This article appeared in the November 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By David Walker, StocksInValue
This article looks at the outlook for shareholder returns from BHP Billiton (BHP), Rio Tinto (RIO), New Hope Corporation (NHC) and Fortescue Metals Group (FMG), and analyses the resource sector's prospects.
S&P/ASX 200 Resources Index compared with S&P/ASX 200 Index
- October 2011 to October 2013
Source: Google Finance
The recent underperformance by the resources index was the result of an unlikely combination of:
- Australian dollar strength and bulk commodity price weakness coupled with weak world economic growth
- A slowdown in Chinese growth from around 10 per cent to 7-8 per cent
- General pessimism about "the end of the mining boom".
In short, StocksInValue does not see resource stock share prices compounding at 20 per cent each year, as many did between 2003 and 2007, because:
- The Australian dollar is persistently strong against the US dollar and is likely to remain so while bond purchases, as part of US quantitative easing, continue at high monthly rates. (Editor's note: continued central bank printing of money is putting downward pressure on some currencies). Ongoing political conflict over the US debt ceiling is negative for sentiment surrounding the US and its currency.
- The strength in bulk commodity prices last decade reflected previous under-investment in mine capacity and surging demand for commodities from countries such as China. Very substantial capacity expansion in new plants is now driving higher mining output. This will restrain commodity prices in a way not possible last decade. In the short term (2014) commodity prices could fall as markets move into a period of surplus supply. (Editor's note: simply put, more investment in mining has led to more output, or supply, and increased the probability of higher commodity stockpiles).
- This time there is not the positive effect on sentiment of financial markets "discovering" China as an investment theme.
Therefore, it will not be as easy as last decade to make money in resource stocks. Instead, investors need to understand the components of total shareholder return and which of these components are available in each stock. The three components are:
- The re-rating opportunity: When a share price rises to equal intrinsic value (the company's true value), having earlier been at a discount to value. Fortescue, and to a lesser extent Rio Tinto, fall into this category.
- The value growth opportunity: When a share price grows in line with intrinsic value as the company compounds earnings and equity per share. BHP Billiton is in this category.
- The income opportunity: The dividend yield, including any franking, on the purchase price. All four stocks pay a dividend, although yields are low at less than 4 per cent.
For the share price of mining stocks to rise typically requires a catalyst such as currency depreciation or higher commodity prices.
The following table presents current share prices and valuations for the four miners in 2014 and 2015. (These are based on StocksInValue analysis.)
Share prices and valuations for selected ASX bulk commodity miners
|Code||Share price||FY14 StocksInValue valuation||FY15 StocksInValue valuation|
All share prices and valuations are at 24 October, 2013
The macro-economic view
World economic growth is a primary influence on steelmaking activity and bulk commodity prices. We expect stronger world growth in 2014, although still well short of a "normal" fast recovery from recession. Much of the world remains dependent on quantitative easing (central banks printing more money) to artificially reduce interest rates and support credit demand, and to inflate asset prices to encourage growth in underlying economic activity.
Major central banks intend to hold cash rates at historically low levels for some time yet, to stimulate their economies. Consumer and business confidence in many countries is still recovering from years of financial crisis and recession. China has slowed.
In general, major Australian miners report firm demand for commodities. The problem is the pressure on prices for iron ore, metallurgical coal and thermal coal resulting from increased supply. This is because of unprecedented investment in new capacity by the industry. The outlook for thermal coal is particularly difficult. Eventually the slower rate of investment growth should balance the supply of new minerals and demand resulting in a levelling out of commodity prices.
Over the long term the outlook is positive because the fundamentals of wealth creation: demographics and urbanisation continue to lift demand for commodities across Asia and other markets. Although China's growth has slowed from 10 per cent to 7-8 per cent and will trend lower over time because of a high base effect, its demand for commodities will keep growing. Chinese steel intensity is rising and yet to level out.
As the chart below shows, bulk commodity prices are well off their peaks but remain above long-term averages. Prices will continue to fluctuate in line with expectations for world growth, especially in China and major countries in developing Asia, as well as a result of inventory cycles in major consuming countries.
Bulk commodity prices, free-on-board basis
Resources story switches to volume growth
Rather than hoping for prolonged commodity price rallies as occurred in the last decade, investors should understand revenue growth is switching from prices to volumes. It can be argued that in the first half of 2013 the sharemarket missed the volume growth story when it overreacted to the slowdown in Chinese growth from 10 per cent to 7-8 per cent and BHP Billiton's share price fell 23 per cent from a peak of $39.34 in February to a low of $30.43 in June. However, 7 per cent growth is still rapid, especially for an economy the size of China's, and the absolute rate of growth is itself rising as the percentage growth rate falls.
Recently, the Bureau of Resources and Energy Economics forecast Chinese iron ore imports of 872 million tonnes in 2014 and as much as a billion tonnes per annum by 2018. Australia may ship 570 million tonnes this year, up 16 per cent from 2012, and 669 million tonnes in 2014. Iron ore exports are forecast to compound at 8 per cent per annum from 2014 to 2018.
Given the shift to volume growth, we recommend miners that can deliver sustainable volume growth at world-competitive production costs per tonne. Competitive unit costs of production (that is, being a lower-cost producer) helps protect a miner's shareholders from commodity price falls and can even deliver market share gains at these times.
For example, BHP Billiton and Rio Tinto export iron ore at around US$50/tonne - less than most of the rest of the global iron ore industry. This means prices could fall well below current levels around US$134/tonne and these companies' Pilbara iron ore operations would still be profitable, while higher-cost firms cease production at uneconomic iron-ore prices for them. Pilbara iron ore is also high quality, another competitive advantage.
Both BHP Billiton and Rio Tinto recently reported strong iron ore production growth for the September quarter. This is consistent with our view that these miners can grow iron ore volumes at mid-single digit percentage growth levels. We think volume growth at this rate can offset sustained falls in iron ore prices to US$90/tonne - which is not our base case, although is a forecast in the market. Average prices of US$100-120 in coming years are more likely, given firm demand.
Plenty of growth ahead
There is plenty of volume growth to come. In addition management determination to reduce operating costs and work assets harder should support operating margins and profitability in the resources sector.
Despite the falls in bulk commodity prices, our BHP Billiton valuation has fallen only 5 per cent all year, while our Rio Tinto valuation is 12 per cent higher. Australian-dollar depreciation would further increase the valuations of both companies.
Lastly, we advise investors to pay attention to balance-sheet strength and financial health. In the charts below, a higher star rating at the top right indicates a stronger balance sheet, better financial health and less risk of a dilutive equity raising. Fortescue is riskier than the other stocks mentioned in this article.
How valuations stack up
The four graphics below show StocksInValue's current and projected valuation for BHP, Rio, Fortescue and New Hope Corporation.
(Editor's note: The charts below compare the company's share price (blue line) to StocksInValue's current and projected valuation (the orange line). Value investors look to buy stocks when the share price is trading below the company's intrinsic or true price, and is thus undervalued. Do not read the analysis in this chart as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes or ideas in this article.)
BHP Billiton (ASX:BHP) historical and projected intrinsic value compared with share price
Rio Tinto (ASX:RIO) historical and projected intrinsic value compared with share price
New Hope Corporation (ASX:NHC) historical and projected intrinsic value compared with share price
Fortescue Metals Group (ASX:FMG) historical and projected intrinsic value compared
About the author
David Walker is Head of Equities Research at StocksInValue, a joint venture between Clime Investment Management, a value fund manager, and Eureka Report. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no-obligation trial, visit StocksInValue or call 1300 136 225.
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