Newsletter Value Investor Insight carried an interview March 30th with Cobalt Capital's Wayne Coooperman, whose fund has returned 25.7% after fees annually since 1995, versus 9.6% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview in which he discusses Companhia Vale do Rio Doce (RIO), which was trading at $37.02 at the time of the interview (current price here):
Tell us why you’re interested in Brazilian mining company Companhia Vale do Rio Doce (RIO).
WC: As we did our work on the steel industry – last year before buying U.S. Steel and more recently with Mittal – we’ve become pretty convinced we’re going to see good global growth in steel demand. We looked at post-war demand for steel in the U.S. to help us think about demand coming from China and India. Prospective steel demand in the U.S. is also fairly strong, from non-residential construction and from long-overdue spending on infrastructure projects like roads and bridges.
Whenever we identify a larger theme like that, we look everywhere for the potential beneficiaries. In this case, strong growth in global demand for steel is going to produce a lot of demand for the iron ore that CVRD produces.
Like the high-end steel tubing business, we consider iron ore to be an attractive business. Most of the global, seaborne iron ore trade is controlled by three large and well-established companies: CVRD, with 35% of the market, Rio Tinto, with 20-25%, and BHP Billiton with 15-20%. With three main players, ore prices are set once each year in contracts with customers, so the business is fairly predictable.
Other than being the biggest, what sets CVRD apart?
WC: Most of its iron ore production is in Brazil, which provides labor-cost and tax advantages, but which also typically means they’re mining a higher-grade ore that allows for extremely low-cost production. The higher the grade, the easier the ore is to get out of the ground and process. As a result, CVRD’s return on capital is over 50% and they generate operating margins of almost 45%.
While it’s been mostly a pure play iron ore producer, the company recently closed its acquisition of Inco, the big nickel producer. Now roughly 55% of EBITDA will be from iron ore and around 35% from nickel. The rest is mostly copper and aluminum. They underwrote the Inco deal economics assuming $5-per-ton nickel, and it’s now closer to $19 per ton because of very strong global demand. We’re not counting on the price of nickel staying that high, but we do think the supplydemand dynamics there support a base price well above $5 per ton.
At a recent share price of $37, how are you looking at valuation?
WC: If we make what we think are reasonable assumptions about production and pricing – we assume iron ore prices rise 5% next year and use $10-per-ton nickel – we expect net earnings in 2008 of around $4.50 per share. So that’s just over an 8x multiple for what we think is a good business that has the wind at its back. If CVRD continues to steadily increase production and price trends stay favorable, we think the stock could double in the next two to three years.
Are there any balance sheet risks or opportunities?
WC: They levered up a bit to buy Inco, but the ratio of debt to EBITDA is still only about 1x. That leaves them with plenty of capacity to use free cash flow to make further acquisitions or return capital to shareholders.