We are paring our fair value estimate for Xstrata to reflect our expectation that the Australian government's mineral resource rent tax will be implemented as presently conceived. The terms of the MRRT, as promulgated by the new Gillard government, are significantly less onerous than the resource super profits tax plan put forth by the Rudd government. We had not elected to reduce our fair value estimate at the time of the RSPT's announcement because of the significant doubts we had regarding Labor's ability to implement the relatively punitive tax programme. We have more confidence concerning the implementation prospects of the MRRT, since it appears to be the product of consultation between the new government and the big mining companies (Xstrata included). Therefore, we think it is prudent to include the MRRT's ramifications in our fair value estimate.
The MRRT is a much better deal for Xstrata on several counts. First, whereas the RSPT would have applied to all mining activities, the MRRT will apply only to iron ore and coal. So, while RSPT would have dinged Xstrata's Australian coal, copper, nickel, and zinc operations, under MRRT all but the first is spared. Second, the headline rate is significantly reduced. Whereas RSPT slapped a 40% tax on resource producers (in addition to the corporate income tax), MRRT applies a 30% tax, which is softened by a 25% extraction allowance, which, in the government's words, would "further shield from tax the important know-how and capital that mining companies bring to mineral extraction." Effectively, this shakes out to a 22.5% tax, which is deductible for corporate income tax purposes. Third, the MRRT allows companies to use the market value of assets when calculating depreciation for tax purposes, reducing the resulting liability for assets with below market book values. Fourth, for new projects, the MRRT allows capital expenditures to be deducted immediately, a significant tax shield for early-stage projects. All told, we estimate the impact on Xstrata's net worth at about $4.5 billion, a modest sum compared with the valuation consequences of the RSPT, which we estimated at $10 billion.
Fair Value Estimate: 1,400p ¦ Uncertainty Rating: Very High ¦ Economic Moat: None
Thesis
Xstrata as we know it today is a product of management ambition, foresight, and good fortune. After taking the helm of what was a modest-size zinc and ferroalloy firm in 2001, the executive team embarked on an aggressive acquisition strategy, cobbling together far-flung operations across the commodity spectrum to create one of the world's largest, most diversified miners in a matter of years. Management's mission now shifts from mergers and acquisitions to the nuts and bolts of internal growth. Whereas Xstrata's fortunes had previously been determined by the value created or destroyed in deals, its fate will now be dictated by its ability to unlock the value embedded in some of its promising, albeit capital-intensive, projects.
Management's strategy was predicated on the belief that supply constraints (declining head grades, decreasing frequency of world-class discoveries) would engender a favourable price environment for the foreseeable future. As it turned out, the acquisitive approach served investors well for several years. Continuously rising prices meant an acquisition would quickly pay for itself, allowing management to deleverage the balance sheet, then embark on yet another acquisition--a virtuous cycle that fuelled Xstrata's breakneck league table ascendance over the past decade. Of course, the shining success of Xstrata's M&A binge had less to do with management's original supply-side thesis than it did with the explosion of Chinese demand, a seminal development for the commodity market and one that management admits it did not foresee.
The situation changed dramatically in the back half of 2008, as global demand collapsed and commodity prices fell through the floor. Xstrata had leveraged up to undertake roughly $26 billion worth of acquisitions since 2006, leaving the balance sheet in a fragile state: Net debt swelled from $2.6 billion heading into 2006 to $16.3 billion at year-end 2008, a level management dryly noted was "above the levels...deemed optimal or prudent," given the economic conditions. In an effort to bolster the company's suddenly bare-bones liquidity position, management raised £4.1 billion from existing shareholders and announced it would slash the capital expenditure budget by $3 billion. The subsequent recovery in commodity prices clinched the matter, permitting Xstrata to cut net debt to $12.6 billion by year-end 2009.
We expect Xstrata, perhaps chastened by the experiences of late 2008 and early 2009, to deploy a much less acquisitive--but no less ambitious--strategy going forward. While there may be a bolt-on acquisition here or there, the existing project pipeline will drive the bulk of future growth. All told, management intends to boost mine output 50% or more within five years. This kind of growth won't come cheap, so capital expenditures will be much larger in the coming years than they had in the past. Management expects $14 billion in expansionary capital expenditures from 2010 through 2012 versus roughly $7 billion in the three years prior and $9 billion total since the company's 2002 initial public offering. Many of the larger projects, once initiated, are relatively inflexible with respect to the timing and size of their capital requirements, a circumstance that may circumscribe management's ability to undertake a major acquisition.
Valuation
We are reducing our fair value estimate to 1,400p from 1,500p to reflect our expectation that the Australian government's mineral resource rent tax will be implemented as presently conceived. The terms of the MRRT, as promulgated by the new Gillard government, are significantly less onerous than the resource super profits tax plan put forth by the Rudd government. We had not elected to reduce our fair value estimate at the time of the RSPT's announcement because of the significant doubts we had regarding Labor's ability to implement the relatively punitive tax program. We have more confidence concerning the implementation prospects of the MRRT, since it appears to be the product of consultation between the new government and the big mining companies. Therefore, we think it is prudent to include the MRRT's ramifications in our fair value estimate.
For the most part, we've modelled volume growth in accordance with the company's rather ambitious plans, including the hefty associated capital outlays, which we expect will constrain management's ability to undertake further transformative acquisitions. Our model incorporates the following midcycle commodity price assumptions: copper at $3.00 per pound, nickel at $10 per pound, zinc at $1 per pound, seaborne thermal coal at $100 per tonne, and seaborne coking coal at $200 per tonne. Other key valuation drivers for Xstrata include unit cost assumptions for some of the larger greenfield projects, including Koniambo and Las Bambas. For the purposes of our model, we assume Koniambo has lower unit costs than Xstrata's average nickel operation and Las Bambas has slightly higher unit costs than the average copper operation. Given the hefty share of total nickel and copper production these projects are expected to account for, modest adjustments to these assumptions have a material impact on our fair value estimate.
Risk
Geographically diverse operations mean the company isn't overly dependent on the political and economic circumstances of any one country. While Xstrata produces a variety of commodities, the prospective benefits of mineral diversification are less clear-cut than the geographical variety. Consider, for example, the case of nickel and copper--demand for which tends to rise and fall together with global industrial production. As a consequence, the prices of these two base metals tend to exhibit an extremely high correlation, such as we saw in the period from 2000 through 2004 (coefficient 0.9). And while divergent supply-side dynamics have diminished the price correlation since 2005, it remains nonetheless material (coefficient 0.7). The major exception to the near lock-step commodity price movements across Xstrata's product portfolio is coal, which is typically priced on a benchmark rather than spot basis. Contract coal prices, therefore, tend to lag underlying supply and demand conditions.
Management & Stewardship
Since assuming the helm of Xstrata in late 2001, the management team led by CEO Mick Davis (formerly CFO of BHP Billiton) and CFO Trevor Reid (formerly of Standard Bank) has been very busy on the acquisition front. With an ample selection of growth projects on its plate, we expect management will be judged less by its M&A acumen and more by its ability to execute on large and challenging greenfield projects.
Investors should be aware of the unusual relationship Xstrata has with its largest shareholder, commodity-trading giant Glencore International, which owns 34% of Xstrata's outstanding shares. Xstrata chairman Willy Strothotte occupies the same position at Glencore; he has held both roles since 1994. Glencore CEO Ivan Glasenberg also sits on Xstrata's board. Xstrata and Glencore have been counterparties in a variety of major transactions over the past several years (in addition to ongoing marketing relationships), including the $2.5 billion Enex and Duiker deal in 2002, Xstrata's $1.7 billion purchase of Glencore's one third stake of Cerrejon in 2006, and Xstrata's $2 billion purchase of Glencore's Prodeco asset in 2009. Because of an embedded call option, the latter deal--announced in conjunction with Xstrata's January 2009 capital raise--proved only temporary. At the end of the day, Prodeco returned to Glencore and Xstrata received additional compensation of $250 million for its trouble. Functionally, the Prodeco deal looked like a collateralised loan from Xstrata shareholders that afforded Glencore sufficient liquidity to maintain its 34% ownership stake in Xstrata. While giving up the attractive Prodeco asset was a negative for Xstrata shareholders, the 12.5% "interest rate" received on the de facto loan wasn't bad. That said, we note that the value of holding a call option at the market's bottom is significant indeed.
Overview
Growth: Xstrata has an ample array of growth projects at its disposal, which management expects will lift total production volume 50% within five years. Consequently, Xstrata's capital budget will be much larger than usual. Management expects $14 billion in expansionary capital expenditures from 2010 through 2012 versus roughly $7 billion in the three years prior and $9 billion total since the company's 2002 IPO. Many of the larger projects, once initiated, are relatively inflexible with respect to the timing and size of their capital requirements. Given this constraint, we don't anticipate growth by means of the transformative acquisitions that defined most of Xstrata's recent history.
Profitability: Profitability will be a function of various commodity prices. Typically, these prices tend to move in tandem, the primary exception being contracted coal tonnage. This proved useful in the fourth quarter of 2008 as record thermal and coking coal contracts offset the deleterious effects of the collapse in spot copper, zinc, and nickel prices.
Financial Health: Acquisitions totalling $26 billion undertaken from 2006 through 2008 left Xstrata with a weakened balance sheet ill-suited to cope with the dramatic downturn in commodity prices. With net debt at $16.3 billion heading into 2009 (up from $2.6 billion at the beginning of 2006), spot copper at $1.50 per pound, and nickel at $5.00 per pound, management raised £4.1 billion from existing shareholders in an effort to bolster the company's liquidity position. The subsequent recovery in commodity prices clinched the matter, permitting Xstrata to cut net debt to $12.6 billion by year-end 2009. Xstrata ended 2009 with a debt/capital ratio of 0.29, a degree of leverage management has termed very comfortable (we'd like to see a bit less). A prolonged slump in commodity prices represents the biggest risk to Xstrata's financial health--a situation that would be compounded if accompanied by an ill-timed and overpriced acquisition or the outright failure of one of the company's larger greenfield projects like Koniambo or Las Bambas.
Profile: A flurry of acquisitions undertaken since its 2002 IPO made Xstrata what it is today: a geographically diversified mining company with a top-five position in seaborne thermal coal, seaborne coking coal, copper, nickel, zinc, and ferrochrome. In terms of revenue and earnings contribution, copper and coal rank as the most important commodities in Xstrata's portfolio, accounting for 41% and 30% of 2009 revenue and 43% and 43% of EBITDA, respectively.
Strategy: Management often says the company's strategic direction has evolved through three phases. The first was defined by acquisition, a strategy predicated on the belief that to compete for resources and opportunities in the mining industry, size would be crucial. The second phase involved an operational transformation of the portfolio (rollup of proximate acquired properties into a single operating infrastructure). In the third and current phase, management's strategic focus centers on generating internal growth from that portfolio.
Bulls Say
1. Commodity demand from China and other emerging economies shows few signs of abating. The limited ability of the supply side to meet this rising demand, due to diminishing ore grades and lack of new world-class discoveries, will translate to higher prices.
2. Xstrata has an ample array of growth projects at its disposal, which management expects will lift total production volume 50% within five years. Many of these projects are expected to have lower unit costs than current operations.
3. Xstrata's decentralised management structure affords local management teams the authority to implement initiatives without Big Brother's interference, producing more informed and nimble decision-making than is typical for a firm of Xstrata's size.
Bears Say
1. Xstrata's assets aren't particularly low cost, potentially leaving the company vulnerable to a sustained slump in commodity prices.
2. Chinese nickel pig iron production capacity effectively caps the nickel price upside, severely limiting the return on investment Xstrata can expect from nickel-related acquisitions like Falconbridge and greenfield projects like Koniambo.
3. Management's demonstrated penchant for aggressive M&A activity, while successful amid the lengthy runup in commodity prices that persisted through early 2008, may be ill-suited to an industry like mining, where boom times can go bust in relatively short order, rendering a big acquisition a balance sheet bomb.
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