Timing the 'Big Three' Iron Miners

 | Mar 24, 2013 | 12:00 PM EDT
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Here's the bad news: Over the next five years, Australia's Bureau of Resources and Energy Economics projects that the Australian port price of iron ore will fall to $96 a metric ton from a $119 a metric ton in 2013.

And the good news? Even at $96 a metric ton, the Big Three companies that make up 75% of the global seaborne trade in iron ore will make a solid profit. Australian miners BHP Billiton (BHP) and Rio Tinto (RIO) can deliver ore to China, the world's biggest market for iron ore, for $50 a metric ton. Brazil's Vale (VALE), the lowest cost producer in the world at $38 a metric ton has to pay more in freight charges to send ore to China from Brazil than its Australian rivals do, but even so, my estimate is that Vale can deliver ore to China at a total cost of $53 a metric ton. (Vale's iron ore contains more iron than Australian ore so it tends to sell at a premium price.)

Do you want to buy on the "good news" to take advantage of low share prices in the sector? (Vale, for example, is down 21% for the 12 months ended March 20 and sells at just 7.5x projected 2013 earnings per share.)

Or do you want to wait on the "bad news" in the belief that already reasonable prices will go even lower in the next year or two?

I say wait. To understand why that's my call you have to understand the source of problems in the sector.

It's not really a demand side problem. Demand from China -- which accounts for 65% of global demand -- will grow at 2% a year for the next few years, according to research by Goldman Sachs. That's roughly the long-term historical average. That would be fine except that iron ore miners upped their capital spending to expand production. Even after recent cuts to spending plans, the Big Three iron ore miners are on track to add 200 million tons of capacity by 2015. That's roughly equal to Rio Tinto's total production today.

Right now we're still in the spending-cut stage of solving this supply-side problem. Vale, for example, has cut its capacity goal to 400 million tons per year by 2017 from an earlier goal of 522 million tons. Vale shipped 258 million metric tons of ore in 2012, which puts the lowered capacity goal for 2017 some 55% above last year's shipments.

The Big Three iron ore stocks aren't all the same -- and that should figure into any decision to buy and into your schedule for when. Rio Tinto and Vale are far more concentrated in iron ore than BHP Billiton. Iron ore made up 70% of revenue at Vale in 2012 and about 90% of earnings before interest payments, taxes, depreciation, and amortization (EBITDA). The comparable figures were 44% of revenue and 71% of EBITDA at Rio Tinto. Iron ore made up just 29% of revenue at BHP Billiton, in contrast.

And the investment opportunities these companies are addressing with their capital budgets aren't all the same, either. You'll remember I noted that Vale makes up for its higher shipping costs to China by selling ore at a premium because of its higher iron content. Vale's biggest investment is the high-grade Carajas project, scheduled to add 90 million tons of production by 2016. Vale's ability to invest in mines with higher ore grades gives the company an opportunity to expand on its pricing premium and earn a higher return on its investments than its two competitors.

Here's how I'd rank and schedule the investment opportunities in these three iron ore miners:

  • Vale gets top rank and the earliest slot on the schedule. The company has the most exposure to the European market of any of the Big Three and that gives it the most leverage to any recovery in European economies in 2014. I'd look at Vale around the middle of 2013 to see what prospects are for European growth six months ahead.
  • Rio Tinto earns my second position but much farther down the road than Vale. The company is even more leveraged to iron ore prices than Vale is. And it has the furthest to go cutting its capital spending down to size. When that process is over for all of the Big Three, Rio Tinto has the biggest upside potential. I'd stash this one away for a look in 2014, although the shares do pay a 3.9% dividend.
  • BHP Billiton gets the third slot. Because of its diversification, it has the least leverage to iron ore prices. That makes it a stable play on a wide range of global commodities but lowers the potential reward from any recovery in this sector. The shares currently yield 3.2%

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