June 28, 2006 Global Gambits The Right Moves for Right Now Metals and Mining chapter The following is a chapter from, dated June 28, 2006. This chapter is presented for convenience, and should be read in conjunction with the full report and its analyst certifications and important disclosures. The full report is available on MorganMarkets.
Metals and Mining The Cycle is Not Over: Still Plenty of Legs Global Sector Coordinator Michael F. Gambardella (1-212) 622-6446 michael.gambardella@jpmorgan.com J.P. Morgan Securities Inc. Full sector coverage details on page 8 Key Drivers Anxiety over inflation, interest rates and the global economy should remain key drivers of metal prices and investors sentiment towards the sector in the near term. However, in the longer term, we believe precious metals, base metals and steel fundamentals will be underpinned by global economic growth, relatively constrained supply and growing belief in commodities as requisites for investment allocation. US dollar strength will likely continue to play a pivotal role for commodity prices. Generally, a weaker US dollar is positive for commodity pricing and vice versa. Gold has become highly volatile in the short term. The fundamental factors of weakening supply, falling central bank sales, double deficits, inflation fears, geo-political tensions, etc., remain intact with a very positive influence on gold prices. However, it is fund flows that should drive gold in the short term, and this adds volatility. We expect to see continued volatility in gold prices in the short term but remain convinced that in the longer term, the risk is on the upside. Steel-making input costs continue to rise; we believe cost push pressure will drive global steel prices higher. Iron ore producers have concluded their 2006 contracts with most major customers (with one notable exception the Chinese) and iron ore fines are set to rise by 19% Y/Y while pellet prices are set to drop by 3% Y/Y. If Chinese steel-makers are forced to swallow a substantial iron ore price increase, as we expect, they will have to raise their prices, which would be bullish for steel prices and steel-makers earnings globally. Our Non-Consensus Views Everybody was wrong on metal prices including us. While we and a number of other industry participants had laid out the analysis of a super-cycle for commodity metals, it looks like no one can say that their estimates were anywhere near the surge in metal prices over the past 18 months. Virtually all commodity analysts, including our own, were forced to raise their metal price forecasts almost on a regular basis over this time period in an attempt to catch up with surging prices, and they were still significantly below spot prices although the recent correction in metals has brought prices more in line with expectations. Steel prices should continue to move higher on a global basis. Global steel fundamentals remain solid, with supply and demand in balance. In addition, steel-making input costs continue to rise, and this cost push pressure should drive steel prices higher through 2006. We like the longer-term fundamentals for coal stocks, but we are bearish in the short term. We believe coal stocks are currently factoring in large premiums for coal-to-liquids (CTL) projects. We do not expect CTL to make a large contribution in most investors time horizons, plus carbon dixode storage issues are likely to complicate permitting. CTL also introduces the interesting dynamic of power utilities feeling that new liquids projects are taking up their coal reserves. Also, in the short term, the current large natural gas inventory overhang could drag coal stocks lower in the absence of an extremely warm summer. 2
Metals & Mining: Top Picks Company Key Financials Rationale and Catalysts Alcoa Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: AA US / AA 2005 2006E 2007E 1.53 3.45 3.25 Exchange: NYSE P/E (Calendar) Price (Local): US$30.26 2006E 2007E Mkt Cap (US$): 26.3 bn 8.8 9.3 Analyst: Michael F. Gambardella EV/EBITDA (Calendar) Phone: (1-212) 622-6446 2006E 2007E Email: michael.gambardella@jpmorgan.com 5.6 5.8 We believe Alcoa has turned the corner and is poised to fully participate in the high metal price environment after its results lagged the results of other metals and mining companies over the last two years. Until posting record 1Q06 results, Alcoa had primarily disappointed investors due to cost headwinds that have since stabilized or abated due to management s restructuring efforts. In our view, the threat of a strike at its US operations has been an overhang on the stock for most of 2Q06. Now that the threat of work stoppage has passed due to the new four-year labor agreement negotiated at the eleventh hour, we expect Alcoa s shares to recover and reflect the strong earnings outlook of the company. Indeed, we expect it to post record results in 2Q06 and the new labor contract should improve Alcoa s competitive position by capping longterm healthcare liabilities and requiring US wage earners to contribute to their healthcare plan for the first time. Besides restructuring to better align costs, Alcoa has invested in several attractive upstream refining and smelting projects that will increase production in lower cost regions (i.e. Iceland, Trinidad and Tobago), which should at a minimum help maintain the company s position along the cost curve. Alcoa is also actively investing downstream and we should begin to see incrementally positive results from its Russian rolling mills and investments in China. We also believe Alcoa s shares represent a compelling value at the current levels given that the stock has historically traded at a forward P/E of 15x and a historical EV/EBITDA multiple of 8.1x, which implies substantial upside to the current share price. BHP Billiton Rating: Overweight Fiscal EPS (Local): Year-end Jun. Ticker: BHP AU / BHP.AX 2005 2006E 2007E Ticker ADR: BHP 107.70 170.50 197.80 Exchange: Sydney Stock Exchange P/E (Calendar) Price (Local): A$26.00 2006E 2007E Mkt Cap (US$): 71.0 bn 9.4 10.6 Analyst: David George EV/EBITDA (Calendar) Phone: (61-3) 9608-4002 2006E 2007E Email: david.b.george@jpmorgan.com 6.1 6.4 Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. With increased volatility in base metal prices, we prefer companies with quality diversified resources and sustainable earnings generated from low cost, long life assets. We maintain our Overweight rating on BHP with a June 2007 price target of A$35, which is 12.5x peak EPS (FY07E) and which corresponds to approximately 15x sustainable EPS. Commodity prices remain the key risk to our price target. BHP s earnings are less sensitive to falling base metal prices because of: (1) its exposure to oil (20% of FY07E EBIT); and (2) its EBIT from non-exchangeable traded commodities increasing to approximately 50% by FY08E. We estimate BHP to generate significant free cash flow over the next three years. Even if our metal price estimates fall below commodity prices, there is still potential for significant investment in new projects and/or capital management. 3
Metals & Mining: Top Picks (cont d) Company Key Financials Rationale and Catalysts Glamis Gold Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: GLG US / GLG 2005 2006E 2007E 0.24 0.93 1.23 Exchange: NYSE P/E (Calendar) Price (Local): US$32.63 2006E 2007E Mkt Cap (US$): 5.4 bn 35.1 26.5 Analyst: John Bridges, CFA, ASCM EV/EBITDA (Calendar) Phone: (1-212) 622-6430 2006E 2007E Email: john.bridges@jpmorgan.com 11.1 9.1 Glamis Gold (GLG) completed the purchase of Western Silver for its Penasquito gold/silver asset on May 2, 2006. Based on Western Silver s reserve estimates, the new project adds about 4.9moz or an extra 85% to GLG s 2005 year-end 5.75moz reserve and more importantly an extra 308 million silver ounces on GLG s own reserves of 42 million silver ounces. The actual value of the Penasquito project will be determined by GLG s engineers with the feasibility study, but we are confident that after spending one year investigating the property, management sees value. Penasquito is additive to GLG s exisiting portfolio of growth projects that should see gold production grow from 435moz in 2005 to 962moz by 2009 and silver from 157moz in 2005 to 10,000moz by 2009. Though its value has grown with the silver price, we believe the market is not fully reflecting the Penasquito upside that results from the larger planned project and our belief that silver prices will remain at higher levels. Consequently, we believe GLG is relatively undervalued compared with its peer group of North American precious metals producers. Kinross Gold Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: KGC 2005 2006E 2007E (0.10) 0.49 0.70 Exchange: NYSE P/E (Calendar) Price (Local): US$9.86 2006E 2007E Mkt Cap (US$): 3.4 bn 20.1 14.1 Analyst: John Bridges, CFA, ASCM EV/EBITDA (Calendar) Phone: (1-212) 622-6430 2006E 2007E Email: john.bridges@jpmorgan.com 8.7 6.7 Kinross has one of the highest sensitivities to gold prices within our coverage list. We believe the accounting dispute with the SEC over how the acquisition costs for TVX Gold and Echo Bay should be reported kept the stock off investors radar screen for some time but did not represent a significant negative to the stock s potential. Kinross, in our opinion, has a much improved portfolio of assets after the Kinross/Echo Bay/TVX merger. It has acquired better quality mines at Paracatu, Round Mountain and Buckhorn and is improving its exisiting mines at Refugio and Fort Knox. These should underpin a growth profile taking the (equivalent) gold production from an estimated 1.4moz in 2006 to 1.9moz in 2009. Kinross plans to expand its grinding mill at Paracatu in two stages from the current throughput rate of 17mtpa to 30mtpa and finally to 50mtpa over a 3-4 year period. The company is also planning expansions at Kettle River/Buckhorn and Round Mountain. Higher sensitivity to gold prices, increasing the attractiveness of its orebodies at higher gold prices and planned expansions underpin our Overweight rating on Kinross. Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. 4
Metals & Mining: Top Picks (cont d) Company Key Financials Rationale and Catalysts Ternium Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: TX US / TX 2005 2006E 2007E 0.58 0.39 0.40 Exchange: NYSE P/E (Calendar) Price (Local): US$22.27 2006E 2007E Mkt Cap (US$): 4.5 bn 5.7 5.6 Analyst: Rodolfo R. De Angele, CFA EV/EBITDA (Calendar) Phone: (55-11) 3048-3888 2006E 2007E Email: rodolfo.r.angele@jpmorgan.com 3.4 2.6 We view Ternium as a growth story. We expect its EBITDA to grow 22% and 7% in 2006E and 2007E, respectively, driven mainly by two factors: (1) an improved steel industry pricing scenario; and (2) cost reductions, as the company starts to reap the benefits of the consolidation of its recently joined operations (the company was created by joining Siderar, Sidor and Hylsamex). We also expect Ternium to pursue a second wave of synergies and cost reduction opportunities in the medium term. In our view, management has the track record and credentials to build a leading steel company while delivering returns to investors. Ternium s creator and controlling shareholder is the Techint Group, which has in the recent past constructed a successful, and to some extent, similar story in the steel industry, i.e. Tenaris, a leading player in its business segment. The price of Tenaris shares have multiplied by around 10x since its IPO in December 2003, vs. a 17% rise for the S&P 500. Ternium is the most inexpensive stock within our Latin American steel stock universe, trading at implicit EV/EBITDA multiples of 3.4x for 2006E and 2.6x for 2007E. This compares to average trading multiples in the global steel industry of 9.0x and 7.6x, respectively. In our opinion, Ternium s stock should not remain cheap for long. We anticipate two main catalysts to drive up valuation: (1) building up of reporting history (currently only two truly comparable quarters of historical performance are available, plus yearly historicals since 2003); and (2) increased coverage from sell side analysts Ternium is a recent story (IPO was at the end of January and the company still has still has thin coverage). Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. 5
Metals & Mining: Top Picks (cont d) Company Key Financials Rationale and Catalysts U.S. Steel Corp. Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: X US / X 2005 2006E 2007E 7.17 11.00 11.50 Exchange: NYSE P/E (Calendar) Price (Local): US$64.00 2006E 2007E Mkt Cap (US$): 7.0 bn 5.8 5.6 Analyst: Michael F. Gambardella EV/EBITDA (Calendar) Phone: (1-212) 622-6446 2006E 2007E Email: michael.gambardella@jpmorgan.com 3.3 3.2 We view U.S. Steel as an attractive investment as we believe the steel market outlook is strong with domestic HRC prices over US$600/ton, rising Asian and European prices, service center inventory levels in balance at three months supply on-hand, and steady imports. We believe the high level of consolidation over the past cycle has created an environment in which supply discipline by steel producers can reduce the cyclicality of steel prices. In addition, high raw material costs are making labor cost differentials less meaningful. As coal, iron ore, natural gas and scrap costs have taken a step-up in prices, they have made labor costs a much smaller percentage of overall steel production costs, allowing domestic producers to narrow the cost gap with overseas producers. We recently increased our 2006 EPS estimate for U.S. Steel to US$11.00 versus consensus estimates of US$8.54 as we believe the company will benefit from the recent restart of its Gary, Indiana blast furnace #14. The restart should help U.S. Steel pick up spot sales, especially due to the recent outage at Mittal Steel s Indiana Harbor facility which we estimate accounts for 4-5% of domestic sheet capacity. We have a May 2007 target price of US$100 for U.S. Steel, based on our sum-of-the-parts valuation analysis representing 56% upside price potential. Key risks to target price earnings and demand for steel are intertwined. If economic growth were to slow, then demand for steel would likely decline, resulting in lower steel selling prices and earnings and cash flow generation. Given such a scenario, it would be unlikely for U.S. Steel to meet our target price. Vedanta Resources Rating: Overweight Fiscal EPS (US$): Year-end Mar. Ticker: VED LN / VED.L 2005 2006 2007E 1.30 3.22 2.25 Exchange: London Stock Exchange P/E (Calendar) Price (Local): 1256p 2006E 2007E Mkt Cap (US$): 6.7 bn 8.2 9.3 Analyst: James E Kelly EV/EBITDA (Calendar) Phone: (44-20) 7325-3561 2006E 2007E Email: james.e.kelly@jpmchase.com 3.1 3.7 Vedanta is an ongoing story of organic growth creating low-cost operations that provide unparalled leverage to the Indian growth story. We believe Vedanta continues to have the best volume growth in the industry as the group moves towards its goal of 1mtpa in each of its core metals. With Phase I expansions nearing completion and Phase II beginnning, the company has built a track record of delivering low-cost expansions on time and within budget. Attention is now turning to what happens after Phase II, and management comments at the recent annual results presentation suggest that more growth is on the way. Vedanta has a long-standing MoU to enter the iron ore market in India, and it is currently looking at how to take this forward in the context of the Indian requirement to process this into steel within India a strategic steel partner is a distinct possibility. When combined with the possible entry into the Indian thermal coal market, we believe that this provides attractive growth and diversification options. Currently, the key metals for Vedanta are zinc and copper (49% and 39% of FY06E EBITDA, respectively), metals that we believe have good fundamentals and which provide upside potential to earnings. We believe the potent combination of zinc and copper exposure coupled with a best in class volume growth profile means that Vedanta is set to continue its outperformance. Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. 6
Metals & Mining: Stock to Underweight Company Key Financials Rationale and Catalysts Antofagasta Rating: Underweight Fiscal EPS (US$l): Year-end Dec. Ticker: ANTO LN ANTO.L 2005 2006E 2007E 3.88 4.89 3.25 Exchange: London Stock Exchange P/E (Calendar) Price (Local): 1926p 2006E 2007E Mt Cap (US$): 7.0 bn 7.3 11.0 Analyst: James E. Kelly EV/EBITDA (Calendar) Phone: (44-20) 7325-3561 2006E 2007E Email: james.e.kelly@jpmchase.com 4.2 3.0 Antofagasta is a pure play copper producer, which is currently benefitting from useful molybdenum by-product credits. Its share price performance has a strong correlation (R-sq of 94%) with copper price performance. Consequently, an over-arching consideration for viewing Antofagasta s potential share price performance is the future copper price outlook. JPMorgan estimates copper to average 181 US c/lb for 2007, over 40% below the current spot price of 320 US c/lb. The historical relationship suggests that Antofagasta is poised for a period of underperformance. Putting aside the copper price relationship, and despite impressive management and assets, we maintain our Underweight rating on Antofagasta against its European base metals and mining peers of Vedanta and Kazakhmys as we believe it has an inferior growth profile in the short to medium term. We estimate that copper production will fall 5% to 442kt in 2006, and it will hold at this level until the completion of the Esperanza or Reko Diq projects (JPMorgan estimates 2010). It is worth noting that since the death of the modern founder, Andronico Luksic, the company is starting to challenge its conservative label. The acquisition of Tethyan (and the contained Reko Diq prospect in Pakistan) is the group s first venture outside Latin America, and the JV with Barrick Gold (to exploit Reko Diq) signals a change in direction. We believe the JV with Barrick could be the first in a series of tie-ups that spread project risk and leverage the two companies skills sets. Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, 2006. 7
JPMorgan Global Metals and Mining Team Research Equity Research Credit Research Americas Americas Michael Gambardella Global Sector Coordinator United States Michael Gambardella Jeffrey Largey Nathan Zibilich, CFA John Bridges, CFA, ACSM. Ankush Agarwal United States Latin America Rodolfo Angele, CFA Debbie Bobovnikova EMEA EMEA Pan-Europe Ross W Gardiner Pan-Europe & CEEMEA Patricia Lopez Del Rio James Kelly CEEMEA Rodolfo Angele, CFA Debbie Bobovnikova South Africa Steve Shepherd Douglas Orsmond Ross W Gardiner Asia Pacific Asia Pacific Australia David George Mark Greenwood Ryan Martyn Matthew Whittall Matthew Mumme Australia, New Zealand China Feng Zhang Japan David Common, CFA (HY-Metals & Mining) Xin Liu Richard Yu (HG- Metals & Mining) Yanru Chen (HG- Metals & Mining) Douglas Krehbiel Tatiana Tchembarova Allison Bellows Tiernan Mana Nakazora Indonesia Ami Tantri Japan Thailand Sukit Chawalitakul 8
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