Big 4 Iron Ore Producers: Rationally Oversupplying the Market?

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Vale (NYSE: VALE), Rio Tinto (NYSE: RIO), BHP Billiton (NYSE: BHP) and Fortescue Metals have a strong grip on the global iron ore market. These players have been aggressively increasing iron ore supply over the past several years. This year and next, supply from the Big 4 will continue to grow at what some fear is an alarming rate. With the iron ore price having fallen about 30% this year to the $90's per metric tonne, many industry pundits question the strategy of the Big 4. Where's the production discipline to maximize pricing? Not only are the Big 4 operating rationally by ramping up production, they are making smart strategic moves.

Profit margins among the Big 4, even at the current spot price, are among the best of any business anywhere in the world. A strategy of maintaining a higher iron ore price by curtailing supply growth would merely give smaller iron ore competitors a leg up and enable new supply from emerging players to come online. There are dozens of iron ore producers and emerging players that require a higher iron ore price (perhaps $100+ per tonne) to be comfortably viable. By propping up the price of iron ore for short-term gains, the Big 4 would be shooting themselves in the foot over the medium and longer term.

Vale looks increasingly attractive
Of the Big 4, Vale is looking highly attractive, with its 6% dividend yield and trading near its 52-week low. Vale is unique among the Big 4 in that its iron ore production comes from Brazil, while the other three majors produce from Australia. This is an attractive investment attribute as it diversifies risk. Make no mistake, Vale has country risk, but in an overall diversified portfolio of investments an allocation to Brazil is prudent. Vale's ADR on the NYSE is trading at roughly $13 per share. Some of the major sell-side firms have recently updated price targets of $17-$20 per share.


I find these targets comforting in that they all assume a long-term iron ore price of $80-$100/tonne. Given market dynamics, this is possibly an overly conservative assumption. At a long-term price of even $120/tonne, Vale's stock could be a double within 18-24 months. Yet, the stock probably only has downside of 20%-30% upon a continued weakening in the spot price below $90/tonne. Importantly though, the last time that iron ore prices fell out of bed in 2012, they bottomed at $86/tonne before rebounding hard.

The Big 4 are free cash flow machines with iron ore prices anywhere near $100/tonne. Despite what the financial press tends to depict about the decline in the iron ore price this year, the Big 4 remain wildly profitable.  It was not that long ago that the iron ore spot price was at $190/tonne. By no means am I suggesting that the price will revert to $190/tonne or even $160/tonne. However, the probability of a long-term iron ore price of $120/tonne (or higher) is a lot higher than analysts and investors realize.

Vale has a solid mix of near-term growth, cost containment opportunities and robust, low-operating-risk cash flow generation. Asian consumers of iron ore need Vale as an important diversifying source of supply. Having all of one's supply coming from a single region in Australia is both unwise and unnecessary. Vale has high exposure to iron ore, 3-5x the exposure of Rio Tinto or BHP. That's why a stock like Vale could double on a relatively small increase in the long-term iron ore price assumption. BHP and Rio Tinto would not double under the same scenario, not even close. In looking at the stock charts, it's interesting to note that both Rio and BHP are well above their respective 52-week lows despite weak iron ore and coking coal prices. Vale is trading quite close to its 52-week low.

BHP, Rio Tinto and Fortescue not as attractive on a risk/reward basis
Of course, BHP, Rio Tinto, and Fortescue would all benefit from a higher iron ore price assumption. However, as I've indicated, BHP and Rio Tinto are giant diversified miners with many factors influencing their respective stock prices. Aside from Vale, the only other major iron ore producer that could see its stock price double is Fortescue Metals. The problem with Fortescue is that it has a burdensome debt balance and a higher cost per tonne in its iron ore operations. Fortescue is a higher risk way to play iron ore than Vale. I think that both Vale and Fortescue have substantial upside, but that Vale is a safer way to articulate a bet on iron ore.

More specifically on Rio Tinto, although more than 90% of its earnings came from iron ore in 2013, that percentage will come down substantially. Rio Tinto is exposed to moderate country risk in Mongolia, where it has a $10 billion copper/gold project called Oyu Tolgoi. Over the next several years, Rio is looking at committing billions into a high-risk African iron ore project in Guinea. Therefore, investors trying to avoid country risk, for example Vale's Brazil country risk, are exposed to both Mongolia and Guinea through an investment in Rio Tinto. Still, Rio has a tremendous management team that should be able to navigate these country risks. Rio also has a very solid 4% dividend yield. Rio remains a lower-risk/lower-return opportunity in the metals and mining space.

BHP is so diversified that it's difficult to say which commodities are most important. BHP made an incredibly smart move a few years ago by moving into oil & gas. Even though BHP doesn't necessarily come to mind when thinking about oil & gas companies, that segment has actually become quite large. In addition to iron ore, the other large segment of note for BHP is coking coal. More so than iron ore, coking coal prices have been very weak at multi-year lows. BHP is the safest of the Big 4, but it has a lower yield than both Rio and Vale and less stock appreciation potential.

Recommendation
The Big 4 have remarkably strong iron ore segments that boast not just industry-leading margins, but world-beating margins. However, BHP and Rio Tinto are too diversified to reliably benefit from an iron ore price rebound. Of the two, Rio has more upside than BHP, but neither has the upside of Vale or Fortescue. Between Vale and Fortescue, Vale is unique with its Brazil operations, has better margins, a 6% dividend yield and less of a debt overhang. Investors should look to buy Vale stock on weakness, leaving room to average down over coming months if the spot price continues to fall.

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The article Big 4 Iron Ore Producers: Rationally Oversupplying the Market? originally appeared on Fool.com.

Peter Epstein is a shareholder of Vale, but has no prior or existing relationship with any of the companies mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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