Gaurav Sodhi Outlook for miners

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

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.