If you are a contrarian investor looking for a mining company working through a tough spot, then you might be asking yourself which is a better buy: Freeport-McMoRan Inc. (NYSE:FCX) or Vale SA (NYSE:VALE). It's not an easy choice -- and it depends a lot on what you see in the future for these troubled miners -- but I think business headwinds are better than legal ones.
An oil dilemma
Sure, the commodity downturn has been an issue for Freeport-McMoRan, just like it has been for almost every other miner. However the company's biggest troubles can be traced almost directly to its acquisitions of McMoRan Exploration Co. and Plains Exploration shortly before oil priced started to plunge in mid-2014.
However, the problem isn't exactly getting into the wrong business as it is getting into it at the wrong time. The real problem is that Freeport loaded up on debt to do it. Before the oil bet, long-term debt stood at around 15% or so of the company's capital structure. After the deal, debt ballooned from $3.5 billion to over $20 billion, and long-term debt was roughly 70% of the capital structure at the start of 2016.
This helps explain why Freeport has been working overtime to try to trim its debt load and, at the same time, reduce its exposure to oil. In fact, the company's core copper and gold business is cash flow positive today -- it's the oil operation that's holding the company back.
Vale's big problems are really threefold. Like other iron ore focused peers, it's been struggling under the weight of low commodity prices. However, there are two other issues going on right now. First, the company's long-term debt load is material (roughly a third of the capital structure), and this is all happening while it's trying to build a massive new mine. That has led the company to sell assets and trim costs everywhere it can since commodity prices have hit the top and bottom lines hard. And while the new mine should be a valuable long-term asset, it will likely exacerbate the global oversupply issue in the short term, potentially lengthening the iron ore industry's downturn.
If that were all Vale was dealing with, it wouldn't be so bad. In fact, the company might get the edge over Freeport. Unfortunately for Vale, it's also dealing with the aftermath of a mining disaster at the Samarco Mine in its home country of Brazil. Although the company and 50/50 partner BHP Billiton (NYSE:BHP) agreed to a $5.5 billion settlement, Brazilian laws aren't so cut and dried. In other words, the issue is far from settled, with another case looking for $44 billion in damages.
So there's a big open-ended question sitting over Vale's head. And while it would "only" be on the hook for half of the $44 billion in damages the current suit is looking for, that's almost the company's entire $28 billion or so market value. Worse, Vale's biggest businesses are located in Brazil, which means its assets could be seized by the courts if things don't go well. This is a doomsday scenario, of course, but you can't dismiss the risks here.
If you think Vale can get out from under the Samarco issue, it could have a fairly bright future. But there's a lot of uncertainty right now that could cause material pain for the miner and its shareholders. Freeport's lot in life isn't easy: It has a lot of hard work ahead of it to get out from under its self-imposed travails. But -- and this is important -- you can see the progress being made at Freeport; Vale's future depends on the outcome of often unpredictable court cases.
Here are some examples of the headway Freeport is making. By the second quarter of this year, the miner had reduced its debt load by roughly $1.5 billion. Perhaps more importantly, it seems to have found a buyer for some of its oil assets, something it was having a hard time with before. Overall this year, it's managed to sell or has agreed to sell around $6 billion worth of non-core assets that it can use to trim its hefty debt load. Now compare that to Vale, where the legal wrangling could go on for years with no way for investors to tell what the outcome might be.
In my view, Vale's open-ended legal issues are large enough to push me to the sidelines. I'd prefer to stick with Freeport-McMoRan, where progress is clearly visible.