Companhia Vale do Rio Doce: From Major to 'Miner'?

Serious questions need to be asked about how much of a mining “major” Companhia Vale do Rio Doce (Vale) (RIO) really is the wake of its failed bid for Xstrata (XSRAF.PK).

The company did all it possibly could to secure the Xstrata approval but in the process damaged its share price, threatened to blow out its debt, endangered its ratings and raised questions about its ability to manage a truly diversified mining giant.

For us Vale is still a very large Brazilian miner with an overseas nickel operation, nothing more and nothing less. It belongs more in the company of Norilsk for provincialism than in the company of BHP (BHP), Rio Tinto (RTP), Anglo-American (AAUK) or even Xstrata.

The bid brought mutterings from the Brazilian government which might suggest that Vale is not only takeover proof, but that its actions abroad might be hamstrung by government intervention on national interest grounds

The company’s imperative to expand may have resulted in excessive “pushing of the envelope” in price negotiations with Asian steel mills. This tempts a price backlash in coming years.

The failure of the bid has spurred talk of smaller bolt-on deals. With the company very much in a “banker” mindset under Roger Agnelli rather than a miner mode of thinking, opportunities like Global Copper pass under the company’s nose unnoticed while it chases its “Great White Whale”.

Brazil – Major or Miner?

Brazil’s mining roots go way back beyond the days of the Jesuits endeavors. It even has a state called General Mines (Minas Gerais) and Vale (or CVRD to the un-modern) was not even around in those days. Recent times have seen the rise and rise of Vale as an investment darling, but there is more to Brazilian mining than the former state-owned giant. A swarm of foreign miners are searching the vast Brazilian territory for new opportunities for a vast array of commodity metals. Many of these names are eclipsed by the Vale phenomenon but at this point they probably represent the best way to make multiple gains on an investment now the Vale’s market capitalization has moved into the stratosphere.

An intriguing new notion to consider is the possibilities that the buoyant Sao Paulo exchange offers to these (largely) Canadian players. It is ironical that now the easiest money to tap is in LatAm rather than in the old-line Western capital markets. We foresee a trend of secondary listings to tap the hunger for new names in Brazil. The possibility to create a “mining sector” in the SP market, beyond the mining monolith of Vale is now looking more realistic. Most other mining giants (the Australian, Canadian and South African/London names) swim in a fishbowl with other inhabitants. Vale swims in splendid (and uncritical) isolation.

An Iconoclastic Approach

Investors must excuse our lack of rhapsody when we mention the name of the Great Totem of Brazilian investing these days. Having grown up surrounded by the great names of Australian mining, BHP, CRA, North Broken Hill, ERA, RTZ, EZ Industries, Western Mining, MIM, one has to suppress a chuckle at the urgency of the need that international investors, who scarcely know names like Southern Copper (PCU), feel to get themselves positioned in Vale. Is the Vale love affair really just the desire of le tout Greenwich to have big liquid names they can park their yen-carry-trade proceeds in for a few hours of days?

It doesn’t take a long memory to even recall the rather ho-hum launch of CVRD out of the state nest and into the private sector in the late 1990s. Only a handful of emerging market cognoscenti felt it was worth the analyzing, and even then it was somewhat opaque in its goals, ownership and management. How have the humble risen! The company’s deal back then was under $4bn. It was a captive of a Brazilian steel company when first flung out of the State’s nest and now terrorizes steelmakers like Godzilla. A few years of unwinding of interlocking holdings and disposal of steel and forestry assets ensued. In the meantime some of its diversity even in mining was lost as its gold and copper mines petered out in a yawn.

New management appeared in the form of a banker, Roger Agnelli. The company hit the corporate road using rising iron ore revenues to tackle first Canico and then INCO at the international level while carrying out an unfettered domestic domination plan in the iron ore sector. Its most recent adventure was the ill-fated jousting with Glencore over Xstrata.

Nowadays, Vale is hot, hot, hot and the much talked about subject at the golf courses of Fairfield County. What other stock in LatAm gives such scope to play with large amounts of cash in LatAm, in the sexiest casino/Bolsa in the region and that’s main claim to fame is a product line, iron ore, that is internationally used, but paradoxically priced on a “by appointment” basis and thus opaque to mark to market or use in valuing its producers going forward.

The “Hidden” Hand of the State

The Xstrata takeover never went far enough to really push the issue on the “Brazilianness” of Vale. It was starting to look at one point as if the stock had the dubious quality of being quasi-statal. This is an aspect played down by the company’s fans, but surfaced during the bid when the Brazilian government signaled that the Xstrata buy “may not be in Brazil’s best interest”.

We suspect that Vale’s management saw the Xstrata buy as attractive deliberately to finally distance themselves form the imperative of “Brazil’s best interests”. Quite clearly the Xstrata deal would have toppled the Brazilian government’s 12% stake into second position behind the former Xstrata holders (i.e. Glencore). This then opened the fear that as an international mining stock, the Vale headquarters might drift (de facto or de jure) in the direction of London or even Zug. With foreigners making up an even larger chunk of the Vale share register there would have been little resistance to such a move (except from the Brazilian government.

Eventually the Xstrata deal came to grief thus removing this problem. However, if the Brazilian government had stepped in to signal more forcefully a negative to the deal then on future occasions Brazil (and Vale) could have thrown back at them the issue that takeovers of “national importance” is a two way street. It still grates in Canadian capital markets that INCO was allowed to fall to foreign interlopers with Falconbridge (and Noranda) disappearing around the same time.

How “state-owned” is Vale? There is the 12% we know of and its rather insignificant, but is there a de facto golden share that gives the federal government a veto over Vale’s corporate strategy. If there is then the company is hamstrung in a way that none of its other competitors for the title of global majors appear to be.

INCO in the Mix

If it hadn’t been for the bid for INCO, then Vale would be very much a regional story and monoline in its product range. Whether the deal was a great help to Vale on the earnings front is not clear but it definitely raised its profile. It also established the company’s reputation for financial daring. In the process it managed to gazump a handful for the world’s most long-established and powerful mining groups. To refresh the memory on August 14, 2006 Vale (then CVRD) extended an all-cash offer to buy Inco for $17 billion. That offer received approval from the Canadian government's investment review agency on October 19, and was accepted by Inco shareholders on October 23. CVRD announced am intention to maintain CVRD Inco as a separate nickel mining division with CVRD’s existing nickel mining projects in Brazil (at Onca Puma and Vermelho) being transferred to Inco's management. These two mines were a result of the preceding year’s takeover of Canico Resources. The only other major international purchase pre-Xstrata was the entry into the coal-mining business when, in 2007, the company purchased the Australian coal mining company AMCI Holdings for $656 million. This latter purchase didn’t make much sense in the mix but seemed to be a case of “collecting the pieces” for creating a “global” player.

INCO launched Vale into a whole new category. Considering the price it was a good deal. By breaking out of the “emerging market” category it could get itself onto a vastly expanded range of investment radars and this helped in motoring the price of the stock dramatically higher. Whether the addition of nickel to the mix would have been as good a choice as copper, for example, is a matter of debate. The sheer number of ex-INCO execs and geologists and mine managers we find in smaller competitors these days suggests to us that despite relatively benign press post-deal that the “Exit” hatch has been crowded by departing talent.

When it comes down to it, Vale is a diversified Brazilian metals miner but globally, it is still only a nickel player. The tilting at Xstrata was obviously directed towards addressing this lopsidedness.

Interestingly most of the other majors have eschewed big-time nickel plays (or any nickel plays for that matter). Xstrata snatched up Falconbridge in the 2006 melee over nickel assets, but Rio Tinto and BHPB have largely taken a pass on a metal that has not been enormously rewarding for a long time. The table on the following page shows the upcoming production. As we have noted elsewhere around one third of new production (Onca Puma, Niquelandia and Barro Alto) is coming from Brazil, turning a relatively minor player into a major new source. Nickel prices are good but also 40% off their recent highs. Maybe Vale felt that getting a grip on Xstrata would have cemented its title as the king of nickel. However, being overexposed to any product line has been something that the majors have tended to avoid. One might even argue that it is this that makes the difference between a major and a merely important marginal player (like Norilsk, or the status that Freeport McMoran and Phelps Dodge had in their pre-merger days).

Again we might mention the ephemeral nature of dominance with Australia being home to a host of deposits while in its own back yard, Vale has Mirabela, Votorantim and Teck/International Nickel Ventures conjuring up new production.

Of the Goose and the Golden Egg

The latest success in shaking down the Asian steel mills to pay a whopping 69% more for next year’s iron ore may be killing the goose that laid the golden egg. Already steel consumers are trembling at the thought of the prices rises coming down the pike into a market that is looking definitely past its prime. The Vale imperative seems to have been a good ravishing to the steel mills to pay for the boost to its offer for Xstrata.

This gambit has been unsuccessful vis a vis Xstrata because the iron ore price rise put into perspective how cheap many base metals still are and it triggered the latest surge in metals prices. That in turn gave Glencore reason to doubt its wisdom in selling off Xstrata. Further down the track there may even be a retreat in iron ore prices at negotiations in 2009 or 2010 as demand proves softer and margins at mills are crushed to satisfy the voraciousness of the iron ore miners, led by Vale. We can already hear some aggressive posturing from the Chinese towards the Australian exporters.

Then we might also mention that while Vale has sewn up most of the current production in Brazil there are large other resources, some in the hands of CSN, others with Indian interests and then there are massive reserves in Bolivia and Peru that are viable at current prices, just in the wrong hands. That is not a situation that will last forever. The Koreans felt the lash of Vale’s last price hike and are out and about looking for base metal assets in the same way the Chinese are doing.

The Xstrata Bid – Hubris Mugs Vale

Glencore either went of their meds for a short period or had some sort of “road to Damascus” on the merits of the commodity supercycle. That they even entertained the original price being bandied around by Vale suggested that the late 2007 retreat in metals prices had them slightly rattled. As the party with the closest ear to the ground in the whole industry one had pause to thought from Glencore having pause to think. So Xstrata was temporarily up for grabs. Vale rushed in where others feared to tread. The bigger players already having most of the “mix” that Xstrata had and thus not being prepared to bid up for it. Despite the deal being described as “friendly” nothing eventually transpired as Xstrata kept pushing the envelope to see how desperate Vale really was. Finally Vale baulked on the issue of permitting Glencore to have exclusive marketing rights over most of the output. This would be fairly outrageous if we had thought Glencore was really serious about it. How can a 40% shareholder sell out a company in exchange for whatever the public offer is but at the same time cut itself an “extra” compensation on a marketing deal? This smacked of “having its cake and eating it too”.

If the Xstrata phenomenon proves one thing is that you can “build it and they will come” and it doesn’t take long and it doesn’t cost an arm and a leg. A sign of the sheer desperation of Vale to get its hands on this array of assets was it disposing of the traditional Latin approach which is not to pay up for anything. Vale went frantic in its hunt for the Great White Whale of mining companies. We are not clear what the rush was all about. Another Xstrata could have been cobbled together from other assets out there in the market place for a much lower price. Maybe now the bid is a flop that is the route that Vale will be forced to follow. That is if Vale is “forced” to follow any route. We suspect that Vale doesn’t have the faith in its own abilities to pursue the standalone opportunities out there. That is why Teck Cominco snapped up Global Copper (GLQ) last week and not Vale.

The best thing emanating from Vale’s failed assault on Xstrata is that we may not lose one of the most efficient and interesting mining giants around. We would prefer investing in Xstrata any day over Vale.

Mother Merrill Takes a Pass

One of the more surprising things for international capital markets denizens was Merrill Lynch’s decision to pass on participating in the great Xstrata chase. The amount of debt involved ($50bn out of the total $90 bn acquisition price) was just too rich coming as it did in the midst of a sea of miseries on other fronts for the Thundering Herd. Those who signed on to the credit line included Citigroup, Credit Suisse Group, HSBC Holdings, Banco Santander, the Calyon arm of Credit Agricole, Royal Bank of Scotland, BNP Paribas and Lehman Brothers. While one or two of these names are still walking unaided most look like Napoleon’s troops on the retreat from Moscow. Maybe that was company that Merrill didn’t want to keep. In passing on the credit line, Merrill was fired by Vale as part of the advisory team that was estimated to be carving up $450mn in fees between themselves. While rarely on the wavelength of this firm, we had to hand them a bouquet as about the only firm that had the gumption to “just say no”.

On “National Champions”

National champions are all the rage these days in the resources field. So Brazil has plumped for Vale as its national champion? Good, so while Australia has hundreds of mining companies and Canada has hundreds and South Africa has scores of them, Brazil has Vale (and Votorantim in the private sector and MMX as a fair-weather miner). The Brazilian approach has effectively shrunk the field down to Vale in the public sphere and thus what this company feels interested in is what gets approved. Before Vale’s fans start casting brickbats at us we might note the best evidence for this hegemonic trend is evidenced by the government’s permission for Vale to take over CAEMI in March 2006 which gave Vale control of MBR, Brazil’s second largest iron ore producer. While MMX (and its sometime JV partner Anglo) have a percentage in the Brazilian iron ore game, it is a relatively small one.

This is not to say that Brazil is restricting mining investment (beyond uranium) because there is a lot of activity going on amongst foreign miners in Brazil these days (though we note BHP, Xstrata and Rio Tinto noticeably absent). However, the national champion designation afforded to Vale cramps the potential for Brazil to develop a broader national mining sector.

Conclusion

BHP is up 60% over the last 12 months and Vale is up 80%. One might argue that BHP is “suffering” due to being more diversified and the Vale is benefiting from being iron-ore focused. But as we have noted CVRD is now the largest nickel player at the global level and that is scarcely a metal that has excited much interest in recent times.

One has to take Wall Street with more than a grain of salt. They showed no interest in CVRD when its market capitalization was a mere few billions. Then when metals become sexy they suddenly discover the stock. Now it is big with lots of liquidity so all sense of disbelieve is suspended and the Wall Street analysts start to froth at the mouth in their enthusiasm for the name.

The big question for the majors these days is whether they can really make a difference in acquiring extra mines. Most of the large scale mines they, or their peers, already own. Cash is gushing in from businesses that are seeing fantastic prices with little prospect of significant weakening. Thus if mine acquisitions aren’t really going to change the game significantly and cash is deluging down, what to do it? When it comes to Vale at least the answer is “hold onto it”. The dividend in 2008 is a pathetic yield of 1.3%. The payout is a mere quarter of last year’s net profit. With profits moving higher again this year (though we note our estimates are way under the Street numbers), the payout could go up significantly. Unfortunately Vale has fallen under the spell of the US policy of lousy dividends. If it truly were a major it would realize that its competition fro investor attention amongst informed mining investors are anmes like BHP and Rio Tinto not IBM and Citicorp with their lousy payout ratios.

To those who can grasp Luso-hispano languages, the name Vale is a pun (though the company probably believes it is more of a statement). We suspect it is wishful thinking and the company hopes you will think it is “worth” investing in. To the quick-witted amongst the Spanish-speaking it almost prompts a retort of “Vale la pena?”. In Latin of course, it means “goodbye” or “farewell”.

Vale is not expensive but with bankers at the helm it is set upon a course of tickling the fancy of Wall Street types rather than traditional mining investors. Let them have it… there are plenty of other names for the mining savvy to pursue and make multiples of their investment. Vale’s days of quantum leaps are over, at least in our opinion. Ave et Vale!

Disclosure: Hallgarten & Company or persons associated with it may own securities of the securities described herein and may make purchases or sales while this report is in circulation. Hallgarten policy does not permit any analyst to own shares in any company that he/she covers.

Comments

[spbigger]

Wow! I am not a particular fan of Vale although I hold a few shares along with those of BHP and Fsumf.

I can not quite get your point here. It expresses jealousy of some sort, I can't quite figure. Or, maybe it's that you are envious for some reason-maybe even vindictive for some convoluted reason.

Seems to me that the company was smart in not further pursuing the failed purchase attempt. Remember too, A large part of the populous there wants to bring it back into the total fold of the country. Their move was to help delay or divert that. Their seemingly next move for the same reason might be to buy smaller companies to further complicate state takeover.

I noticed that you did not tie your article in with the negatively aggresive and out-of-order activities and comments of BHP/RTP. Something is a little one-sided here.

That's OK!

[MM17]

My first impression on this hit job is, How many shares are you short?

[maher]

RIO's days of Wine & Roses are OVER now.

Like Hossayn Obama, RIO has had its 'flash in the pants' 15 mins. of fame; and now it is only known as "another mining company".
Nothing special.
That's it.

[buckeyecw]

I have and will continue to add RIO to my portfolio...

[robertseibert]

Funny, very likely this guy is shorting the stock! Just bought some after hours today, the fundementals are awesome! thanks for bringing down the price, I've been waiting for a dip to buy :) More than likely RIO will be over a hundred dollars by years end! market manipulation is getting rampamnt, maybe the SEC will go after this guy, but only after I buy some more, ok!!!

[urbanhiker]

I like RIO. I believe it will reward me monetarily with it vast nickel and iron ore deposits, as it has. You definately have a psychological problem, if you feel the necessity to undermine a company as vehemently as you have. Have you tried medication?

[eleecarioca]

Good view of Vale. I have made lots of money on RIO over the years, along with BG, GOL, BBD, and SDA. I thought that the article was very strong on an area I see litte about, the 'brazilianess' of Vale. As someone who spends a lot of time in Rio, and speaks the lingo, it was spot on. Brazil is living the perfect storm, and I will ride the wave as long as it peaks, but it will hit the shore sometime as the structure of Brasil and the mindset of its people has not changed. O Brasil e o pais de futura, e sempre vai ser.....

[Itsjustal]

What a load of malarkey. Vale demonstrated good judgment and discipline to walk away from XSTRATA. Vale generates BILLIONS of dollars in profit PER QUARTER.

The ONLY reason Vale missed the consensus earnings number for 1Q08 is because ONE analyst made his estimate so high in the stratosphere that it skewed the balance of the analysts' estimates. If you throw out the crazy number, Vale's number was in line....

And, take a look at the rest of the numbers Vale posted....

When I read your piece, I had to agree with another poster above who questioned your agenda here. Your opinion is pretty unsubstantiated and does read like a carefully crafted hit piece.

Last, Merril has myriad problems, and participating as a major player in the financing deal just might not have been possible for it at the time, but you didn't mention that, did you?

I hate to repeat myself, but your opinion is a bunch of malarkey!

[Nawz]

I don’t know what you’re trying to say but this is one of the nastiest and most negative reviews I’ve ever read regarding a great company. Lighten up!