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Quarter-End Insights

Our Outlook for Basic Materials Stocks

Commodities are hot again, but much depends on Asian demand and government action.

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  • Performance in the basic materials sector will be driven by emerging-markets demand, government regulation, and government spending. These look to be tailwinds through 2010.
     
  • While application rates for fertilizer have shown a promising trend recently, continued concerns about oversupply may damp long-term profitability.
     
  • Steel production in China and India continues to be the key driver for coal and iron ore pricing. Robust demand through 2010 will be a powerful potential catalyst for pricing.

Most basic materials equities have soared from their year-ago lows as investors priced in economic recovery. We've seen some more tangible signs of that since the beginning of 2010. Equity investors in many globally traded commodities producers, like iron ore and coal, are especially optimistic as China seems poised to suck up vast quantities of materials and drive up prices. Even fertilizer, which suffered last year as application rates stumbled, is showing signs of life.

We think a few factors will continue to drive basic materials for the coming months. First, robust global demand, especially from emerging economies, will be a deciding factor in pricing. This has been the story in commodities for several years now, and this demand probably saved the sector from purgatory in 2009.

Second, government actions (both domestic and foreign) can have a profound impact on several basic materials industries--including building materials, engineering and construction, iron ore, and coal. This is especially apparent for companies directly dependent on the government for revenues. For example, the building materials industry, which includes several of our present and past highlighted companies, caught a second wind in March as the government passed the Hiring Incentives to Restore Employment Act, which provided funding for highway construction.

Industry Insights
Building Materials
When the federal highway bill expired in the fall of 2009 (followed by numerous short-term extensions at reduced levels of funding), many states became cautious with highway spending plans. It didn't make sense for states to go forward with large, long-term projects given the uncertainty regarding funding. This put yet another damper on demand for building materials, which have been dealt blow after blow during a multiyear downturn in residential construction, and now, the weakness in commercial construction activity. Fortunately, the tide turned in mid-March with the passage of the Hiring Incentives to Restore Employment Act, which extended highway programs through the end of 2010 and restored the previous levels of funding. This has removed some of the uncertainty surrounding a key end market for building materials.

Fertilizer
At the beginning of 2010, two key questions remained for potash fertilizer producers. First was whether growers would return to necessary potash application rates following nearly two years of reduced usage. And the second was whether the looming capacity expansions in potash production will place downward pressure on prices several years out. Now, it appears that the first question is being resolved. Activity in potash markets is indeed picking up--producers' inventories are decreasing, and new contracts are being signed. However, we believe the second question will remain unanswered for some years. In fact, the specter of potash oversupply several years from now has grown recently, given  BHP Billiton's (BHP) latest moves in funding greenfield potash mine feasibility studies and buying a junior exploration-phase potash company.

Coal
After taking a break in 2009, the coal sector is roaring back to life in 2010. Though the sector is still suffering from high inventory levels, and production (especially in the eastern U.S.) is still well off historical levels, companies and investors are looking forward to resurgent demand and higher pricing.

The big trend in coal is the effect China and India will have on global trade patterns, especially for metallurgical coal. In 2009, Chinese steel production set yet another record, and the country imported a record amount of coal, both thermal and metallurgical. Given the tightness in the global coal supply chain and as traditional big exporters like Indonesia, Australia, or South Africa hit infrastructure or geological limits, the U.S. comes to the fore as a swing producer. Furthermore, a cold winter ameliorated high inventory levels, and demand should rebound with the economy. The end result, as long as production growth remains tame, is a dramatically tightened supply chain and potentially much more robust margins.

Continuing a several-year-long trend, the government is aiding in the last point. The difficulty of permitting new mines and high compliance costs for safety and environmental regulation should damp supply growth. That said, given the high margins offered by metallurgical coals, U.S. companies are expanding mines, "upgrading" or "upblending" coals to metallurgical specifications, and even trying to start new mines. This increased supply may hurt the industry, should demand fail to meet rosy expectations.

 

Iron Ore
Much ink will be spilled in the coming weeks on the annual iron ore benchmark price negotiations between Chinese steel producers (led by Baosteel) and the Big Three iron ore exporters ( Vale (VALE), BHP Billiton, and  Rio Tinto (RTP)), with major implications for steel producers around the world. Historically, most seaborne iron ore has traded according to this benchmark price, rather than the spot price, a characteristic seaborne iron ore shares with other "bulk" commodities that travel long distances, such as metallurgical coal and potash.

Amid last year's massive economic uncertainty for the global economy, the Japanese steel producers (the Chinese failed to reach an accord) and the Big Three struck an accord at $62 per metric ton, a 33% drop from 2008's $93 per metric ton. This year, with nightmares of economic Armageddon having largely abated, base metal spot prices up across the board, and Chinese steel output at record levels, prospects seem ripe for a major increase. Indeed, China's continued appetite for seaborne ore will be the biggest demand-side driver of benchmark price negotiations.

Here, while many have expressed concerns about general Chinese economic "overheating," the big iron ore miners remain bullish (perhaps talking their books). During its February earnings call, Vale noted that every indication from China is that steel production will continue to grow, albeit not at the same pace as last year. Vale expects iron ore imports to China will be "at least" 650 million metric tons in 2010 (versus 627 million metric tons in 2009). Part of Vale's confidence stems from a belief in "customer stickiness": Chinese steel makers who made the switch to higher-quality imported ore during the past year will be reluctant to switch back to the lower-quality product, which requires greater energy usage.

With the central importance of Chinese demand in mind, we can obtain a general sense of where things might shake out by looking at the Chinese spot market for iron ore, which, due to the failure of Chinese steel producers to reach an accord with the Big Three in 2009, accounts for roughly 70% of the country's total iron ore imports. At present, spot prices on a CFR basis (that is, exporter pays for freight to the destination) stand at around $140 per metric ton, double the prior year's benchmark settlement.

Basic Materials Stocks for Your Radar Screen
Given the recent rally in equity markets, true buying opportunities are rare. However, we want to take the opportunity to highlight several firms worth keeping on your radar screens. Should the markets stage a retreat, these companies may become very attractive holdings for your portfolio.

Furthermore, in a break with tradition, we are highlighting two European companies: Lafarge and Holcim, whose home markets are France and Switzerland, respectively. We view these as very high-quality franchises that U.S. investors are generally not well aware of, and their shares can be purchased over the counter by U.S. investors, though liquidity can be sparse.

 Top Basic Materials Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty

Consider Buy Price

Lafarge EUR 68.00 Narrow High EUR 34.00
Holcim CHF 78.00 Narrow High CHF 39.00
Arch Coal $27.00 Narrow High $13.50
Sasol $45.00 Narrow High $22.50
Southern Copper $29.00 Narrow Very High $11.60
Data as of 03-23-10.

 Lafarge (LG)
Lafarge is also available to U.S. investors over-the-counter trading under (LFRGY)

Lafarge is the largest producer of cement on the planet and a leading producer of other construction materials such as aggregates (rock, sand, and gravel), concrete, and gypsum (such as, wallboard). Lafarge's main business, cement production, is characterized by capital intensity, some stiff barriers to entry, energy intensity, and a low value/weight ratio that leads to regional rather than global markets. We believe Lafarge has strong and sustainable competitive advantages thanks to these barriers to entry and a cost advantage. Lafarge has been investing heavily in capacity expansion in emerging markets, given their more promising prospects for materials demand. The company's early 2008 acquisition of Orascom Cement gave it a leading position in the Middle East and the Mediterranean Basin, and the Orascom plants are some of the newest, largest, and lowest-cost in Lafarge's entire portfolio.

 Holcim (HOLN)
Holcim is also available to U.S. investors over-the-counter trading under (HCMLF)

Holcim is a leading global producer of cement and a major producer of other construction materials such as aggregates and concrete. Like Lafarge, Holcim's main business is also cement production, which is similarly characterized by capital and energy intensity, barriers to entry, and a low value/weight ratio that leads to regional rather than global markets. We believe that Holcim's strong competitive advantages are sustainable because of these barriers to entry and a cost advantage. Holcim has invested heavily in the Indian cement market, given its more promising prospects for cement demand. Although profitability in India may be occasionally hampered by factors such as government anti-inflation measures, price competition in some areas, and imports from Pakistan, the potential for high-single-digit demand growth makes this an attractive market for cement producers.

 Arch Coal (ACI)
Arch's crown jewel is its Powder River Basin (PRB) mine portfolio, which it recently upgraded by acquiring the Jacobs Ranch mine from Rio Tinto. We like Arch's strategic position within the U.S. (and global) coal industry, but the next year or two will be hairy thanks to a big inventory overhang, economic uncertainty, and a heavy debt load.

Arch benefits from two long-term trends. First, the prolific Central Appalachia basin is in terminal decline thanks to poor geology, high costs, and strict regulation. PRB coal will gain market share and ride the coattails of any price appreciation as costs rise in Appalachia. Further, Arch's acquisition of Jacobs Ranch improved its PRB market position materially. We believe this and several other recent transactions in the PRB will result in a more disciplined basin, laying the groundwork for long-term margin expansion.

 Sasol (SSL)
We believe Sasol has a cost advantage that should support the earnings power of most of its existing operations, plus the option to benefit from future alternative energy projects. The firm currently faces headwinds from an appreciating rand and still-weak demand for petrochemicals. Although the company can't control exchange rates, oil prices, or chemicals demand, its cost-advantaged synfuels operations should allow for robust profitability in many market environments. On top of this solid base of earnings power lies the option of additional coal-to-liquids (CTL) or gas-to-liquids (GTL) projects, though both technologies likely need improved track records before they'll be widely accepted by resource holders. On the downside, a ramp-up of refining and petrochemical capacity in the Middle East and Asia could hurt Sasol's profit margins, though the magnitude of the impact is highly uncertain.

 Southern Copper (SCCO)
In its current form, Southern Copper ranks as the world's second-largest copper miner by reserves (111 billion pounds of proven and probable reserves as of year-end 2008), among the largest by annual output (1.1 billion pounds in 2008), and, thanks to an enviable portfolio of world-class open pit mines, among the lowest cost.

Copper prices will be the biggest driver of Southern Copper's earnings power. The multi-billion-dollar question for Southern Copper will be whether the $3.00-plus prices that prevailed for most of the past few years represent a "new normal" or if an eventual supply-side response will push price levels down to the $1.00 range that persisted for the decade prior. For our part, we expect a future supply/demand balance that looks more like 2007 than 1997. However, whether copper remains above $3.00 or returns to more modest levels, we expect Southern Copper to remain solidly profitable thanks to the low-cost profile of its large and long-lived Mexican and Peruvian open pit mines.

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Michael Tian does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.