Mining

Friday, 1st June 2012 10:21 - by David Harbage

The mining sector.....

In the last blog, of 18 May, commenting on recent events within the domestic equity market we promised to provide a view on the mining sector. Given the magnitude of the subject, which was hinted at, if not highlighted in part by the article on Commodities published on 29 May, there is no room for other topical wider market observations this week.

There are more than 200 companies with a full or Alternative Investment Market (AIM) listing on the London stock exchange engaged in the extraction of a wide range of minerals - from bulk industrial material such as iron ore, through to rare earth elements used in electronics, onto precious metals. Making up around 12% of the FTSE100 index, as newcomers such as Evraz and Polymetal swell the LSE, the sector is characterised by its international business and is typically cyclical in nature. Strong economies, most notably China, are natural high consumers of many raw metals and minerals – such as copper or iron ore. With limited supply, commodity prices reflect such global demand and although there are exceptional factors (such as transportation cost), individual metals and materials have a standard which can be universally valued. Accordingly, unlike manufactured product, miners’ output (if not their reserves) can be readily assessed and perhaps the underlying stocks are a more reliable means of capturing pro-cyclical trends. (Predicting the near or longer term economic trend is, of course, quite another matter!)

The miners can be split between those that possess a portfolio of various or several minerals, and those companies that are single product or barely diversified. Beyond that, prospective investors should assess the maturity of the mine or mines via discovered reserves and resources, but more particularly by reference to current cash flow status – reflecting how far the business has progressed, in production terms. Start-up, or less mature, businesses will require significant up-front funding in order to expense drilling and other costs until sales revenue arises, or otherwise will have to raise additional capital from investors, the debt market or banks.

While some resources - such as rare earths - are less economically efficient to extract than others, individual miners can be distinguished by their cost of production. This tends to define the perceived quality of an asset, and while certain extraction costs (for example: labour) can be cheaper in particular locations, the grade of the ore is paramount. For example iron ore is typically hewn at US$40 a tonne in Australia, but US$120 in China. Gold mines vary dramatically from US$200 per ounce to US$1,000, and analysts keenly scan management updates for such detail. More particularly, the marginal cost of extraction of a particular mineral is critical to determining whether or not a business breaks even.

Another risk or issue demanding consideration is the location of a company’s mines – both by reference to geological landscape or the local political business regime. The prospect of relatively easy expansion of existing mines, via low cost development, would be an example of the former, while the political geography represents an entirely different risk factor. Beyond labour relations and infrastructural considerations (for example black empowerment or electricity rationing in South Africa), this is of growing importance as higher commodity prices have prompted many governments to opportunely ‘extract’ additional revenue from existing mine operators or new ventures (be it in the form of taxes, royalties or equity stakes).

Within the UK listed market, Anglo American, BHP Billiton, Glencore, Rio Tinto and Xstrata represent the largest businesses with each possessing a number of core mineral assets. While diverse, each company has its own particular personality – be it by reference to location or mix of assets, level of debt, cost of production or trading activity. Given the location of their assets (much in Australia and Canada), BHP Billiton and Rio Tinto may be favoured by more conservative investors; energy assets (oil & gas) makes up a third of BHP Billiton’s business, while Rio’s metal bias offers greater sensitivity to global economic activity. Moreover, consumption within developed economies like the US has the greater impact on oil & gas, while demand for metals typically arises from the emerging economic nations. The latter, incidentally, are also the prime consumers of gold – via central bank and personal purchases. Anglo American has a significant bias to South Africa and South America, while commodities trader Glencore & Xstrata plan to merge.

Corporate activity in the mining industry has been a major theme – with its power to destroy, or add, value for share holders – over the past decade. Primarily occurring in the later stages of the economic cycle, as the larger more mature companies generate very high levels of cash and seek to expand by acquiring competitor’s assets or ‘coming to the rescue’ of financially weak peers. Investors would prefer to see the big miners return cash to shareholders – via dividend payouts, rather than share buybacks – rather than invest in to increase supply (just as demand may be peaking), which would help to inject a greater degree of stability to future shareholder returns. In particular, company management would have to exercise greater discipline in committing monies to new projects or trade purchases; in turn reducing the volatility of the industry cycle and providing  investors with greater comfort on earnings progression, more visibility on returns on capital employed and payout ratios. BHP Billiton’s advice this week that they are revisiting their US$80bn capital expenditure plans represents a positive step in this regard. The City welcomed this evidence of the group’s flexibility (and perhaps mindful of slowing global economic demand) – as BHP Billiton is freezing all board level major project approvals for the next six months.

Beyond the diversified giants of the industry, investors can take their pick from a wide range of asset specific producers of varying size, location, production maturity and balance sheet strength. Within the FTSE100, one can invest in South American located copper via Antofagasta or the African gold assets of Randgold Resources. There are of course other smaller diversified miners within the FTSE100, sometimes featuring particular locations or assets biases, which may also merit investigation. Some of these feature lower levels of liquidity than might be anticipated by the market capitalisation, as significant stakes are tightly held by investors or associated companies, and corporate governance in some jurisdictions might also fall short of best expectations. The latter often becomes more difficult when considering smaller or medium sized companies (exacerbated by the remote location of asset or management), as the prospect of procuring good quality independent research opinion abates. 

While mining is a core cyclical industry for institutional or serious personal investors seeking relatively reliable beneficiaries of strong economic activity (inevitably one must mention China again), the sector also ranks – alongside oil exploration companies – as a favourite amongst speculators. The prospect of a new discovery or proven resource amongst junior miners can have a dramatic impact on the share price, especially as many of these companies have limited dwindling cash resources. Finding a new asset can make the difference between thriving and surviving (or not). In similar vein (please excuse the pun, geologist reader), a marked increase in a particular commodity price can lead to the resumption of production and therefore revenue at a mine which previously would have been unable to operate profitably. Of course, for such higher cost mines, the opposite scenario – of a marked fall in the price of a mineral – can also apply, and the business may no longer be viable.

After having fallen by more than 10% in 2012 to date, the reader might ask: are stock exchange listed mining companies now good value? Smaller or mineral specific businesses will have to be assessed on their own individual merits, as suggested above, but the writer believes that the overall sector – dominated as it is by big diversified miners – features attractively priced investment opportunities. As a prime example, base metal-biased Rio Tinto is expected (based on a survey of 24 broker analyst forecasts) to generate earnings per share of 445pence this year, and 505p next – paying a dividend of 98p and 105p for 2012 & 2013 respectively. At a current share price of £28, this equates to forward looking price/earnings multiples of 6.3 & 5.5 times current and next calendar, year’s profits. Accordingly, these ratings represent a 30% discount to the overall market’s earnings valuation – which implies that investors anticipate a marked reduction in profits in 2014, or at least over the medium term. By contrast, if demand for, and the price of, Rio’s minerals (notably aluminium, coal, copper, diamonds and iron ore) remains around current levels, Rio’s profits, dividend and stock worth appear underpinned.

We would stress that each individual company stock should be assessed on its own merits, and by reference to its specific risks. If Rio Tinto represents a clear call on whether the world – including Asia - experiences an economic ‘hard landing’, other mining stocks may have different drivers by reference to their proposition. Certainly, almost irrespective of economic developments, the prospect of further industry consolidation is very real – as cash-rich miners seek to expand their portfolio of assets or perhaps ‘rescue’ weaker financially based peers. Clearly this blog cannot begin to assess each mining sector opportunity, and we would certainly not wish to make any personal recommendation, but next week - by contrast with industrial giant Rio Tinto - we will take a look at a medium sized gold miner. Meantime, the writer would refer to the blog on Commodities as a starting point in assessing individual metals and minerals.