Companhia Vale do Rio Doce (RIO): Strong play on iron ore

Posted Dec 6th 2007 4:10PM by Steven Halpern
Filed under: International Markets, Newsletters, BHP Billiton Ltd ADR (BHP), Rio Tinto plc ADS (RIO), Freep't McMoRan Copper (FCX), Commodities, Stocks to Buy

According to Roger Conrad and Yiannis Mostrous, "Resource stocks are by nature volatile. The important thing is we're still very much in a long-term bull market. And when the market mood does shift, today's pain will convert very quickly to massive gain."

In Vital Resource Investor they explain, "There is ongoing consolidation in this sector and the recent setback in stock prices make deals more attractive for acquirers." Here, they look at Companhia Vale do Rio Doce (NYSE: RIO), a play on consolidation in the iron ore industry.

"And when the market mood does shift, today's pain will convert very quickly to massive gain. The long-term underpinnings for vital resources are strong as ever: Soaring demand from the world's emerging growth engines, a growing scarcity of easily accessed supplies, rising development costs, resurgent resource nationalism and ongoing sector consolidation.

"It's this last trend that's captured our attention lately. Importantly, when it comes to developing vital resources profitably, size is essential. This year has already witnessed two mega-deals: Freeport Copper & Gold (NYSE: FCX) has bought Phelps Dodge and Rio Tinto (NYSE: RTP) purchased Alcan.

"And we're certain to see many more announced in coming months. The recent dance between BHP Billiton (NYSE: BHP) and its giant rival suggest the need to get bigger is greater than ever. Even if it doesn't succeed, the proposed merger is already increasing rivals' urge to merge.

"One of our key objectives with Vital Resource Investor is to spot potential merger candidates. Our rule is to avoid anything we wouldn't want to own if there were no deal. Happily, the best-run companies tend to fetch the biggest takeover premiums, making them the juiciest merger bets as well.

"Companhia Vale do Rio Doce (NYSE: RIO) is a potential bet on iron ore consolidation. The big issue is freight. Most iron ore producers negotiate contract prices with steel mills based on the market's supply and demand outlook. CVRD is getting roughly USD $40 per ton more than the Australians.

"CVRD's advantage is basically geography. Shipping rates are less from Australia than from its home country of Brazil, due to the former's proximity to China. Historically the difference has been around USD $5 per ton, something the Australians could accept, particularly because CVRD's iron is of premium quality.

"Now, given the structural shift in shipping costs, the numbers are becoming too big to be ignored. Rio Tinto and BHP leave an estimated US $3 billion of pre-tax profit per year on the table. That's in part because of the value they place on their long-term customer relationships. But it's also because they haven't had a unified front on the issue, something that would of course change with a merger.

"Given the tight market situation, the pair could sell a bigger part of their production in the spot market, essentially forcing the steel mills to pay higher prices. The result is again higher iron ore prices. That will benefit all producers, including CVRD. And it will also boost the company's takeover appeal – making this a double play."

Each day, Steven Halpern's TheStockAdvisors.com website features the latest investment commentary and favorite stock picks of the nation's leading financial newsletter advisors.

Tags: brazil stocks, companhia vale do rio doce, fcx, freeport mcmoran, FreeportMcmoran, iron ore stocks, metals stocks, mining stocks, phelps dodge, resource stocks, rio, rio tinto, roger conrad, rtp, vital resource investor, yannis mostrous

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Reader Comments (Page 1 of 1)

12-07-2007 @ 4:41PM

Robert said...

RIO does look like a great stock, cheap and very levered to Iron Ore and Nickel. It is not a takeout candidate though and never will be. The Brazilian government owns several "super voting right" shares that give it a majority voting position in the stock, and they are not about to let a national champion be acquired by an outsider.

The reason this looks so compelling? Current consensus for Iron Ore price increases is 35-45% up from the $45 level it is at now. Current spot rate (including freight) is $190, and over the last 3 years (since this cycle became really strong), the contract has come in at a discount to spot rates of between 7 and 20%. At a 20% discount to spot, the cost of iron ore (including freight) is $152. Once you subtract freight ($80 from Brazil) you get an Iron Ore price of $72, that is a 60% increase in Iron Ore price, which means RIO is still VERY cheap.