The commodity downturn that started in 2011 was tough on mining industry giants Freeport-McMoRan Inc (NYSE:FCX) and Vale SA (NYSE:VALE). Both were left bleeding red ink and forced to sell assets and cut costs to support their balance sheets. Now that commodity prices have turned higher again, however, it's time to look to the future. Both Vale and Freeport have clouds darkening their paths forward. Investors should stick with the miner that's closer to a resolution.
Vale's business is built around iron ore. That business accounted for roughly 70% of revenue in the second quarter and a massive 80% of adjusted EBITDA. This isn't good or bad, per se; it's just important to note that iron ore is what drives Vale's results. If that's not what you want, then you shouldn't even be looking at this miner.
That said, iron ore prices have been volatile of late, but are much higher than they were at the bottom of the commodity downturn, in early 2016. Not surprisingly, Vale's results have also improved a lot. To put a number on that, underlying earnings in the first half of 2017 more than doubled, year over year. There's a lot to like here.
But there's a dark cloud that continues to linger over Vale. It dates back to the 2015 Samarco mine disaster, in which a waste retention dam ruptured, flooding nearby towns with mine waste and killing numerous people. Vale and BHP Billiton (NYSE:BHP), its equal partner in Samarco, have already agreed to one settlement worth $6 billion, with payments spread out over a number of years. But it's still facing another legal action that's looking for as much as $47 billion.
The two sides have been working on a deal, but it's been a long and hard process. When it's over, Vale is likely to face an ongoing headwind to earnings in the form of huge settlement costs -- for years into the future. This is a risk that investors shouldn't take lightly.
Freeport-McMoRan focuses on copper, though it also mines for gold and molybdenum. That said, it's one of the largest copper producers in the world, so you shouldn't own Freeport unless you are looking for, or willing to have, significant exposure to copper.
Like Vale, it faced hard times during the commodity downturn. Some of the pain was self-inflicted -- Freeport made an ill-timed bet on the oil patch that didn't work out well. It has sold much of that business, in addition to other noncore assets, and materially reduced the roughly $20 billion of debt it took on to buy into the oil industry. Oil is basically a rounding error for Freeport today, and the balance sheet is in good enough shape that management has stopped worrying as much about debt reduction. (The company's debt level was reduced by roughly a half between the start of 2016 and the middle of 2017.)
Add in improving commodity markets and things should look pretty good for Freeport. In fact, it has been back in the black for four consecutive quarters. Only now it's dealing with legal and political issues at one of its most important assets, the Grasberg mine, in Indonesia. The mine accounts for virtually all of Freeport's gold reserves and roughly 30% of its copper reserves. News of the trouble at the mine hit the wires earlier this year, just as Freeport was starting to emerge from the overhang left from its oil investment.
In a nutshell, Indonesia wants to benefit more from the mine than it is today and, among other things, is pushing to change the mine's ownership structure. That doesn't make Freeport happy, as you might expect. However, the two sides have come to terms on a basic framework for a resolution. The problem isn't solved yet, but a deal is likely close at hand.
And once an agreement is finally in place, the outlook at Freeport-McMoRan will be a lot clearer. Freeport may end up making less from the mine than it has in the past, but expansion plans should help to offset that. In other words, once there is a resolution at Grasberg, it should be pretty close to business as usual for Freeport.
The lesser evil
When I look at Vale and Freeport, I see two dominant global miners -- one focused on copper, the other on iron ore. But I also see companies facing big issues dragging on results. The difference is that the lingering impact from Vale's troubles could last a decade or more, and has already resulted in billions of dollars of extra costs, with even more costs likely in the near future. Freeport, on the other hand, is getting closer to a deal with Indonesian government that should quickly return its business back to a more normal state and unlock growth opportunities at one of its most important mines. Freeport's problem is the lesser risk in my opinion.
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