Portfolio Advisory Group July 28th, 2011
Teck Resources Limited (TCK/B): Leveraged to China and Growing
Summary Introduction Investment Rationale As a component of our Focus List, we have written the following comment to provide investors with •Exposure to China’s demand for commodities an update on Teck Resources Limited (TCK/B). •Strong production growth profile Teck has assembled a portfolio of assets focused •Strong balance sheet on three commodities that are poised to benefit from continued Chinese urbanization: •Reasonable valuation metallurgical (steelmaking) coal, copper, and zinc. Teck is the #1 producer of metallurgical Risks coal in North America, and the #2 exporter of •Commodity prices are elevated versus metallurgical coal in the world. The company historical averages is a global top 3 miner of zinc and has one of the largest and most efficient smelting and •Global leading economic indicator is declining refining operations in the industry. Teck is also a major producer of copper, and it is expanding •A hard landing for the Chinese economy would its production with a strong asset base geared usher in commodity price correction towards future growth. •Teck’s growth plans face execution risk In addition to being a global leader in these RBC Capital Markets rates Teck Resources commodities, Teck has significant growth Outperform, Average Risk, Price Target C$60.00. opportunities. Expansion plans at the company’s existing coal mines plus the re-start of a dormant coal mine lead management to expect a 30% increase in volumes by 2014. In copper, a similar volume increase is expected by Global Map of Operations 2013. Further expansion opportunities in copper offer growth of approximately 150% over the next 5-7 years. Teck has a strong balance sheet as exemplified by its investment grade credit ratings and pays investors a current dividend yield of 1%. The stock trades at a modest discount to net asset value, which would suggest a reasonable price level in the context of the historical range for diversified mining companies.
Company Description
Teck is Canada’s largest diversified mining company. Its operations are primarily concentrated Source: Annual Report 2010 in metallurgical coal, copper, and zinc. Teck also owns interests in large, oil sands development Coal Operations projects that offer a natural hedge against rising energy costs. In metallurgical coal, or coking coal, which is used for making steel, Teck is the #1 producer in North Over the last five years, Teck has completed two America and the #2 seaborne exporter in the world. transformational acquisitions. In 2007, Teck The coal business represented 47% of Teck’s 2010 acquired Aur Resources for $4 billion, which revenues and 50% of its operating profit. materially increased its copper production. In 2009, Teck acquired Fording Coal for $13.6 billion, Top Global Metallurgical Coal Producers by Sales significantly increasing its exposure to metallurgical (2010) coal. Despite facing debt challenges following its
acquisition of Fording Coal prior to the global
financial crisis, Teck re-established its balance sheet strength through a series of financings and divestitures. After establishing a strong footing, it re-established its dividend in April 2010.
Source: Alpha Natural Resources * Pro forma Massey Energy ** Pro forma Western Coal
Teck has six large-scale, open-pit coal mines in operation in Alberta and British Columbia. Approximately 90% of the coal is transported Teck has a dual-class share structure that has the west to the seaborne market, with the remainder effect of limiting any take-out premium in the sold to steel mills in North America. Of the total, stock. Teck’s Class B shares carry a single vote per approximately 65% is sold to Asia, with major share; the Class A shares carry 100 votes per share. customers located in China, Japan, Korea and While the Class A shares represent 1.6% of shares Taiwan. The coal produced is largely high-quality, outstanding, they represent 61.7% of the total votes. hard-coking coal, which is an attractive form for The Keevil family and Sumitomo control 40.9% of steel companies to use in blast furnaces. The the total votes. balance of production, approximately 12% in 2010, is thermal coal and other lower quality coal. Teck has significant expansion plans for its coal operations, with management targeting 30 mtpa (million tonnes per annum) by 2014. This expansion Strength in coking coal prices has been driven by a represents a 30% increase from the 2010 production number of long-term market dynamics, including: level of 23 mtpa. The growth is set to come from (i) Chinese urbanization, (ii) a transformation of expansion of the Elk Valley operations in southern China’s steel industry, and (iii) a highly concentrated B.C., as well as from the re-start of the Quintette seaborne supply market. mine in east central B.C. The Quintette mine was in operation from 1982 to 2000 but was put on care Chinese urbanization has led to a substantial and maintenance because of low prices. With prices increase in steel production over the last decade. now robust, Teck is planning a potential restart of Another 80 million people in China are expected the mine at approximately 3.0 mtpa by 2013; the to move to cities by 2015 and 200 million by 2022. feasibility study for this restart is expected in mid- The chart of world steel production shows the rapid 2011. growth in China, in contrast to the relatively stable production levels for the rest of the world. Teck Coal Production Forecast World Steel Production
Source: Teck Resources Source: World Steel Association Metallurgical Coal Market Commentary In recent years, China has been transforming its steel industry in an effort to reduce production Metallurgical coal is produced in relatively few from its many smaller plants and encourage more countries and is a key raw material for about 70% production from larger, more efficient plants. The of the world’s steelmaking operations. It includes consolidation process is expected to continue, and hard-coking coal, semi-soft coking coal, and PCI by 2015, China’s top 10 steel producers are expected coal. The global production of hard coal exceeded to account for 60% of the country’s output. These 6.0 billion tonnes in 2010. Most of it is used in the plants are located in coastal areas to access seaborne country of origin because of high transportation coking coal. Imports of coking coal to China have costs. A relatively small amount is traded across increased rapidly in the last three years, with China land borders (e.g. Canada-US). In 2010, the moving from just 3% of this market in 2008 to 19% in seaborne metallurgical coking coal market was 2010. approximately 240 million tonnes.
Seaborne Coking Coal Demand Outlook (mtpa)
Source: J.P. Morgan
Source: Wood Mackenzie (Rio Tinto investor presentation) Supply is relatively concentrated. The top six Further out in time, substantial growth exporters of coking coal represent approximately opportunities exist. Teck estimates its copper two-thirds of supply. This kind of concentration production growth potential over the next five to has given the supply side significant negotiating seven years to be approximately 150%. Quabrada power in settling quarterly contract prices with key Blanca Phase II (76.5% owned) holds 200 ktpa of customer groups. potential, and Relincho (100%) 190 ktpa. Finally, a pre-feasibility study on Galore Creek (50% Teck/50% Prices in the near term have been driven beyond NovaGold), which will define the production profile, the prior peak in 2008. Exports from Australia is underway with a final report expected soon. represent about two-thirds of the seaborne market, and flooding in Queensland has limited supply from Teck Copper Production Forecast this region for much of H1/2011. Water remains in many Queensland mining pits, and lingering supply problems remain today. As this supply recovers, analysts expect coking coal prices to moderate.
Coking Coal Price Forecast
Price 2011E 2012E 2013E 2014E Long forecasts Term RBC CM $279/t $220/t $200/t $160/t $130/t J.P.Morgan $295/t $264/t $254/t N/A $150/t Source: Teck Resources
Coking Coal Prices (US$/tonne) Copper Market Commentary Similar to coking coal, the demand outlook for copper is dominated by China, which consumed 38% of global consumption in 2010. Global Refined Copper Demand Outlook
Source: J.P. Morgan
Copper Operations The copper business represented 28% of Teck’s 2010 revenues and 35% of its operating profit. Teck has Source: RBC CM significant growth plans for its copper business, targeting 400 ktpa (kilo-tonnes per annum) by A supply deficit is expected for copper this year, 2013, which represents a 28% increase from full- resulting in a drawdown of inventories, which year 2010 production of 313 ktpa. The growth is to should continue to provide price support. RBC CM come mainly from Highland Valley (97.5% owned) forecasts a modest supply surplus for 2012 that may where one of the three pits is being expanded, cause a moderation in prices. Further out in time, Antamina (22.5% Teck/33.75% BHP/33.75% RBC CM forecasts a modest deficit in 2013 following Xstrata/10% Mitsubishi) where the mill is being by relatively balanced markets in 2014 and 2015. J.P. expanded by 38%, and Andacollo (90%) where the Morgan forecasts significant surpluses from 2013 to mine is transitioning from copper cathode to copper 2015. concentrate production. Copper Supply / Demand Balance (‘000 tonnes) Zinc Market Commentary Approximately half of global zinc consumption is for galvanizing steel, a process that improves corrosion resistance. China dominates the global demand picture for zinc, representing about 43% of total in 2010. The primary end uses are construction and auto. Global Zinc Demand Outlook
Source: RBC CM
Copper Price Forecast
Price 2011E 2012E 2013E 2014E Long forecasts Term RBC CM $4.25/lb $3.75/lb $4.00/lb $4.25/lb $2.25/lb J.P.Morgan $4.38/lb $4.42/lb $4.24/lb $3.86/lb N/A Source: RBC CM The zinc market has been in surplus for the last Historical and Forecasted Copper Prices four years, and it is expected that stronger demand in 2011 and 2012 will be met with higher mine production, leaving the market in surplus. In the near term, high inventories and a market in surplus point to a cautious outlook for zinc. In the long- term, a number of permanent mine closures are coming, including two large mines - Brunswick in 2013 and Century in 2015. These closures,
combined with declining ore grades globally, are expected to drive the market into deficit in the 2013- 2015 timeframe. Both RBC CM and J.P. Morgan
see supply deficits forming out a few years, with
RBC CM forecasting a deficit in 2013-2015 and J.P. Morgan forecasting deficits in 2014 and 2015. New projects to balance this deficit will need much Source: Bloomberg and RBC CM higher capital investment and thus will require Zinc Operations higher zinc prices to justify construction. Teck is one of the world’s largest producers of zinc, capable of producing approximately 645 ktpa of zinc in concentrates and 278 ktpa of refined zinc. The company’s 100%-owned Red Dog mine in Alaska is the world’s second-largest zinc mine, and Antamina is another world-class producer. Antamina contains both copper-only and copper-zinc ore; thus, the production of zinc concentrate varies over time. Teck’s metallurgical facility at Trail, B.C. is one of the world’s largest and highest margin zinc and lead smelting and refining operations in the world. Zinc Supply / Demand Balance (‘000 tonnes) Balance Sheet Despite facing balance sheet stress during the global financial crisis, Teck has re-established its investment grade ratings (Moodys’ Baa2 Stable, S&P BBB Stable). In April of 2010, Teck’s financial position had stabilized sufficiently to allow its Board of Directors to reinstate a dividend.
Key Risks Declining Global Leading Economic Indicator Source: RBC CM The global leading economic indicator has usually turned six months in advance of the Zinc Price Forecast CRB (Commodity Research Bureau) Index. This relationship can be seen by the graph below Price 2011E 2012E 2013E 2014E 2015E Long showing the global LEI advanced six months versus forecasts Term the performance of the CRB Index. With the global RBC CM $1.00/lb $0.90/lb $1.00/lb $1.30/lb $1.50/lb $0.90/lb LEI in decline, this graph suggests the possibility of J.P.Morgan $1.07/lb $1.11/lb $1.13/lb $1.18/lb N/A N/A downside risk being elevated at present. Correlation of the CRB Index to the Global Leading Economic Indicator Historical and Forecasted Zinc Prices
Source: RBC CM Source: Bloomberg and RBC CM
A Hard Landing in China Oil Sands Demand for Teck’s three key commodities is Teck has interests in several oil sands mining dominated by China and its urbanization efforts. development projects including: Fort Hills (20% Economists have been debating how a slowdown Teck, 41% Suncor, 39% Total) and Equinox and in China may shape up as stimulus is reduced Fronteer (both projects 50% Teck, 50% SilverBirch following the record levels implemented during Energy). The Fort Hills project has an estimated the global financial crisis. A hard landing for the 50-year life with production planned for mid-2016 Chinese economy could usher in a more difficult starting with 164 kbpd (thousand barrels per day) period of correction for these commodities. in Phase 1, and up to 320 kbpd in Phase 2. Equinox The Chinese Purchasing Managers’ Index, a key and Fronteer are earlier stage projects but also leading economic indicator, has been in decline. contain very large resource bases. While the official reading for July is due out August 1st, the preliminary data shows manufacturing may have contracted for the first time in a year since the Summary PMI gauge recently reported by HSBC and Markit Economics dropped to 48.9. A reading below 50 is Teck’s portfolio of metallurgical coal, copper, and indicative of contraction. zinc positions the company to benefit from the strong fixed-asset investment underway in China. Execution Risk With world-leading positions in metallurgical coal and zinc, and strong growth opportunities in coal With significant expansion plans for its coal and and copper, Teck is one of our preferred mining copper operations, Teck faces substantial execution investment vehicles for investors in the Canadian risks including potential cost escalation and project market. delays. Foreign Exchange While the pricing of its products are in U.S. dollars, many of Teck’s operations are in Canada and face costs denominated in Canadian dollars. A further appreciation of the Canadian dollar could lead to costs exceeding current expectations. Valuation At present, Teck trades at a discount of 12% to RBC CM’s net asset value of C$54.04. Diversified mining companies typically trade around their net asset value, with support on the downside commonly settling in at a 20-30% discount. On the upside, when sentiment is strong, premiums of 30% or more can be observed. Estimated Net Asset Value Break-Down
Source: RBC CM Required Disclosures Explanation of RBC Capital Markets Rating System Distribution of ratings, firmwide An analyst’s “sector” is the universe of companies for which the analyst RBC Capital markets provides research coverage. Accordingly, the rating assigned to a par- ticular stock represents solely the analyst’s view of how that stock will perform over the next 12 months relative to the analyst’s sector.
Ratings: Top Pick (TP): Represents best in Outperform category; analyst’s best ideas; expected to significantly outperform the sector over 12 months; provides best risk-reward ratio; approximately 10% of analyst’s recom- Important Disclosures mendations. Teck Resources Outperform (O): Expected to materially outperform sector average over 12 months. Royal Bank of Canada, together with its affiliates, beneficially owns 1 Sector Perform (SP): Returns expected to be in line with sector aver- percent or more of a class of common equity securities of Teck Resources age over 12 months. Limited. Underperform (U): Returns expected to be materially below sector A member company of RBC Capital Markets or one of its affiliates average over 12 months. received compensation for investment banking services from Teck Resources Limited in the past 12 months. Risk Qualifiers A member company of RBC Capital Markets or one of its affiliates man- (any of the following criteria may be present): aged or co-managed a public offering of securities for Teck Resources Average Risk (Avg): Volatility and risk expected to be comparable to Limited in the past 12 months. sector; average revenue and earnings predictability; no significant cash RBC Capital Markets, LLC makes a market in the securities of Teck flow/financing concerns over coming 12-24 months; fairly liquid. Resources Limited and may act as principal with regard to sales or Above Average Risk (AA): Volatility and risk expected to be above purchases of this security. sector; below average revenue and earnings predictability; may not be RBC Dominion Securities Inc. makes a market in the securities of Teck suitable for a significant class of individual equity investors; may have Resources Limited and may act as principal with regard to sales or negative cash flow; low market cap or float. purchases of this security. Speculative (Spec): Risk consistent with venture capital; low public RBC Capital Markets is currently providing Teck Resources Limited with float; potential balance sheet concerns; risk of being delisted. non-securities services. RBC Capital Markets has provided Teck Resources Limited with invest- Distribution of Ratings, Firmwide ment banking services in the past 12 months. For purposes of disclosing ratings distributions, regulatory rules require member firms to assign all rated stocks to one of three rating RBC Capital Markets has provided Teck Resources Limited with non- categories−Buy, Hold/Neutral, or Sell−regardless of a firm’s own rating securities services in the past 12 months. categories. Although RBC Capital Markets’ stock ratings of Top Pick/Out- A member company of RBC Capital Markets or one of its affiliates perform, Sector Perform and Underperform most closely correspond to received compensation for products or services other than invest- Buy, Hold/Neutral and Sell, respectively, the meanings are not the same ment banking services from Teck Resources Limited during the past 12 because our ratings are determined on a relative basis (as described months. During this time, a member company of RBC Capital Markets or above). one of its affiliates provided non-securities services to Teck Resources In the event that this is a compendium report (covers six or more subject Limited. companies), RBC Dominion Securities may choose to provide specific disclosures for the subject companies by reference. To access current The author(s) of this report are employed by RBC Dominion Securities disclosures, clients should send a request to RBC Dominion Securities, Inc., a securities broker-dealer with principal offices located in Toronto, Attention: Manager, Portfolio Advisory Group, 155 Wellington Street Canada. West, 17th Floor, Toronto, ON M5V 3K7. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. “Member CIPF. ®Registered trademark of Royal Bank of Canada. Used under licence. ©Copyright 2011. All rights reserved.
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