Global Gambits - 2006 Metals and Mining - J.P. Morgan · Global Gambits - 2006 ... strength and certain commodity prices like gold and copper. ... Michael F. Gambardella (1-212) 622-6446

Global Equity ResearchDecember 8, 2005

Global Gambits - 2006The Right Moves for Right Now

See jpmorganSaVanT.com for gobal sector valuation tools

The following is a chapter from Global Gambits � The Right Moves for Right Now, dated December 8, 2005. This chapter is presented for convenience, and should be read in conjunction with the full report and its analyst certifications and important disclosures. The full report is available on MorganMarkets.

Metals and Miningchapter

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December 8, 2005

Global Equity Research Global Gambits - 2006 — The Right Moves for Right Now See jpmorganSaVanT.com for global sector valuation tools

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Metals and Mining Base Metal Prices Look Poised to Roll Over; Steel Prices Should Remain Stable in 2006 Key Drivers • China––from both a fundamental and a headline

perspective—remains a key driver of this sector. China is now the number one or number two consumer of most major metals and we believe consumption growth will remain at elevated levels for years to come, driving both demand and capacity expansions globally. The Chinese government’s efforts to slow its economic expansion and reduce investment in overheated industries (like aluminum and steel) have met with limited success. However, we believe the risk of a “hard-landing” is low.

• The strength of the US dollar will continue to play a pivotal role for commodity prices. Generally, a stronger US dollar is negative for commodity pricing and vice versa––although in recent months, we have witnessed a disconnect between US dollar strength and certain commodity prices like gold and copper.

• Growing global steel-making capacity is driving demand for bulk commodities. China, in particular, continues to ramp up steel-making production, driving investment in iron ore and metallurgical coal mines.

• Gold has disconnected from the inverse relationship with the dollar. Stronger demand and weakening supply seem to be the biggest drivers of better gold prices, but the double deficits and trade imbalances also help. We expect gold prices to be above US$500/oz in 2006.

• The larger US coal miners control enormous energy reserves. Peabody reports its contained energy rivals Exxon’s. This has become more important as high natural gas prices are encouraging the displacement of gas with coal. Additionally, we expect coal to liquids to raise the profile of coal miners later in the decade.

Our Non-Consensus Views • Domestic steel prices have bottomed and should remain stable

and relatively high compared to historical average prices. The current HRC price appears to have stabilized at US$550/ton, where it has hovered for the past two months after rebounding 30% off its recent low in August. This compares to an average price of US$350/ton since 1997. We believe the scale consolidation the domestic steel industry underwent in the last downturn has taken much of the cyclicality out of the industry.

• Unlike the relatively synchronized past downturns, metals are likely to keel over one by one during this cycle, based on the specifics of each industry rather than a broad-based, economically inspired collapse in metal demand. Tin was the first one to give up the chase in 2Q05 when its inventory decline was arrested. Around mid-year, nickel followed suit when irrational exuberance amongst the stainless steel producers resulted in big inventory rises and the need to cut back vigorously on production. The next likely candidate is lead, which has bravely tried to follow the excellent fundamentals of sister metal zinc (which should still have a big shortfall next year), while its own fundamentals are distinctly unexciting. The metal is looking distinctly leaden at the moment and will likely soon exit the bull market fray, leaving copper, aluminum and zinc to determine whose batteries will last the longest.

• We like the longer-term fundamentals for coal stocks. But in the short to medium term, we expect them to range trade, until we can quantify benefits from growth projects.

Global Sector Coordinator

Michael F. Gambardella (1-212) 622-6446 [email protected] J.P. Morgan Securities Inc. Full sector coverage details on page 147

December 8, 2005


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Metals and Mining: Top Picks Company Key Financials Rationale and Catalysts U.S. Steel Corp. Recommendation: Overweight Fiscal EPS (Local): Year-end December Ticker: X US / X 2004 2005E 2006E 8.17 6.97 8.00 Exchange: NYSE P/E (Calendar) Price (Local): US$39.77 2005E 2006EMkt Cap (US$): 4.5 bn 5.7 5.0 Analyst: Michael F. Gambardella EV/EBITDA (Calendar) Phone: (1-212) 622-6446 2005E 2006EEmail: [email protected] 2.9 2.7

• We view US Steel as an attractive investment as we believe the domestic steel market environment is strong with service center inventories at 19-month lows, imports below 13% versus the long-term average of 17%, and spot market prices up 30% over the past three months. The high level of consolidation over the past cycle has created an environment in which supply constraint by steel producers can reduce the cyclicality of steel prices.

• High raw material costs are making labor cost differentials less meaningful. As coal, iron ore, natural gas and scrap costs have taken a ‘step-up’ in price, they have made labor costs a much smaller percentage of overall steel production costs, allowing domestic producers to narrow the cost gap with overseas producers.

• We believe shares of US Steel are attractive trading at 2.7x our 2006 EBITDA estimate and at only 1.1x book value versus its 1.4x average since 1997---includes periods of losses---which does not appear likely any time soon.

Teck Cominco Ltd. Recommendation: Overweight Fiscal EPS (Local): Year-end December Ticker: TEK/SV/B CN / TEKsvb.TO 2004 2005E 2006E 3.12 5.25 5.40 Exchange: TSE P/E (Calendar) Price (Local): C$53.00 2005E 2006EMkt Cap (US$): 8.9 bn 10.1 9.8 Analyst: Michael F. Gambardella EV/EBITDA (Calendar) Phone: (1-212) 622-6446 2005E 2006EEmail: [email protected] 5.0 4.7

• We believe Teck Cominco has one of the best balanced portfolio of assets among its peers, with exposure to zinc, copper, coal, gold, molybdenum and lead, giving its cash flow and earnings a more consistent and stable outlook compared to other base metal pure play companies.

• The zinc market fundamentals have tightened considerably, driving the zinc price up over US$0.73/lb. As the largest zinc miner in the world, we believe Teck Cominco is well positioned to benefit.

• We believe Teck Cominco’s assets are currently being undervalued by the market. The stock currently trades at a 25% discount to its base metal peers N, FAL, FCX, PD.

Source: Company data, Datastream, JPMorgan estimates, JPMorgan SaVanT. Prices as of November 22, 2005.

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Metals and Mining: Top Picks (cont’d) Company Key Financials Rationale and Catalysts BHP Billiton Ltd. Recommendation: Overweight Fiscal EPS (Local): Year-end June Ticker: BHP AU / BHP.AX 2004 2005 2006ETicker ADR: 56.4 107.7 163 Exchange: ASX P/E (Calendar) Price (Local): A$21.55 2005E 2006EMkt Cap (US$): 57.1 bn 15.2 9.5 Analyst: David George EV/EBITDA (Calendar) Phone: (61-03) 9608-4002 x34002 2005E 2006EEmail: [email protected] 10 6.5

• Our core recommendations for BHP and RIO remain Overweight, but the catalysts to spur sustainable ongoing share price outperformance are becoming increasingly difficult to identify. Our preference between the two is Rio Tinto, but we believe that the call is marginal.

• The current round of iron ore negotiations, which could carry on into the new year, is the key driver of expected share price performance over the next quarter. We believe there is reasonable upside risk to our view of a 7.5% increase, and moderate upside risk to the market consensus view of a 10% rise. We expect that a 20% or higher price outcome will deliver further share price appreciation.

• While both companies are large producers of iron ore (Rio ranking no. 2 and BHP no. 3), Rio Tinto’s earnings sensitivity is about double that of BHP Billiton’s due to its higher production and the higher proportion of Rio’s earnings that iron ore contributes compared to BHP’s proportion. A better-than-expected price outcome for the April 1, 2006, contracts would be more positive for Rio than for BHP, in our view.

• A significant re-rating would require a change to the status quo to be realized. Either a super cycle would need to eventuate, or the companies are rated the same as industrials, or the companies are valued as the sum of the parts of their pure play components (which would require a break-up, which we think is unlikely). Scenario 1—Our super cycle assumptions yield potential upper target prices of A$71 for RIO and A$25 for BHP. Scenario 2—the quasi-industrial case yields potential upper target prices of A$70 for RIO and A$28 for BHP. Scenario 3—where we attribute pure play, peak cycle multiples to earnings yield potential upper target prices of A$107 for RIO and A$39 for BHP.

Rio Tinto Ltd. Recommendation: Overweight Fiscal EPS (Local): Year-end December Ticker: RIO AU / RIO.AX 2004 2005E 2006ETicker ADR: 166.9 369.3 431.5 Exchange: ASX P/E (Calendar) Price (Local): A$60.70 2005E 2006EMkt Cap (US$): 20.7 bn 12.7 10.1 Analyst: David George EV/EBITDA (Calendar) Phone: (61-03) 9608-4002 x34002 2005E 2006EEmail: [email protected] 7.5 6.4

• Our core recommendations for BHP and RIO remain Overweight, but the catalysts to spur sustainable ongoing share price outperformance are becoming increasingly difficult to identify. Our preference between the two is Rio Tinto, but we believe that the call is marginal.

• The current round of iron ore negotiations, which could carry on into the new year, is the key driver of expected share price performance over the next quarter. We believe there is reasonable upside risk to our view of a 7.5% increase, and moderate upside risk to the market consensus view of a 10% rise. We expect that a 20% or higher price outcome will deliver further share price appreciation.

• While both companies are large producers of iron ore (Rio ranking no. 2 and BHP no. 3), Rio Tinto’s earnings sensitivity is about double that of BHP Billiton’s due to its higher production and the higher proportion of Rio’s earnings that iron ore contributes compared to BHP’s proportion. A better-than-expected price outcome for the April 1, 2006, contracts would be more positive for Rio than for BHP, in our view.

• A significant re-rating would require a change to the status quo to be realized. Either a super cycle would need to eventuate, or the companies are rated the same as industrials, or the companies are valued as the sum of the parts of their pure play components (which would require a break-up, which we think is unlikely). Scenario 1—Our super cycle assumptions yield potential upper target prices of A$71 for RIO and A$25 for BHP. Scenario 2—the quasi-industrial case yields potential upper target prices of A$70 for RIO and A$28 for BHP. Scenario 3—where we attribute pure play, peak cycle multiples to earnings yield potential upper target prices of A$107 for RIO and A$39 for BHP.


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Metals and Mining: Stocks to Underweight Company Key Financials Rationale and Catalysts China Oriental Recommendation: Underweight Fiscal EPS (Rmb) Year-end December Ticker: 581 HK / 0581.HK 2004 2005E 2006E 0.42 0.35 0.33 Exchange: Hong Kong Stock Exchange P/E (Calendar) Price (Local): HK$1.94 2005E 2006EMkt Cap (US$): 0.7 bn 5.7 6.0 Analyst: Feng Zhang EV/EBITDA (Calendar) Phone: (852) 2800-8513 2005E 2006EEmail: [email protected] 5.2 5.2

• China Oriental Group is a privately owned holding company incorporated in Bermuda. Its only operating asset is the 97.6%-owned Jinxi Iron & Steel Limited, a medium-sized steel producer with an annual capacity of 3.1 million tons. The company currently produces two construction-related long products—billets and hot rolled narrow strips, which accounted for 60.4% and 39.6% of revenue, respectively, in 2004.

• Surging steel production and falling steel prices are key investment risks. We continue to hold the view that rapid growth of China’s steel capacity will likely weigh on the market over the next 12 months. China’s spot HRC prices have fallen by about 41% since their peak in March, while raw material prices of iron ore and coke have remained resilient.

• Our target price of HK$1.46 is based on applying 0.8x P/B multiple to 2006E BVPS of Rmb1.93.

Maanshan Iron and Steel Recommendation: Underweight Fiscal EPS (Local) Year-end December Ticker: 323 HK / 0323.HK 2004 2005E 2006E 0.56 0.49 0.39 Exchange: Hong Kong Stock Exchange P/E (Calendar) Price (Local): HK$2.32 2005E 2006EMkt Cap (US$): 0.5 bn 5.0 6.3 Analyst: Feng Zhang EV/EBITDA (Calendar) Phone: (852) 2800-8513 2005E 2006EEmail: [email protected] 3.6 4.4

• Maanshan Iron and Steel manufactures and sells iron and steel products. Its major products are wire rods, sections, plates, train wheels and hot-rolled and cold-rolled products. In 2004, the group produced a total of 7.1 million tons of pig iron, 8.0 million tons of crude steel and 7.4 million tons of steel products. Maanshan sells more than 90% of its products in China, mainly in the Anhui and Jiangsu provinces.

• Negative steel price cycle risk: Recently, domestic steel prices in China fell sharply due to strong production growth and rising imports. The current HRC price is about 26% below YTD’s and last year’s average. We believe China’s spot steel prices will likely fall further next year as we expect supply to outstrip demand, which would put more pressure on Maanshan’s earnings.

• We maintain our Underweight rating on Maanshan with a target price of HK$1.46, based on 0.8x FY06E BVPS of Rmb1.93.


December 8, 2005


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JPMorgan Global Metals and Mining Team – Research Equity Research Credit Research Americas Americas

United States

Michael Gambardella Jeffrey Largey Nathan Zibilich, CFA John Bridges Ankush Agarwal

United States David Common, CFA (HY-Metals & Mining) Xin Liu Richard Yu (HG- Metals & Mining) Yanru Chen

Latin America Debbie Bobovnikova EMEA EMEA Pan-Europe Ross W Gardiner

Patricia Lopez Del Rio James Kelly

Pan-Europe & CEEMEA Douglas Krehbiel Tatiana Tchembarova

South Africa Steve Shepherd Douglas Orsmond Ross W Gardiner

Asia Pacific Asia Pacific Pan Asia Pacific (incl. Japan) Henry Kwon Australia, New Zealand Allison Bellows Tiernan

Japan Mana Nakazora Australia

David George Mark Greenwood Ryan Martyn Matthew Whittall

China Feng Zhang Indonesia Ami Tantri Japan Henry Kwon

Ryo Kiyokawa

South Korea Henry Kwon Elaine Chung

Taiwan Henry Kwon

Michael Gambardella Global Sector Coordinator Commodities Research Jon Bertheil Anindya Mohinta Thailand Sukit Chawalitakul See page 193 for team member contact details.

December 8, 2005


Analyst Certification The research analyst who is primarily responsible for this research and whose name is listed first on the front cover certifies (or in a case where multiple research analysts are primarily responsible for this research, the research analyst named first in each group on the front cover or named within the document individually certifies, with respect to each security or issuer that the research analyst covered in this research) that: (1) all of the views expressed in this research accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research.

Important Disclosures for Compendium Reports — U.S., European, Latin American, and Australian equities recommended in this report: Important disclosures, including price charts for all companies under coverage for at least one year, are available through the search function on JP Morgan's website https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406).

Important Disclosures — Asian and Japanese equities recommended in this report: • Market Maker: JPMSI makes a market in the stock of Pacific Basin Shipping, SPIL (Siliconware Precision Industries). • Lead or Co-manager: JPMSI or its affiliates acted as lead or co-manager in a public offering of equity and/or debt securities for San Miguel Corporation,

Standard Chartered within the past 12 months. • Analyst Position: The covering analyst, research associate, or member(s) of their respective household(s) have a long position in the securities of CapitaLand. • Beneficial Ownership (1% or more): JPMSI or its affiliates beneficially own 1% or more of a class of common equity securities of Maanshan Iron and Steel. • Client of the Firm: Acer Inc is or was in the past 12 months a client of JPMSI. Alcatel is or was in the past 12 months a client of JPMSI; during the past 12

months, JPMSI provided to the company investment banking services and non-investment banking securities-related service. AU Optronics is or was in the past 12 months a client of JPMSI. CapitaLand is or was in the past 12 months a client of JPMSI. China Oriental is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. Chinatrust Financial Holdings is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services. Henderson Land Development is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. Hyundai Motor is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related service and non-securities-related services. Ibiden (4062) is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related service. Japan Tobacco (2914) is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related service. Komatsu (6301) is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services. Mitsubishi UFJ Financial Group (8306) is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. NEC Electronics (6723) is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related service and non-securities-related services. Pacific Basin Shipping is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services. Polaris Industries is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-securities-related services. San Miguel Corporation is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services. Sinopec Corp. is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-securities-related services. SPIL (Siliconware Precision Industries) is or was in the past 12 months a client of JPMSI. Standard Chartered is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment banking services, non-investment banking securities-related service and non-securities-related services. Taiwan Cement is or was in the past 12 months a client of JPMSI. Tata Consultancy Services is or was in the past 12 months a client of JPMSI.

December 8, 2005


• Investment Banking (past 12 months): JPMSI or its affiliates received in the past 12 months compensation for investment banking services from Alcatel, China Oriental, Chinatrust Financial Holdings, Henderson Land Development, Komatsu (6301), Mitsubishi UFJ Financial Group (8306), Pacific Basin Shipping, San Miguel Corporation, Standard Chartered.

• Investment Banking (next 3 months): JPMSI or its affiliates expect to receive, or intend to seek, compensation for investment banking services in the next three months from Alcatel, CapitaLand, China Oriental, Chinatrust Financial Holdings, Henderson Land Development, Hyundai Motor, Komatsu (6301), Mitsubishi UFJ Financial Group (8306), NEC Electronics (6723), Pacific Basin Shipping, San Miguel Corporation, Standard Chartered.

• Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other than investment banking from Alcatel, Chinatrust Financial Holdings, Hyundai Motor, Ibiden (4062), Japan Tobacco (2914), Komatsu (6301), NEC Electronics (6723), San Miguel Corporation, Standard Chartered. An affiliate of JPMSI has received compensation in the past 12 months for products or services other than investment banking from CapitaLand, Chinatrust Financial Holdings, Hyundai Motor, Komatsu (6301), NEC Electronics (6723), San Miguel Corporation, Standard Chartered.

Explanation of Ratings and Analyst(s) Coverage Universe: JPMorgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] The analyst or analyst’s team’s coverage universe is the sector and/or country shown on the cover of each publication.

JPMorgan Equity Research Ratings Distribution, as of September 30, 2005 Overweight

(buy) Neutral (hold)

Underweight(sell)

JPM Global Equity Research Coverage 40% 42% 18% IB clients* 46% 45% 39% JPMSI Equity Research Coverage 34% 49% 17% IB clients* 65% 55% 45%

*Percentage of investment banking clients in each rating category. For purposes only of NASD/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category, our Neutral rating falls into a hold rating category, and our Underweight rating falls into a sell rating category.

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December 8, 2005


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Global Gambits - 2006 Metals and Mining - J.P. Morgan · Global Gambits - 2006 ... strength and certain commodity prices like gold and copper. ... Michael F. Gambardella (1-212) 622-6446