MINING: THE STORY OF AN INDUSTRY IN DISTRESS
CAN THE TURNAROUND PLANS SAVE THE SECTOR?
MINING COMPANIES HAVE ANNOUNCED BILLION-DOLLAR WRITE-DOWNS,
MINE CLOSURES AND THOUSANDS OF JOB CUTS – BUT THE CONTINUING DECLINE IN METAL PRICES MEANS THE SECTOR, THE WORLD’S WORST PERFORMER SINCE 2011, REMAINS AN “INDUSTRY IN REVERSE”. FINWEEK UNPACKS THE REASONS BEHIND THE “BLOODBATH” AND FACTORS THAT
COULD RESULT IN A TURNAROUND.
You can see what former Anglo American CEO Tony Trahar i ntended when he installed the South African company in the sumptuous district of London’s St James shortly after its UK listing in 1999. Situated in a neighbourhood designed by Regency architect John Nash, Anglo’s head office at 20 Carlton Terrace is a declaration that the far-flung mining house could comfortably stand its ground with the city’s blue bloods: Rio Tinto and BHP Billiton.
It didn’t seem to matter that the likes of Rio Tinto would put i ts elegant St James Square offices in Mayfair up for sale or that BHP Billiton decided to take up premises a stone’s throw from the A202, conveniently adjacent to the discount utility chain Argos.
In bold contrast, Carlton Terrace has a view of St James’s Park, an advantage it shares with Buckingham Palace, while Anglo’s neighbours at Number 18 made headlines in 2013 when they sold the property for £250m, making it the country’s most expensive residence.
Of course, at the time of Anglo’s arrival i n the UK, the mining market was on the cusp of a breathtakingly spectacular bull market driven by Chinese economic growth, a movement that economists likened to the industrial re-awakening of Germany in the 1950s, only bigger. It was a far cry from the straitened times of today.
For instance, BHP Billiton was able to take its place as a sponsor of the Beijing Olympics in 2008, an event described as China’s coming-out party, while miners fell over themselves supplying millions of China’s newly moneyed middle class with fridges, hair dryers and washing machines and Beijing invested in the railways, ports and roads through which its minerals for manufacture were delivered.
Sponsoring the Beijing Olympics was a strenuous marketing of ambition that’s quite unthinkable today as China’s economic growth slows, transforming the mining sector’s supernova into a black hole in less than three years.
It’s against this background that Mark Cutifani, Anglo American CEO, was left to impart a message all of his own. “We are looking for a residence that is more appropriate and cost effective,” he said, announcing a hefty downsizing of Anglo’s London offices. “St James’s is a very expensive place to stay for a mining company.”
AN INDUSTRY IN REVERSE
It ’s only a head office move – the t ype that companies do all the time – but it’s also a metaphor for an i ndustry i n reverse. Whereas Cutifani’s decision to sell Anglo’s corporate jet two years ago could be interpreted as showmanship, a dart at Anglo’s upper-crust culture by its newly appointed Australian iconoclast, the office relocation seems tinged by survival.
There’s also the shocking reality that Anglo will need less office space after it unleashed a brutal $500m cost-cutting drive, of which $300m would be derived through the cutting of 6 000 jobs, equal to 46% of the organisation’s total support head count.
All in all, the group’s interim results last week came with both good and bad news. The interim dividend was, surprisingly, maintained, and net debt was cut significantly to $11.9bn, but there was also a $4bn write-down of Anglo’s coal and iron ore assets – a common theme running through the sector that few companies have been able to escape.
BHP Billiton announced a $3bn write-down of its onshore assets on 3 July – a move determined by the continued decline in metal prices in a year analysts thought would represent the “bottoming-out” of the mining slump.
Instead of the bottoming out, there’s been an acceleration in metal and share price liquidations. For Anglo, every mineral or metal it produced was lower in the first six months of this year, and some, such as nickel, were off by some margin (20%), while metallurgical coal and iron ore were both 14% lower; copper was 10% weaker, and platinum was 11% lower year-on-year.
Market conditions like these are virtually unplayable. Analysts clearly point the finger at China as it transforms from an investment-led economy to one driven by consumerism.
The meaning of this transformation can be explained by turning the clock back to 2002 when China embarked on a programme of centralised investment. Normally, economies are built on higher GDP growth per capita, which leads to a larger tax take that, in turn, all ows government t he spending power on things such as infrastructure, water provi s i on , sewerage an d road construction.
In China, however, this process was slightly different in that it centralised resources in Beijing, allowing it to build out infrastructure at a much faster rate and earlier in the GDP/capita cycle than other major economies.
The problem for mining companies – which threw themselves into massive expansion to meet this economic growth – is that the resulting post-party hangover can only be a brain atomising one. That’s because China’s take of major mining commodities is between 40% to 70% of the global total, but its economy is only 13% of the world’s GDP.
“The commodity intensity per capita in China has surpassed many advanced economies, and we believe the outlook is for GDP to grow from consumption demand r ather t han i nvestment demand,” said Goldman Sachs in a recent report. It forecast a normalisation over time.
“Normalisation”, however, seems hard to come by presently.
Metal price weakness has given way to volatility. Iron ore lost 25% in a week in mid-July, its single biggest price swing ever. It regained some of the ground, but it was enough to justify Kumba Iron Ore’s decision to suspend its dividend.
That was bad news for Exxaro Resources, predominantly a coal producer but with a 19% stake in Kumba, that handily yielded dividend flow worth billions of rand in previous years.
Now, however, Exxaro has spoken of how this could mean failing to produce dividends of i ts own, or worse: an inability to meet its bank covenants. Its flagship empowerment structure, held in Main Street 333, has asked it for a R400m loan in order to refinance its own debt structure. Thus one company’s problems cascade to another.
In an interview with Finweek, Cutifani expressed his surprise at the continued weakness in the metals market this year. “We didn’t expect the rout to be this severe,” he said. “I think the concerns around China are reasonably founded. Maybe this was overdue, but we probably need another six months to work it out.
“It’s not a disaster,” he said, adding that, “We always tend to overreact to some degree in the mining sector.”
Perhaps Cutifani’s view is somewhat coloured by the fact that, for others, the change i n China’s economy i s not a catastrophe so much as it is a necessary evolution.
Over the l ong term, an economy driven by consumer spend is a naturally mature one.
And it ’s actually quite positive for the likes of Anglo American subsidiaries Anglo American Platinum (Amplats) and De Beers, it s 85% di amond producer, which rely on jewellery sales for a portion of revenue. Both have long identified the rise of the Chinese middle class as an exciting new market.
“Ultimately, a consumer-led economy i s very good for j ewellery and for platinum,” said Chris Griffith, CEO of Amplats. “That is a good outcome for platinum, but at the moment what we’re seeing is a very nervous economy, certainly for iron ore and steel,” he said.
“It’s difficult to read too much into dayto-day developments, but right now I’d say we’re in nervous territory.”
Bruce Cleaver, head of strategy at De Beers, said the group wasn’t “terribly worried” about the economic slow-down in China, but he nonetheless acknowledged it was a factor in the diamond market.
“China i s our s econd- biggest market and an interesting one given its potential growth and the impact that has on diamond jewellery,” he said in a telephonic interview. “There’s a tremendous number of middle- cl ass homes,
and people are still getting married, bearing in mind that the Chinese only buy diamond rings for marriages, not engagements.
“We also are seeing more and more affluent Chinese people buying diamond jewellery outside their own country in places such as Japan and South Korea, possibly motivated by the weaker currencies there. So certainly, big commodity businesses are rethinking things, but for us, as the economy in China matures it moves more into a consumer phase,” he explained.
Nonetheless, investors following the mining markets have been through the wringer, this year especially. Shares i n the JSE’s Resource Top 1 0 have fallen 23% since May, representing big casualties such as Glencore, down 18% in three months, 24% in a month, while BHP Billiton is 15% weaker, and Anglo is down 17%, also since May.
According to analysts, the current vulnerabilities of mining stocks come down to the fact that in attempting to lower costs and raise production – a means of reducing unit costs, i ncreasing margins and ultimately improving payouts to shareholders – they perpetuate poor conditions in the market.
“Are you managing the market as you claim?” asked Allan Cooke, an analyst for JP Morgan, of Amplats’s Griffith, who spoke of readjusting the company’s sights and raising production at the group’s interim results announcement.
The group had, after all, cut l abour numbers to 8 700 from 32 000 at its Rustenburg and Union section mine, but now proposes to increase output 80 000 ounces at the mines between the 2015 and 2017 financial years. “Firstly, we’ve already cut our production, and secondly we continue to cut production when we are producing unprofitable ounces,” Griffith responded.
It’s down to the self-preservation tactics of mining firms that Goldman Sachs responded in a report in July that put the skids under the mining market. It said the early gains of cost cutting Rio Tinto, Glencore and BHP Billiton undertook would have limited effect today.
“With the China super cycle fading from 2011 onwards, miners have shifted the focus on the controllable with the focus being on increasing productivity, reducing costs and cutting capex/ assets to combat falling commodity prices,” the bank said.
“But we suspect most of the early actions were taken expecting the cycle to mean revert soon and prices to start trending up again. These actions have not been enough to stop declines in earnings and see miners continuing to underperform – being the worstperforming sector in 2011 through to and including 2015 year-to-date,” it said.
Sometimes the cost- cutting and restructuring is just not vigorous enough.
Lonmin l ost a quite staggering 56% of its value in the last 30 days, notwithstanding its decision to extend j ob cuts to 6 000 and close down 100 000 ounces of platinum group metal production over the next two years.
According to RMB Morgan Stanley analyst Chris Nicholson, Lonmin had bought itself time, but the restructuring was not “a sustainable solution”. He estimated the firm was burning $175m a year at spot prices even after closing down production.
“We estimate that prices 15% to 20% higher than spot are required for Lonmin to achieve FCF [free cash flow] breakeven,” said Nicholson, who added that this assumed capex of $130m even though Lonmin needed to spend up to $250m in order to sustain output in the medium term.
At spot commodity prices, and after reducing capex to $ 120m, Lonmin was likely to be marginally cash-flow negative through 2016, said Andrew Byrne, an analyst at Barclays Capital. He added that the “big picture” showed more trouble for Lonmin.
“[ T] hi s r educed s upply won’t impact metal markets for around two years, and thus if larger peers Amplats
“IT’S DIFFICULT TO READ TOO MUCH INTO DAY-TO-DAY DEVELOPMENTS [IN CHINA], BUT
RIGHT NOW I’D SAY WE’RE IN
and Impala Platinum were to employ similar strategies, the market is likely to remain oversupplied over this period, exacerbating downward pricing pressure on commodity markets and profitability,” said Byrne.
IS RECOVERY POSSIBLE?
For conditions to improve for mining companies in the short term, there are a number of scenarios that would have to pan out, each of them more and more improbable. One is that Chinese demand actually improves – which is unlikely in the short term.
The second and third factors are that India’s economic growth steps up and that there are supply closures – both equally unlikely given the focus companies are putting on unit costs rather than deep-vein surgery. The fourth hope is that the mining sector simply “bottoms out” – and rebounds – but analysts don’t think that’s a possibility, at least not yet.
“It’s a bloodbath out there. Prices are so low, but that makes stocks look expensive unless prices recover,” said an industry source who didn’t want to be named, as his comments didn’t reflect company policy.
“There are lots of concerns about debt and cash flow levels, but supply cuts never seem to come. They cut costs, then they high grade [mine the assets for the best ore first] and then to the banks, but rarely is there [mine] closure,” the source said. “We just have to wait for demand to eat into excess supply. That is the only way, but it takes time.”
It’s not all bad news. David Butler, an analyst for Barclays Capital, is convinced the news from China will improve in the second half of the year, effectively from about now.
“We [...] continue to believe that Chinese economic data and commodity consumption will improve in the second half [. . .] accompanied by ongoing economic recovery in Europe,” he said, adding that overall the current share price weakness was “an opportunity”.
There is also the fact that eventually mining companies will have to take the really bitter medicine. Said Goldman Sachs: “We believe if 2015 plays out as we expect, and mining stays near the bottom, it will likely set 2016 out to be the year of bolder moves.”
Among the “bolder moves” would be more aggressive portfolio restructuring, similar to what is already happening in the gold sector, as well as cutting stickier and inherently more difficult cost areas, it said.
Merger and acquisition activity in the diversified mining sector seems to be thin on the ground, largely because it appears as if the big players still have decent access to capital. But it is coming, analysts say.
“A positive signal to look out for is the deployment of private equity capital that currently remains surprisingly subdued,” said Hunter Hillcoat, an analyst for Investec Securities in London.
“We note t hat X2 has yet t o undertake a major transaction,” he said. This is the company founded by former Xstrata CEO Mick Davis, who said in 2014 that supply cuts would naturally sow the seeds for a new lift in global demand for commodities.
I n the meantime, i nvestors can expect equities to r emain under pressure with the risk of further pain an omniscience. “If spot prices persist or worsen, we see ongoing dividend commitments at risk, for the majors in particular,” said Hillcoat. “This may necessitate difficult decisions such as moving to close or divest assets.”
Said Goldman Sachs: “Ultimately, we think the sector bottoming out combined with some capacity closures i s the only way miners could again outperform peers – and we believe we are far from that point still.”
ANGLO WILL NEED LESS OFFICE SPACE AFTER IT UNLEASHED A BRUTAL $500M
COST-CUTTING DRIVE, OF WHICH $300M WOULD BE DERIVED THROUGH
THE CUTTING OF 6 000 JOBS.
Anglo American CEO