Partner of the Axion Opportunity Fund. Joel previously founded and was CEO of Applied Molecular Technology Corporation, which was sold to European metals company Boliden AB. Prior to that, he was founder and CEO of MicroMetallics Corporation, which was sold to Xstrata PLC, an international mining and metals company. Joel was also Senior Vice President of LMC Corporation, now part of Sims Metal Management (SMS), a worldwide ferrous and non ferrous metals company.
Axion Opportunity Fund has been ranked number one in the Equity Long / Short Opportunistic classification by BarclayHedge, based on compound annual return over the one, three and five year intervals and life of the fund.
We recently had the opportunity to ask Joel about his current highest conviction holding in his fund.
Joel, to start please tell us a bit about your fund and what it holds.
I established Axion Capital Management and Axion Opportunity Fund in 2001. The Axion Opportunity Fund, LP is an absolute return fund that seeks to deliver superior returns over the mid- to long-term through opportunistic investment strategies. In the last two years we have concentrated our focus on the emerging markets, energy, commodities and technology spaces.
We have added to our energy related holdings, particularly oil, during periods of weakness and plan to do so in the future. We also continue to build our commodity positions in base materials and other commodities. In Q3 and Q4 of 2009 we added soft commodity positions to our portfolio.
What is your highest conviction stock position in the fund currently - long or short?
While we hold all of our positions with a high degree of conviction, one of those stocks in our fund is the Brazilian mining company, Vale (VALE). We have a 12 month ADR share price target of $42, which at the time of this interview would imply a gain of more than 30% over the current price. In addition, we own call options on the stock.
Vale is the largest diversified mining company in the Americas and the second largest metals and mining company in the world, with a presence in 30 countries and a market capitalization of around $150 billion. It is also the largest producer and exporter of iron ore and pellets, which comprises around 70% of gross revenue but over 90% of its EBITDA. The remaining nonferrous division, primarily nickel, copper, potash, coal and aluminum products account for roughly 8-10% of the remaining EBITDA.
Vale is also the largest logistics company in Brazil. Due to the frequent remoteness of mines and energy intensive nature of mining, Vale has invested in hydroelectric dam projects such as the Belo Monte hydroelectric dam project. In total, Vale owns stakes in eight hydro dams in Brazil and Indonesia with roughly 2,500 total megawatt capacities. The company also owns its own transportation networks, ports and processing plants and is strategically growing this side of the business in ways that provide for a very compelling growth story.
Can you talk a bit about the sector? And to what extent is Vale an industry pick as opposed to a pure bottom-up pick?
The iron ore mining market is worth about $200 billion a year, second only to crude oil. We are very optimistic about the mining sector over the next few years. In our view, global demand for mineral and metal commodities have begun a new growth cycle fueled by the nascent recovery of the developed economies and the resumption of high growth rates in the emerging economies, namely China.
We believe China will continue to be a significant demand driver for iron ore for the foreseeable future. In addition, demand is coming online in South East Asia and the Middle East. As a result, we are seeing a tighter than previously estimated iron ore market. The strong demand coupled with limited supply is reflected in the rapidly rising iron ore spot prices which have shot up from $82 in September to the current price of $138 per ton, which represents a jump of nearly 70% in six months.
In tandem with increased demand, I think a significant value driver for the industry will come in the form of the upward adjustment in the pricing mechanism for iron ore. While negotiations continue to develop, I think we could see a resetting of the benchmark price to as much as 60% or more in 2010, versus previous estimates in the 20-30% range.
Our decision to add Vale as one of our core holdings is a reflection on how we tend to invest. In general our fund tends to spend a great deal of time processing information, developing a thesis and then building our positions accordingly. This is precisely what happened in the case of Vale. While I have experience in commodities and metals in particular, we still looked closely at the industry as a whole before we identified some unique and compelling characteristics in the company that we felt would benefit most from the emerging growth story. In many respects it is an organic global-macro, top down approach. We feel this approach has allowed us to stay nimble and opportunistically pick our spots where we can generate the most value for our investors.
How is Vale currently positioned vis a vis its competitors?
Vale is the largest iron ore mining company in the world and competes primarily with Australian based Rio Tinto (RTP) and BHP Billiton (BHP) as well as a diverse universe of regional providers. Vale currently owns nearly 33% of the seaborne iron ore market compared to Rio Tinto’s market share of around 19% and BHP’s share of 17%. The remainder of the market is divided among smaller market participants. Vale also produces some of the highest quality iron ore with iron content up to 67% giving it premium pricing power.
While Vale enjoys the dominant role of iron ore producer, it is disadvantaged by structural market challenges that are not easily overcome. Namely, Vale’s shipping time to its largest customer is on average 45 days or three times longer than Rio Tinto and BHP. Greater transit distances naturally translate into higher freight costs and increased risk exposure to transport price volatility and a generally greater risk profile in terms of weather, event risk, etc.
Having said that, as I alluded to earlier one of the most exciting things about Vale has been the strategic thinking behind the company’s growth plan which we feel will allow it to build market share and reduce variability to its cost structure.
Vale expects to increase iron ore production capacity by 50% from 300 mtpy to 450 mtpy by 2014. Much of these gains are likely to come from the Carajas complex which, because of previous logistical investments, has lowered the production cost of high quality iron ore. This should have a constructive expansion of margins.
In addition, Vale is embarking on a strategy to reduce its dependency on the maritime freight spot market by extending its transport fleet of ore carriers. Currently, the Vale fleet consists of 18 Capesize vessels with a capacity of 150,000 tons each for a total haul capacity of 2,700,000 tons. The company has recently ordered 12 VLOCs (Very Large Ore Carriers) which can each carry 400,000 tons each, more than doubling the company’s previous haul capacity. It also has an option to add an additional 6 VLOCs for another 2,400,000 ton of haul capacity.
To handle the massive carriers, the Chinese port at Qingdao will build three 400,000-tonnage terminals for the unloading of Vale’s iron ore. The first project is slated for completion by the end of 2010. Vale will also make use of long-term freight contracts which when combined with larger ore carriers, should minimize some of the structural transit advantages enjoyed by Rio Tinto an BHP Billiton.
One can make strategic adjustments with ore carriers and freight contracts, but it doesn’t change the fact that relative to its main competitors it has an extended distribution channel. It still takes Vale’s iron ore on average 45 days to travel from Brazil to Chinese ports and by contrast, it only takes around 15 days on average for iron ore to travel from Australia to China.
To minimize these disadvantages, Vale has embarked on a thoughtful strategic plan that effectively shortens the distribution channel for end users while growing market share organically and gaining greater access to smaller regional markets. The company is acquiring land in strategic forward locations closer to the end users and developing massive regional storage and distribution and pelletizing facilities. These facilities will have the potential to produce various blends to meet the specific needs of each client.
For example, the Malaysian facility will be capable of handling 30 mtpy with an expandable capacity of 90 mtpy. Like Qingdao, Malaysia will be able to handle the extra large ore carriers. This facility will cut transit time to China to around 15 days, enabling the company to supply its clients more promptly and will be comparable to that of its main competitors. In addition, it should have a positive impact on the company’s variable cost structure. A similar facility in Oman will serve the Middle East and North Africa.
Not only does this distribution strategy improve their position relative to the Australian companies in selling to China, but it also opens up new opportunities to sell directly to smaller regional buyers in the Middle East and South East Asia. These new distribution channels effectively cut out the middle men and provide a point of differentiation.
In summation, we believe that Vale is very well positioned to grow their existing market share organically over the coming years while reducing variable costs and opening new markets. This is a long term, game-changing strategy.
What are your thoughts on Vale's stock valuation?
In our view, equity prices have not fully discounted future industry earnings growth. We believe that the market has mispriced the multiple it should be willing to pay for an industry leading blue chip growth story that is well positioned at the beginning of a significant growth cycle. Vale has strong fundamentals in a tight iron ore market environment and a solid balance sheet. As a result, we believe that the divergence between commodity forecasts and company valuation makes this an attractive opportunity.
We think there are a number of key drivers supporting the current valuation. Our underlying thesis is that manufacturing is gradually turning positive and strengthening in the U.S. and Europe, which is being reflected in the month over month trend in the ISM manufacturing reports. We also think the long trend of economic growth will continue in emerging markets, specifically China, which is good news for Vale.
We believe we are going to see a significant adjustment up in the pricing mechanism. As negotiations continue, momentum is growing for a significant upward price adjustment in the benchmark. The only question is the size of the increase. But we are also seeing an increasing segment of the market exposed to much higher spot prices. As a result, feel there a number of value drivers which will provide ongoing opportunities for multiple expansion and believe Vale is reasonably priced and inline with its competitors.
What is the current sentiment on the stock? How does your view differ from the consensus?
The consensus is nearly universally positive regarding the growth of demand for iron ore going forward and the upward trend in iron ore pricing. The points of divergence tend to focus on issues of demand sustainability coming out of China and how to address revisions to the iron ore pricing mechanism.
Between 45-55% of Vale’s total iron ore and pellet sales are related to China. China is the principal buyer of iron ore and drives global demand so we tend to follow the country very closely. While there has been a lot of discussion about China’s tightening credit market, we feel this has been somewhat overstated.
Clearly there are growing concerns that the Chinese economy is heating up and stoking inflation concerns. We also recognize that a general weakening of bank loan portfolios through a rise in nonperforming loan (NPL) rates would tend to point toward tighter credit availability. However, at this juncture we believe what is occurring relative to the steel producers, is a greater focus on risk management but not a significant reduction in loan availability. I believe this view is supported, in part by the fact that many of the smaller, less efficient steel producers are being shuttered.
Vale’s customers are typically associated with the larger industrial companies known as SOEs (State Owned Enterprises). In toto, SOEs contribute somewhere around 30% to aggregate GDP but are the recipients of over 60% of all loans. For many reasons both economic and political, we feel the large steel producers will continue to have access to credit which should be positive for iron ore demand.
Besides credit availability, we also expect to see the Chinese economy continue to lead the global recovery with GDP growth with consensus estimates in the 8-9% range. Lastly, the government is likely to continue to make significant infrastructure investments. When taken together, we feel these trends are bullish for Chinese demand and is sustainable over the near to intermediate term and likely beyond.
The other point of discussion has been how to evaluate revisions to the pricing mechanism. We feel this will likely be a significant driver for the industry. The three big iron ore producers are seeking significant upward revisions to benchmark pricing. Price talks between iron ore suppliers with China have so far ended in deadlock and a new benchmark price has not been established. The benchmark traditionally takes effect in April. The alternative is for the mills to buy on the spot market, which is significantly above last years benchmark. Spot prices have gained over 50 percent in the past 12 months and we have the potential for additional upward pressure.
So while our views six months ago would have been perceived as overly bullish, I think we’ve seen the body of opinions trend our way over time. In our view aggregate demand will grow and on a per unit basis, prices will ratchet up significantly. This is bullish for the industry and bullish for Vale.
Does the company's management play a role in your position?
Yes. In any investment there is an infinite universe of potential risks, some more probable than others but a big one is company leadership. In short, does the CEO have the right vision and do they have the ability to execute? Vale’s CEO, Roger Agnelli, has led the company since 2001 and has demonstrated both the strategic vision to grow the business and the ability to execute the vision.
Nearly 40 years ago I started my first specialty metallurgical company. I subsequently started and ran two more reasonably large specialty metals and application companies which supplied materials to Silicon Valley. As a result, I believe I may have a number of unique insights into how the industry works and specifically how well Vale’s CEO has managed the company.
It would be difficult for me to overstate the complexity of Roger’s job, due to the dynamic nature and number of moving parts associated with running a large, vertically integrated mining company. The logistical proficiencies required to keep all the moving parts greased and working together are significant. This is particularly true when attempting to execute an aggressive corporate strategic plan that has the potential to dramatically impact the iron ore market. So execution is immensely important and requires talented leadership to do all of those things well, and I think Roger has done a magnificent job.
It is also worth noting that Roger oversaw the divestment of something like three billion dollars in businesses over his tenure in an effort to focus the company’s efforts and resources and grow the mining business. That decision brought with it potential risks and not everyone was happy with that decision at the time - but it proved to be the right one.
What catalysts do you see on the horizon that could move Vale stock?
In the near term we feel the primary catalysts will be the progression of benchmark pricing negotiations. We are anticipating much higher rates. Over the short to intermediate term we would be looking for evidence that the global economy continues to strengthening. Specifically we would be looking for evidence that Chinese demand is increasing and perhaps get some additional transparency on inventories. We also view potential currency appreciation of the Renminbi (RMB) as a catalyst as it would positively impact demand by making imports of raw materials cheaper for steel companies.
Over the short to intermediate time frame, we are also expecting to see increased steel consumption in the Middle East and North Africa where construction is booming in places like Egypt and Saudi Arabia.
Vale is gradually ramping up its production in Canada and could positively surprise with increased production in the non-ferrous minerals segment. We could also see positive developments in the ongoing strike at the Canadian nickel facilities.
The competitive landscape is also changing relative to Indian producers as the Indian government has introduced environmental laws which should restrict the country’s high grade ore exports. I would expect Vale to marginally benefit from this development.
Longer term some of the initiatives I outlined earlier should be coming on line later in the year, which has the potential to add real value to the company long term and be accretive to the bottom line and be a significant catalyst for the stock.
What could go wrong with this stock pick?
We break Vale’s risk profile down into essentially six categories: economic, currency, political, competitive and execution risks. We also include a wildcard of generic event risk.
Economic risk can be further sub divided into Asia, European and U.S. based risk. If we begin to see evidence of larger than expected inventories and diminishing demand from China we would view this as potentially a red flag. China is the largest consumer of Vale’s main products of iron ore, pellets and nickel. For Vale to do well, China needs to be doing well. Japan and South Korea are also principal buyers so a souring economy in those countries would be evidence that Vale is going to suffer.
Europe tends to be very nimble at adjusting their demand in response to economic conditions. So like Asia, if the general economy were to fail to recover as expected we would expect to see that quickly reflected in European demand.
The U.S. is not a major customer of Vale's for a number of reasons. However, it is still the largest economy in the world and drives demand for many heavy manufacturing and steel-based products. If we were to see a double dip recession or a prolonged U-shaped recovery, this would put downward pressure on Vale.
Currency risk: All things being equal, Vale’s bottom line is positively correlated to the U.S. dollar. Virtually all of Vale’s revenue is linked to the dollar while approximately 85% of all costs are real denominated. Therefore, further appreciation of the Brazilian real relative to the dollar would tend to have a negative impact on margins. In fact, in Vale’s Q4 report this very issue was cited as a negative contributing factor.
M&A Risk: For some time there has been discussion regarding a potential merger or acquisition of Rio Tinto by BHP Billiton. A merger between the number two and three iron ore producers would significantly alter the competitive landscape and present a new set of challenges that Vale would need to confront.
Governmental and Political Risk: Brazilian President Lula da Silva’s current term will end in 2011. Over his tenure he has moderated his political views and has largely presided over a reformist administration that has not been overtly hostile toward big business. Having said that, we note that Vale management has been under pressure from the Brazilian government to invest more inside the country. In addition, there is always the risk in any emerging economy that a swing in the political pendulum could have a significant impact on the business climate. In this scenario we might expect greater administrative control, higher taxes, regulatory control, labor and wages and environmental restrictions.
The risks we’ve outlined above tend to be exogenous risks and largely outside the control of Vale. Vale has a very aggressive strategic plan that has required significant investments in infrastructure and distribution and storage. Part of Vale’s current price has discounted the value of this strategy going forward. However if somehow the strategy ran into significant delays, significant additional cost overruns or were canceled altogether then we would expect the company’s share price to be reflective of these problems.
Thank you very much for sharing your thorough thesis, Joel.
Happy to participate.
Disclosure: Axion Opportunity Fund is long Vale
If you are a fund manager and interested in doing an interview with us on your highest conviction stock holding, please email Rebecca Barnett.