Quarter-End Insights

Our Outlook for Basic Materials Stocks

We're still waiting for steel and construction materials to follow the rest of the sector's rapid recovery.

Dec 29, 2010

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As long as metals prices remain high and borrowing costs stay low, we're likely to see more marginal mining projects getting the green light and fewer projects ending up on the cutting room floor.
For U.S. steel producers, we believe the fourth quarter should mark the bottom for earnings, but production discipline across the board will be critical to preventing a repeat of the crash and burn from 2010.
Although U.S. coal demand trends (both short and long term) are weak, exports could put a floor under U.S. prices, and hence earnings, for our companies.

We expect 2011 to be the year of big spending plans from the mining companies. Metals prices are soaring, borrowing costs are quite favorable, and most major miners will likely shy away from huge acquisitions after having been burned by highly leveraged transactions prior to the downturn in 2008.

Most miners are placing a huge bet on continued strong economic growth and demand for metals in China, India, and other emerging markets. Their views are supported by low per-capita consumption rates in these countries and the strong forces of industrialization and urbanization. On the supply side, ore grades are decreasing and world class deposits are increasingly hard to find, and labor disputes are disrupting production in the short term.

Oddly, each major miner claims that it should be able to grow its production of key metals such as copper or iron ore significantly over the next several years. Apparently, each mining company is the exception to the rule that it will be hard to grow production. Instead, we'd argue that only one of the following can be true: Either growth in global output of metals will remain constrained and prices will remain elevated while large miners will face declining production absent major acquisitions; or, mine supply will expand significantly, pushing commodity prices lower towards the marginal cost of supply.

Meanwhile, the robust prices for iron ore that have padded the pockets of mining companies have brought much pain upon U.S. steel producers. While steel production in developed economies plummeted in 2009, China reached a record high, driven by strong domestic consumption on the back of economic growth and industrialization. This helped to hold up steel prices somewhat, but the impact has been far greater on the raw material side. China's growth in steel production, coupled with its limited domestic raw material sources, caused it to turn more heavily to global sources, most notably iron ore, which is in relatively short supply relative to global steelmaking capacity. As a result, iron ore prices have reached record levels in 2010 while steel prices are still down considerably from their 2008 peak. Given that China now represents such a large share of the steel market, fluctuations in steel consumption or production in the country have large implications for steel prices and iron ore prices, leading to significant volatility. For U.S. steel producers, price increases have been announced recently, and early signs indicate these are taking hold, which should help the mills recoup some of the cost of higher-priced feed stock. However, production discipline will be critical for sustainable margin improvement in 2011.

The outlook for U.S. coal demand is weak, and this is beyond a cyclical issue. Although the cyclical downturn in industrial production and low natural gas prices (a substitute for coal in power generation) are playing a role in the dismal near-term outlook for U.S. coal demand, the more-important long-term factor of environmental regulations is throttling future demand. Even without federal greenhouse gas emission limitations, power generation companies are facing increasing restrictions on pollutants such as mercury and sulfur dioxide. This should cause coal-fired generation to lose share to gas-fired plants in the near term, and even nuclear power in the long term.

One might think this would spell the eventual end of the entire U.S. coal mining industry. However, we think the future is promising for players in the Powder River Basin of Wyoming. First, the center of the global industry is irrevocably in the Pacific Basin, which has driven coal pricing for the past two or three years. If Asian demand remains strong, U.S. pricing will be strong as well as coal trade flows into Asia. Second, production is falling in Appalachia due to increasingly stringent safety regulations, the exhaustion of high-quality reserves, and labor shortages. This means Powder River Basin coal miners can gain share at the expense of their Appalachian peers.

Industry-Level Insights
Agriculture
Fertilizer demand recovery is in full swing, and we're expecting the party to continue into next year. High crop prices, supply chain restocking, and a need to replenish depleted fertilizer levels in soils all contributed to strong year-to-date growth.

Distributors were finally able to find some confidence in potash pricing during the third quarter and boosted inventories as a result. Intrepid Potash (IPI) believes potash pricing has bottomed from the 2008 peak and expects sequential price increases into 2011. Potash Corp (POT) also noted that it has seen some sporadic shortages in the supply chain, pushing additional pressures on farmers and distributors to increasingly lock in inventories.

We tend to agree. Potash prices have jumped considerably since the end of the third quarter, which should boost fourth quarter and early 2011 results for producers. Even if potash prices come down in the coming months, producers such as Agrium and Potash Corp should see a benefit next year from current higher prices, as the companies allow some farmers to lock in prices before the next growing season--a gamble farmers are more willing to take in an environment of rising prices.

Additionally, a longer-than-usual fall application window and expected near-record planted corn acreage next spring should keep demand high in the North American market. High crop prices for the 2010 harvest should improve farmer incomes, increasing growers' ability to purchase fertilizer for 2011. While we expect strong fertilizer prices and demand into 2011, we believe the positive impact from supply chain restocking has nearly run its course. Further, with higher fertilizer application rates in 2010, farmers have raised nutrient levels in soils, and could choose to skip potash and phosphate application this growing season if crop prices drop precipitously. However, this is not the most likely outcome, in our opinion.

Demand for genetically modified seeds is riding the same wave of high corn and soybean prices. Both Monsanto and Pioneer ( DuPont ) are staging for a decent increase in volumes in 2011.

Building Materials
Highway construction activity is an important end market for producers of aggregates, cement, and concrete. The key aspect of highway construction is the multiyear transportation bill that governs federal highway spending. Tangled in the lame duck session of the U.S. Congress, there are a few pieces of key legislation that are set to expire by the end of 2010, such as the sixth extension of SAFETY-LU, the most-recent highway bill. We expect another six- or nine-month extension to this legislation, which essentially holds the funding level on transportation projects stable at around $40-$42 billion per annum.

During 2009-2010, most states relied on another funding mechanism, Build America Bonds, to fund infrastructure constructions. The BABs program is set to sunset this year as well, and the political mood in Congress is weighted toward killing this program in the future. We acknowledge that there are tremendous pent-up needs for infrastructure around the world, and we note that the activity levels are highest in places that can afford to pay. In the U.S., we expect some more dialogue concerning funding levels and funding mechanisms in the coming year, possibly with a mixture of fuel tax increases and public-private partnerships.

Chemicals
Most chemical players had a banner year in 2010, with revenue increases largely wiping out depressing 2009 figures. We attribute most of the growth to industrywide restocking, combined with a strong rebound in automobile production. However, we think 2011 will be less rosy than 2010. The OECD countries are experiencing fragile economic recoveries, and housing and construction markets will continue to be weak, in our view. We do not see a clear catalyst for both markets to rebound strongly in 2012, and we feel the story will continue to be managing cost structures in mature economies and taking advantage of emerging markets in 2011.

Additionally, the crude oil price has run up to almost $90 per barrel in the past quarter, and petrochemical players, particularly those relying on naphtha chains, will face disproportionately larger feedstock increases in the near term. We think that will put significant pressures on margins, unless companies are confident enough to push through price increases. We are also looking at ethylene capacity increases coming online in the Middle East in 2011-12, which may create an ethylene and propylene oversupply situation worldwide. We fear this low-cost production will encroach heavily on U.S. petrochemical producers' margins.

Coal
Coal stocks fared very well recently, with most stocks in our coverage universe rallying 20% to 50% in the last three months. This is perhaps somewhat surprising considering that the U.S. economy remains anemic, and natural gas prices are barely above $4 heading into the peak heating season. However, as we have said previously, the coal market is not primarily driven by domestic factors any longer. International developments have become much more influential.

In that department, coal has found something to cheer for. China's economy continues to steam along merrily, and the government recently refused to raise key interest rates despite inflationary concerns, fearing a hard landing for the economy. The Pacific coal markets responded, with the Australian Newcastle benchmark rallying to $115 per metric ton, up from $90 in August. Prices inside China reached as high as $130 per metric ton. To put these numbers in context, Central Appalachian coals trade for just $70 per short ton and Powder River Basin coals are worth only $13 per short ton.

We expect this disparity in pricing to suck even more supply out of the U.S. into Asia. Although U.S. demand trends (both short and long term) are weak, exports could put a floor under U.S. prices and hence earnings for our companies. In particular, we are more bullish on the Powder River Basin miners, such as Cloud Peak , Arch Coal (ACI), and Peabody Energy . If current Asian prices are sustainable, it is economical to build a new coal terminal on the West Coast and open a direct export route to the Orient. Although shipping across the Pacific is both riskier and extremely expensive, the incremental margins could be very attractive.

Of course, the big risk in this story is Asian economic growth. The coal market is finely balanced right now, and even a small disruption to the demand dynamic could send prices tottering. We see precious few signs of this at the present, but that doesn't mean danger isn't lurking around the corner.

Engineering & Construction
The performance of E&C companies is increasingly diverging depending on their geographic exposure to the U.S. and the U.K., versus the Middle East, Asia, and other fast-growing regions, in addition to their areas of expertise. In 2011, we expect companies operating in diverse geographic regions will fare generally better than companies that concentrate on the U.S. and Western European countries. In particular, we are seeing a resurgence of nuclear power plant design and construction in the Middle East and Asian countries, mostly to the benefit of a selected few E&C companies. We also expect companies to start deploying their cash judiciously, either through M&A activity or share repurchases, to improve their earnings growth profiles.

Forest Products
Containerboard producers have been the beneficiaries of several strong tailwinds during 2010. Firms such as International Paper (IP), Temple-Inland , and Packaging Corporation of America (PKG) have seen their profitability rebound as box volumes grew and as pricing increases outpaced input-cost inflation. Trailing 12-month domestic corrugated box shipments have climbed by 10 billion square feet (3%) since the lows of January 2010; however, they are still off about 10% from their 2006 levels.

The federal government once again bestowed the American corrugated manufacturers with an extra boost. The cellulosic bio-fuel tax credit program will enable forest product companies to reclassify their black liquor fuel burned in 2009. This will result in IP, PKG, and Temple-Inland having 2011 and 2012 cash tax rates that are considerably lower than their effective tax rates--providing a nice boost to the firms' cash flows.

Unfortunately, we do not believe that these good times can last forever. High levels of profits and rebounding volumes make some of the other forest product companies envious. Firms such as Boise , Greenpac, and AbitibiBowater may consider adding containerboard capacity or converting newsprint machines to run containerboard. While these expansions are currently "under study," we would not be surprised if new supply is brought into the market during the next three years. And with any new supply, we'd expect rising inventories, falling prices and shrinking profit margins.

Metals & Mining: Aluminum
The fourth quarter looks relatively bright for aluminum producers, particularly those outside China, but the supply/demand picture also requires a close watch. The average price of aluminum on the London Metals Exchange has increased considerably compared to the third quarter.

While there is a short lag in the price impact on financial results, higher average prices should give a decent boost to the top line for global aluminum producers. Part of this pricing support came from government-mandated production cuts for an estimated 20% of Chinese smelters due to energy efficiency goals. As China represents over 40% of global aluminum production, this took a sizable share of supply out of the market having a positive effect on pricing. With relatively stable order rates and production costs for the fourth quarter, this could be the best quarter of the year for companies unaffected by these output restrictions.

Whether aluminum prices hold strong into 2011 depends heavily on the supply/demand balance, particularly in China. While aluminum consumption is slowly rising globally, there exists massive overcapacity with high-cost smelters sitting idle and plenty of excess inventories. In the absence of permanent capacity reductions, aluminum prices have only a little room to climb in the next year.

Metals & Mining: Mining
Industrial metals prices and mining stocks fared well in the fourth quarter, despite uneven macroeconomic readings in the OECD countries and recurring worries that the Chinese government would take meaningful action to tamp down the country's arguably overheated growth rates.

Iron ore rose 19% to $170/ton in the spot market as of Dec. 14 from $142/ton as of Sept. 30. Among base metals, no commodity had a better quarter than copper, which rose 15% to $4.20/lb from $3.65/lb breaching all time highs set in the first half of 2008. (Meanwhile, more ballyhooed gold was up a mere 7%.)

Multiple supply-side developments fueled copper's relative outperformance. For starters, the industry continues to be plagued by labor unrest, highlighted in the fourth quarter by a lengthy strike at Collahuasi in Chile (the world's third-largest copper mine, accounting for 3% of annual global output). Worries about the potentially deleterious supply-draining effects of physical copper ETFs also contributed to the story. Finally, in contrast with fellow base metal nickel--for which nickel pig iron acts as a swing supplier when prices get high--copper has no such release valve (nickel gained 6% in the quarter).

At the end of the day, mining companies would love to goose output, but there's simply no slack left in the system, as evidenced by the 6% decline in LME stocks through Dec. 14. Barring a setback in emerging-markets growth, we're unlikely to see a significant drop in industrial metal prices in the first quarter of 2011.

A few years down the road, however, it's another matter entirely. After several quarters of cautious capital budgeting and cash conservation, mining companies look ready to open their wallets in a major way. Growth, not survival, is now the name of the game.

As we discussed in our last quarterly outlook, we continue to believe capital expenditures will be the primary means of growth. Notably, this would stand in sharp contrast to the massive M&A deals we saw in the years leading up to the financial crisis. Five of the largest miners we cover-- Vale (VALE), Xstrata (XTA), Anglo American (AAL), Freeport-McMoRan (FCX), and Teck Resources (TCK)--spent a staggering $79 billion on acquisitions from 2006 through 2008, more than double the sum they spent on expansionary capex. Yet judging by the most recent budget plans we've seen, the ratio is likely to reverse in the coming years. Take the three largest for instance: Vale, Xstrata, and Anglo. Vale, already a massive firm ($182 billion market capitalization as of Dec. 14), plans to double its size by 2015, budgeting $24 billion in capital expenditures for 2011 alone (more than twice its previous high-water mark). Xstrata sees 50% growth by 2014 and the potential for 80% growth by 2016. Anglo projects 33% by 2013 and 90% further down the road.

Granted, some of the projects contemplated by these miners may never come to fruition. But conditions are arguably much riper for growth than they have been in recent memory: Commodity prices are very strong, balance sheets are healthy, and borrowing costs are low. Consequently, we'd argue that as long as these conditions persist, we're likely to see more marginal projects getting the green light and fewer projects ending up on the cutting room floor.

Steel
Capacity concerns and economic uncertainty have led steelmakers to take a cautious view on the fourth quarter, particularly those in the U.S. Late-quarter seasonal weakness and lower realized selling prices are likely to overcome some improvement in order rates and cost relief, resulting in fourth-quarter financial performance resembling the third, which wasn't a pretty picture.

But while the latter half of 2010 will pale in comparison to the first half, we do not expect recently improving fundamentals to cause a repeat for 2011. In the past few weeks, multiple rounds of price increases were announced by U.S. steelmakers on nearly all products, and early indications are that these price hikes are sticking, with some order books closed until February.

While iron ore and scrap prices are also on the rise, the net effect on the first quarter of 2011 should be an improvement in profitability. The sustainability of these margins depends on the supply/demand balance in the U.S. steel market. We believe steel demand is continuing to recover but at a very slow pace. Prevailing lean inventories can make it difficult to match production with underlying demand trends. At the beginning of 2010, surging steel prices driven by higher costs induced an overly optimistic perception of demand, and hence prices and profitability sank in the latter half of the year as output came on too quickly. The difference heading into 2011 is that there isn't much blast furnace capacity sitting idle awaiting signs to restart, so adjusting production appropriately should be an easier task.

We believe the fourth quarter should be the bottom for earnings, but production discipline across the board will be critical to preventing a repeat of the crash and burn from 2010.

Our Top Basic Materials Picks

Top Basic Materials Sector Picks

	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buy

China Gerui		$10.00	Narrow	High	$6.00

Cloud Peak		$31.00	Narrow	High	$18.60

Lafarge		EUR 65	Narrow	High	EUR 39

Vulcan Materials		$68.00	Wide	Medium	$47.60

Yamana Gold		$17.00	None	High	$10.20


Data as of 12-16-10.

China Gerui (CHOP)
China Gerui produces specialty steel products for the Chinese market, the largest and fastest-growing steel consumer. The company has a leading position in its key narrow-strip product, which has a favorable demand outlook, plentiful raw material supply, and few sizable competitors. China Gerui has generated impressive margins with very low volatility relative to other steel market players. While substantial expansion plans in the works add risk to the sustainability of its margins, the company is currently trading at only five times our 2011 earnings estimate, which we believe is too low for a company with its track record and market position. In our view, the company has flown under the radar amid China's massive steel giants, and a substantial warrant overhang and few direct comparables in China have caused investors to shy away from a compelling opportunity to gain exposure to China's continued industrialization.

Cloud Peak
Cloud Peak is the only coal pure play in the Powder River Basin (PRB), one of the most prolific and lowest-cost coal basins in the world. The basin is an oligopoly, anchored by giants Arch Coal and Peabody Energy, which have increasingly exercised volume discipline during market weakness. Cloud is an impressive operator within the basin, and we think it has the highest per ton cash margins in the region. Moreover, its cost controls this year has been extremely impressive. We expect pricing to rise in the next several years--this will happen even if Cloud simply prices to the forward curve. This puts the company in a great position to expand per ton margins. Beyond this, we expect Cloud to benefit from a burgeoning Asian coal market, via a direct export route on the West Coast or through the convoluted flows of the global coal trade. This has the potential to drive pricing and margins much higher in future years.

Lafarge (LG)
Lafarge is the largest producer of cement on the planet, and a leading producer of other construction materials such as aggregates (rock, sand, and gravel), concrete, and gypsum (i.e., wallboard). Lafarge's main business, cement production, is characterized by capital intensity, some stiff barriers to entry, energy intensity, and a low value/weight ratio that leads to regional, rather than global, markets. We believe Lafarge has strong and sustainable competitive advantages thanks to these barriers to entry, as well as a cost advantage. Lafarge has been investing heavily in capacity expansion in emerging markets, given its more promising prospects for materials demand. The company's early 2008 acquisition of Orascom Cement gave it a leading position in the Middle East and the Mediterranean Basin, and the Orascom plants are some of the newest, largest, and lowest-cost in Lafarge's entire portfolio. The recent share price of EUR 47 translates into an EV/EBITDA multiple of less than 7 times our 2011 forecast of a still-depressed EUR 4.2 billion, which we believe doesn't reflect the longer-term recovery in earnings power that Lafarge should experience post-2011 as construction activity eventually returns to more-normal levels. We think the market is focusing on the near-term weakness and largely ignoring the likelihood of a longer-term recovery. We believe the market is treating many building material companies in the same fashion, but the weak valuation is exacerbated in Lafarge's case due to the company's greater financial leverage following the hefty Orascom acquisition in 2008.

Vulcan Materials (VMC)
Patience is the name of the game for Vulcan Materials' shareholders. The company leveraged up to purchase Florida Rock in 2007, leaving it highly exposed to the subsequent downturn in construction activity. Moreover, Vulcan paid a handsome price--a 45% premium to the market and 11 times EV/EBITDA. Since the height of the housing bubble through 2010, aggregates demand is down some 40%-50%. We think Vulcan's shares are currently undervalued, as a return to more-normal demand levels should result in a significant increase in earnings. However, the recovery will probably progress slowly, given the severity and breadth of the recession and the widespread weakness of governments' budgets. Still, in the long run, the attractive characteristics of aggregates markets and production methods should allow Vulcan to return to robust profitability.

Yamana Gold
Yamana is a midtier gold producer that operates a portfolio of six mines in Central and South America. The firm is one of the lowest-cost producers in the gold mining space and has a quartet of near-term projects that is scheduled to start gold production over the next few years. Yamana is currently trading at one of the lowest enterprise value-to-reserves ratios among the major gold miners, which we believe is unwarranted given the firm's low-cost profile and promising growth trajectory. We think a major overhang on the stock is the market's misgivings about Yamana's ability to execute on its growth projects. However, we think that Yamana will be better able to focus on internal development projects after spending the last few years digesting major acquisitions. The first of these projects, Mercedes, has already broken ground, and we anticipate the remaining three projects to receive final permits and start construction in early 2011. Other factors dragging down Yamana's relative valuation are likely its high weighting of copper production as well as the fact that Agua Rica, an undeveloped gold-copper deposit, contains a significant portion of Yamana's proven reserves. However, we think Yamana's ratio of copper to gold production should decrease going forward as new mines start production, and our valuation is supported by a discounted cash-flow model that doesn't fully incorporate Agua Rica's potential.

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