CIBC's Matt Gibson sees upside in iron in 2013
Investors who want to play in the iron and copper space should look to small-cap producers for attractive valuations and lower risk, says Matt Gibson, institutional research analyst with CIBC World Markets. In this Gold Report interview, he says he believes iron has found its floor in 2012 and names iron ore and copper companies with upside potential.
The Gold Report: Matt, you cover four companies in the iron space with market caps that range from Cliffs Natural Resources Inc. (CLF:NYSE) at $4.2 billion and Labrador Iron Mines Holdings Ltd. (LIM:TSX) to Alderon Iron Ore Corp. (ADV:TSX; AXX:NYSE.MKT) and New Millennium Iron Corp. (NML:TSX) with market caps around $200 million. In Q1/12, all of them were worth double what they are trading at today. Why should investors be interested in these companies?
Matt Gibson: We have started to see positive trends in the iron ore space. Chinese port inventories have started to tick down, while capacity utilization globally and in the U.S. has started to tick up for steel companies. Iron ore prices have rebounded from lows of $86/metric ton (Mt) to the $118–120 Mt level.
TGR: Are larger companies like Cliffs being punished for their acquisitions or is the across-the-board share price decline all about low steel prices and global economic fears?
MG: I think most of it has to do with iron ore prices and sentiment regarding Chinese growth.
"We have started to see positive trends in the iron ore space."
For Cliffs, the slow ramp-up at its Bloom Lake mine, which has led to elevated cash costs at the facility and lower margins, has not helped. Delays to the planned expansion and the downward revision of the mine plan to an ultimate capacity of 14 Mt have not helped either. Finally, higher operating costs put pressure on the company's balance sheet.
TGR: A recent CIBC World Markets' research report stated, "Despite elevated inventories of steel and iron ore, Chinese steel mills continue to maintain daily crude steel output near record levels." As you mentioned, that seems to be changing. But is it changing quickly enough?
MG: I think China's infrastructure announcement earlier in the fall helped draw down some of the inventories. Certainly, the overcapacity issue in China has a lot to do with the fragmented nature of the industry there, and that will take some time to play out. However, the Chinese government has been putting efforts into consolidating production into larger, more efficient operations.
TGR: The Chinese bought in at much higher prices on several juniors in the iron space. Do you think the Chinese regret that decision or was this always about the long term?
MG: China's real interest is not so much from an investment point of view as it was about longer-term offtake, securing supply of iron ore and being able to diversify away from reliance on the big three producers.
TGR: In September, you dropped your 2012 near-term iron ore price forecast from $143/Mt cost, insurance and freight (CIF) to $128/Mt CIF. That also caused you to lower your target prices for the four iron companies you cover. Have we reached a bottom to the price drop?
MG: Near term, I believe prices found a floor in the $110–120/Mt level. That's pretty much where most estimate the average cost of production to be in China.
That being said, the upside or potential price increases will be limited by growth in China and economic growth in Western Europe.
TGR: Would you say your view of global economic growth is reasonably bullish?
MG: There are some positive indications and I am optimistic that 2013 will be a better year than 2012, and that will be good for the iron ore sector.
TGR: Let's move to your coverage, starting with Alderon Iron. Your 12-to-18 month target price on that company is $5.20, more than double its current share price. What about Alderon and its Kami Iron Project engenders that kind of confidence?
MG: Alderon's management team has experience developing and building these types of assets. Several people on the management team have a background with Consolidated Thompson or with the Iron Ore Company of Canada, which have operated in the Labrador Trough for a long time.
Copper remains one of the tightest markets from the fundamental supply-and-demand perspective."
Alderon also has a strong partnership with the largest Chinese steel producer. This is a producer that has only a small fraction of its iron ore supply captive right now.
Finally, there are potential catalysts on the horizon, including the release of definitive feasibility studies, rail agreements and permitting.
TGR: Cliffs Natural Resources went on a spending spree a few years ago, buying Consolidated Thompson, KWG Resources, Freewest Resources and Spider Resources, among others. Earlier, you attributed some of that drop to issues at Bloom Lake. But do you think Cliffs took on too much in those acquisitions?
MG: I think Cliffs got caught in a difficult position when it bought development assets just when prices turned. In retrospect, it looks as if the company may have stretched or overextended itself, but if prices stay stable things will look different a year from now.
TGR: You have a Sector Perform rating on Cliffs and a $55 target price, not quite double its current price. What will it take to get Cliffs from here to there?
MG: Cliffs needs to get up to full production at Bloom Lake. It has been ramping up and doing a lot of predevelopment stripping for a number of different mining phases. In U.S. accounting practices, all of those expenses have to be expensed on the income statement and impact cash costs. In other jurisdictions, those cash costs would be capitalized and amortized over a period.
Now that the stripping is done, Cliffs has multiple phases up and running. When Bloom Lake hits the 7 Mt annualized capacity mark, it should be able to drive its costs down on a per tonne basis.
TGR: Next, let's talk about Labrador Iron Ore Royalty. It started out as an income trust—a form of company that does not exist in the U.S.—and is now a dividend-paying corporation. Why did the company make that change and how will it affect investors?
MG: As an income trust, Labrador Iron Ore Royalty was basically a flow-through vehicle for the royalty income and dividend stream coming out of the Iron Ore Company of Canada. It was organized that way for tax efficiency purposes. The Canadian government changed its stance on how those types of vehicles are taxed and most of the income trusts converted back into dividend-paying corporations.
"In the near term, small-cap producers offer some attractive valuations and a lower risk way to play copper compared to development companies."
I really do not think anything has changed in how Labrador Iron Ore Royalty will operate. The company also is expanding annual capacity from 17 Mt to 23.3 Mt on an asset at Iron Ore Company of Canada that is run by Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK). Increased sales volume from that should contribute to higher royalty income and likely a large special dividend from Iron Ore Company of Canada in the latter half of 2013.
TGR: Should shareholders be pleased with this change in structure?
MG: The real impact for an individual investor is the change from getting part of the distributions in the form of interest payment, to getting it all as a dividend. For individual investors in Canada, it is more advantageous to receive everything as a dividend; I'm not sure about the tax implications for U.S. investors.
This actually represents one of the lower-risk plays in iron ore if you want exposure to iron ore while getting paid to hold the stock. Over the last 12 months, Labrador Iron Ore Royalty has distributed $1.50/share to shareholders, which represents about a 5% yield on the current stock price. The distribution could increase to $2.30/share in 2013.
TGR: Is your target price on Labrador Iron Ore still $40?
MG: Yes, it is.
TGR: The fourth company you cover is New Millennium Iron Ore. It is developing the Direct Ship Ore (DSO) project in Northern Québec. Tata Steel Ltd. (TTST:LSE; TATLY:OTC) has already agreed to take 100% of the ore produced, correct?
MG: Yes. The DSO Project is under construction. In 2012, it produced around 300,000 tons of sellable product, and will probably do about 2–2.5 Mt in 2013.
TGR: The total resource at DSO is 125 Mt. How does that compare to other companies of similar size in this space?
MG: The DSO resource base is similar to Labrador Iron Mines Holdings Ltd.'s (LIM:TSX) resource located nearby. Labrador Iron is more of a seasonal operator and delivers its product through Iron Ore Company of Canada.
New Millennium will operate year round in an enclosed structure and sell its product initially through port facilities owned by a local aluminum plant in Sept-Îles and later through the multiuser port that the Port of Sept-Îles is now building. That facility should be completed at the end of 2013 or early 2014.
TGR: Do you consider it an advantage that 100% of the offtake at DSO has been secured by Tata Steel?
MG: I suppose one could see that as a potential risk. But at the end of the day, Tata is the lead operator of the DSO project and New Millennium has a free carry into production. Unless Tata's view of the Corus steel manufacturing facility in the U.K. changes, this offtake should be fairly secure and on typical commercial terms priced on international benchmarks.
TGR: Do you think New Millennium is secure enough in exchange for that 100% offtake agreement?
MG: The offtake agreement gets New Millennium to the point of generating cash flow; making that transaction positive for any junior.
Whether it is a fair deal or not, getting DSO up and running was really just an entry point for Tata Steel into the Labrador Trough. The strategic value of that will really be reflected when New Millennium starts developing and getting the larger taconite projects into production. That will require further investment decisions by Tata. The cash-flow implications for New Millennium from getting the larger, taconite projects up and running could be a real game changer.
TGR: What is taconite?
MG: Taconite is a colloquial term used to describe banded iron formations.
The investment decision required for the larger taconite project will be predicated on the definitive feasibility study that should be published in the next few months. We expect the investment decision in mid-2013.
TGR: How big an issue is transportation for New Millennium at both DSO and the taconite projects? Does it need a rail agreement to induce Tata to sign on to those taconite projects?
MG: The taconite project requires a slurry pipeline from the processing facility in the north down to a pelletizing facility in Sept-Îles.
There's potential for New Millennium to sign an agreement with a consortium of the Canadian National Railway and the Caisse de Dépôt that is contemplating building a new rail line to where this project is going to be located. Canadian National Rail will head up construction and the Caisse de Dépôt will provide financial backing.
It signed a rail agreement for DSO with Québec North Shore and Labrador Railway in January 2012.
TGR: What is your target price on New Millennium?
MG: It is $4.30, almost triple where it is right now, based on a discounted cash flow model.
Lately in the Labrador Trough, a lot of players have been painted with the same brush as Cliffs and Labrador Iron Mines, and similar discounts have been applied across the board. But I think New Millennium is operating differently from other startups.
TGR: Is that due to its management team?
MG: Yes, it is due to a solid management team. This team understands how the business operates and the pitfalls of not owning your own infrastructure.
TGR: I would like to move on to copper. Copper traded down in October but looked to be rebounding at the end of November. What is your near-term outlook for copper?
MG: We see some marginal upside to copper prices in 2013, although not materially higher than today's $3.60/pound (lb). We are forecasting $3.75/lb for 2013; overall, some strength, but limited downside from current price levels.
TGR: What is your central thesis for the primary copper plays you cover?
MG: Copper remains one of the tightest markets from the fundamental supply-and-demand perspective.
Right now, the junior producers are heavily discounted compared to the more senior players. A lot of the juniors have no value reflected in the market for some of their growth projects.
I think development or preproduction plays offer the opportunity to gain a lot of torque to the copper prices albeit with higher risk. They also offer investors the opportunity to participate in derisking projects, growing resources and the potential to rerate when a play moves from development into production.
TGR: Which companies do you cover in the copper space?
MG: Starting at the top of the alphabet, Augusta Resource Corp. (AZC:TSX; AZC:NYSE.MKT; A5R:FSE) is really a permitting story at this point. We expect it to obtain its record of decision early in 2013. This is a very robust project from a capital intensive point of view.
In terms of upcoming catalysts, Rio Alto Mining Ltd. (RIO:TSX.V; RIO:BVL) should come out with some 2013 guidance in January, along with a new reserve calculation and mine plan. We expect its life-of-mine rates to increase substantially on the back of recent grade reconciliations from production and a previous resource model, as well as exploration results from work done this year.
Rio Alto is also starting a regional exploration program on its land package; we expect those results to boost the stock.
TGR: How did Rio Alto perform against guidance in 2012?
MG: The company revised guidance upward twice in 2012. The original estimate of 100,000 ounces (100 Koz) was revised at midyear to 160 Koz and again to 200 Koz toward the end of the year. We believe Rio Alto will reach 200 Koz, mostly due to positive grade reconciliations.
TGR: Rio Alto's La Arena is a massive open-pit mine in Peru. What is its expected mine life?
MG: Right now the oxide has an expected mine life of about six to seven years for the material close to surface. The sulfide deposit will have a much longer life.
Those mine lives are based on what the company has drilled off to NI 43-101 standards to date. It has a large land package, so I would expect the mine life to be extended on the gold side through exploration.
TGR: What are your targets on Augusta and Rio Alto?
MG: My target on Augusta is $5/share and Rio Alto is $8/share.
TGR: Finally, what is up with Western Copper and Gold Corp. (WRN:TSX; WRN:NYSE.MKT) and its massive Proven and Probable reserve?
MG: That project has the potential to move the needle for a major copper producer. We expect the results of a definitive feasibility study in the near term to provide some clarity around power options for the project. The investment community and potential joint venture partners have both focused on that issue. Clarifying the power issue should pave the way for the company to find a joint venture agreement with a major copper producer or lead to an outright sale of the company.
TGR: But the big copper producers do not like to share. Which company could swallow something this large?
MG: It would have to be a company the size of a Teck Resources Ltd. (TCK:NYSE; TCK.A:TSX), Rio Tinto, BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) or Antofagasta Plc (ANTO:LSE).
TGR: Do you have any parting thoughts on the infrastructure material space for our readers?
MG: In the near term, small-cap producers offer some attractive valuations and a lower risk way to play copper compared to development companies.
I would look for companies with strong balance sheets, capable management teams and good projected growth over the next five to seven years for near-term returns.
TGR: And would you include the iron companies in that?
MG: Yes, absolutely. The criteria are very similar.
TGR: Matt, thanks for your time and your insights.
Matt Gibson joined CIBC's Equity Research Department in February 2009. He covers the junior base metal, rare earth, uranium and iron ore spaces. His more macro focus and financial acumen have helped to support commodity-related calls and augment the wealth of technical expertise on the mining research team. Gibson holds a Master of Business Administration from McMaster University, where he focused on financial markets and business valuation, and a bachelor's degree (Honors) in economics from McMaster University.
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1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Alderon Iron Ore Corp. and New Millennium Iron Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Matt Gibson: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.