Gau­rav Sodhi Out­look for min­ers

The big min­ers are leaner and meaner, en­joy­ing boom-time prof­its with­out the ben­e­fit of boom-time prices

Money Magazine Australia - - CONTENTS - STORY GAU­RAV SODHI Gau­rav Sodhi is a deputy head of re­search at In­tel­li­gent In­vestor, part of In­vestSMART Group (un­der AFSL 282288). This ar­ti­cle con­tains gen­eral in­vest­ment advice only. Find out more about In­tel­li­gent In­vestor and start a 15-day free tr

The big min­ers got lazy amid the riches de­liv­ered by the com­mod­ity price su­per cy­cle. Just how lazy is only now ev­i­dent in the stag­ger­ing amounts of cash be­ing gen­er­ated by BHP Bil­li­ton, Rio Tinto and other large min­ers. How did they do it? The com­mod­ity price crash forced them to man­age their busi­ness not for fi­nan­cial ex­cess but for drought. The re­sult was bet­ter cap­i­tal al­lo­ca­tion, tighter man­age­ment and stag­ger­ing pro­duc­tiv­ity gains. This has re­sulted in even bet­ter re­turns on cap­i­tal than dur­ing the boom, even though prices are far from their boom-time highs.

BHP per­haps de­serves the most ku­dos. It flipped decades of min­ing con­ven­tion by fo­cus­ing on higher-re­turn­ing as­sets and pri­ori­tis­ing share­holder re­turns over com­pany size and pro­duc­tion vol­umes. That model is now be­ing repli­cated by Rio Tinto and other ma­jor min­ing houses. But it was BHP that got it started, so let’s be­gin there.

BHP is on track to post a net profit of about $US10 bil­lion ($14 bil­lion) this year, 10 times as much as it made just two years ago. No longer the un­pop­u­lar miner it was when we sug­gested tak­ing a nib­ble in Jan­uary 2015, it’s also a long way from the dis­tressed, prob­lem-prone busi­ness it ap­peared to be three years ago.

If in­vestors should aim to buy min­ers low and sell them high, with BHP’s share price up over 80% since our last buy rec­om­men­da­tion two years ago, surely the mis­sion has been ac­com­plished?

It’s not time to move on just yet. While com­mod­ity prices have im­proved, the big min­ers’ re­sults have re­cov­ered and cash flow has bal­looned. Th­ese busi­nesses are worth more than they were a few years ago; the case for hang­ing on has strength­ened.

The min­ing sec­tor rightly earned a rep­u­ta­tion as a cap­i­tal sink. Losses arose from mis­takes of cap­i­tal al­lo­ca­tion rather than op­er­at­ing per­for­mance. Buy­ing ex­pen­sive as­sets, chas­ing growth and pri­ori­tis­ing vol­ume were the hall­marks of BHP and the rest of the in­dus­try for decades. That’s no longer the case.

Cap­i­tal ex­pen­di­ture which, hav­ing peaked at over $US22 bil­lion in 2013, has now fallen to a more sus­tain­able $US5 bil­lion to $US6 bil­lion. This has had a tremen­dous im­pact on free cash flow. After be­ing neg­a­tive for most of the cen­tury, we ex­pect BHP to gen­er­ate free cash flow of about $US10 bil­lion in the

2018 fi­nan­cial year, equat­ing to a free cash flow yield ap­proach­ing 6%. To that you can add a handy frank­ing bal­ance and an ex­pected $US10 bil­lion cash injection from the sale of its US shale as­sets.

With BHP no longer prof­li­gate with prof­its, cash re­turns are soar­ing. Share­hold­ers can ex­pect even more debt to be re­paid plus higher div­i­dends, de­spite com­mod­ity prices re­main­ing well be­low pre­vi­ous peaks. This busi­ness is now be­ing run for share­hold­ers rather than em­pire builders.

BHP’s glo­ri­ous as­set base can at last shine. Iron ore costs have fallen to less than $US15 a tonne; big spend­ing on the world’s largest cop­per mine, Es­con­dida, should help re­duce costs; and coal has been re­vived. Hav­ing sold as­sets, BHP is smaller, sim­pler and more prof­itable.

Over the past 10 years – a pe­riod that in­cludes cycli­cal highs and lows – BHP’s ag­gre­gate re­turn on as­sets has reached over 30% in its best year and less than 10% in its worst. That won’t change: min­ing will al­ways be cycli­cal.

But the changes to the port­fo­lio – sell­ing shale, spin­ning off South32, po­ten­tially sell­ing nickel mines – mean that higher re­turns are pos­si­ble in peak years but low costs should bet­ter in­su­late it from the cycli­cal troughs. Free from the bur­den of get­ting big­ger, BHP has be­come BHP is now be­ing run for share­hold­ers rather than em­pire builders bet­ter. We’re rais­ing our buy price from $23 to $25 and stick­ing with “hold”.

What of Rio Tinto, which has en­joyed years of out­ra­geous prof­itabil­ity and re­cent bumper pro­duc­tion num­bers? Like BHP, it is a smaller but bet­ter busi­ness, de­spite dis­ap­point­ing in­vestors after its lat­est in­terim re­sult.

Rio gen­er­ated un­der­ly­ing net profit of $US4.4 bil­lion, up 33% from last year, and an­nounced a 15% hike in div­i­dends to $US1.27 per share, plus ad­di­tional buy­backs.

At 43%, Rio’s earn­ings be­fore in­ter­est, tax, amor­ti­sa­tion and de­pre­ci­a­tion (EBITDA) mar­gin are the same as they were at the height of the re­sources boom, even though iron ore prices are at about half their peak. The com­pany is gen­er­at­ing boom-time prof­its with­out boom-time prices.

An­a­lysts were quick to con­demn the re­sult. De­spite flat un­der­ly­ing EBITDA, op­er­at­ing cash flow was 17% lower than it was last year and free cash flow fell 38% to $US2.8 bil­lion. That’s un­der­stand­able. Cur­rent costs still re­flect cycli­cal lows even though prices do not. Op­er­at­ing mar­gins are ar­guably a lit­tle gen­er­ous and there is room to ab­sorb higher costs. This isn’t the prob­lem it was a few years ago.

Higher costs were, in any case, over­shad­owed by prices. Higher com­mod­ity prices added $US600 mil­lion to EBITDA with alu­minium the star. Although with trade wars and tar­iffs on the agenda that might change in the short term. But an en­trenched cost ad­van­tage and an enor­mous re­source base will out­last trade dis­putes.

Rio’s iron ore busi­ness boasted as­tound­ing mar­gins of 67% as unit costs have fallen from over $US20 a tonne to just over $US13 a tonne over four years. On an as­set base of over US$15 bil­lion, the divi­sion con­sis­tently gen­er­ates re­turns of over 50%, after tax and cap­i­tal ex­pen­di­tures. This is ar­guably the best busi­ness in global min­ing.

And yet with about $US5 bil­lion of as­set sales an­nounced, Rio con­tin­ues to shrink. On the chop­ping block this time is its stake in the world’s largest gold mine in West Pa­pua. What re­mains are high-qual­ity, long-life, low-cost mines and a com­pany con­tent to milk its as­sets for cash.

Rio’s re­turn on eq­uity – at over 23% – is as high as it has ever been. This may be a smaller, less am­bi­tious busi­ness but it is, like BHP, a bet­ter one.

The iron ore and alu­minium di­vi­sions alone are worth about $65 a share while the rest of the busi­ness – cop­per, en­ergy and spe­cialty min­er­als – gen­er­ated over $US1.4 bil­lion in cash flow. Th­ese are also clearly worth a de­cent sum. That sug­gests to­day’s share price is fair or even marginally cheap.

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