/ 15 December 2011

In troubled times, size matters

Global mining executives will have more than the odd flutter of insecurity in 2012, as Europe sets out on a path of a painful debt recovery and Chinese growth slows as a result.

But in this gloomy setting, diversified mining conglomerates such as Anglo American and BHP Billiton could be sector winners in the new year. In a troubled world where accurate forecasting is a laughable notion, these heavyweights have the balance-sheet gravitas and commodity diversification to maintain their earnings and cash-flow momentum. Their pricier but smaller peers, such as Kumba Iron Ore, Exxaro and African Rainbow Minerals, don’t have this buffer.

The intensification of the European sovereign-debt crisis and initial evidence of the dulling effect it is having on global growth took the S&P Goldman Sachs Commodity Index to an 11-month low in October. Still, “commodity prices for the most part are still high and above levels which we would view as normal”, said Coronation Fund Managers portfolio manager Henk Groenewald,

China’s commodity-guzzling growth, on the back of the emerging giant’s fixation on infrastructure expansion, remains an overriding driver for resource price movements.

“Since commodity supply for the coming year is more or less predictable, the big swing factor for commodity price movements will be the behaviour of Chinese demand,” Groenewald said, pointing out that it was difficult to say which way it could go.

But China’s scope to switch to a more stimulatory policy stance, demonstrated last week with the relaxation of its bank-reserve requirements, will underpin growth and commodity usage.

Said Ian Woodley, the head of resources at Old Mutual Investment Group South Africa: “From our conversations with the mining companies, it is clear that times are tough, but conditions still aren’t nearly as dire as in 2008 and 2009. Whereas cargos were being sent back at that stage, we are still in a position where commodity buyers are accepting shipments.”

Meanwhile, mining bosses are bracing themselves for uncertainty and increased risk. BHP Billiton’s Marius Kloppers, for example, warned last month that his clients were practising more cautious inventory management.

In spite of resource prices holding up well this year, the markets are betting that prices could slump next year. Diversified mining stalwarts are bearing the brunt of this stance, trading at price-earnings ratings that are the lowest in at least a decade, with the exception of the 2008 nadir.

Cor Booysen, senior research analyst at HSBC Securities in South Africa, said the markets were “worried that the super-profits notched up by these big players could fall away over the short term, even though today’s commodity prices and rand levels are good for the bottom line”.

Tom Albanese, the chief executive of London-headquartered, diversified miner Rio Tinto, signalled this week that higher price volatility was here to stay, an uncomfortable setting for a sector committed to billions of dollars in capital expenditure to ramp up capacity and future sales.

Rio Tinto has $27-billion in capital projects in place, Brazilian diversified miner Vale has a capital budget of $21.4-billion for next year, and BHP Billiton boasts of a capital expenditure pipeline of $80-billion over the medium term.

Currency swings and, in some regions, double-digit cost increases add to the complexity of these capital-allocation decisions. According to Ernst & Young’s annual mining risk survey, the biggest hurdle to mining profit is that governments are moving towards resource nationalisation by imposing incremental taxes and royalties.

Large-capitalisation mining houses were in a better relative position to weather these risks, said Booysen, adding to the attractiveness of their low valuations.

“Compared with 2008 and 2009, when Anglo American and Rio Tinto were caught out with weak balance sheets, the global diversified miners now all have healthy capital positions that make them more able to withstand a crisis.”

Should a crisis fail to materialise, their healthy capital position and sustained cash flows will support dividend payments to shareholders. What is more, in an environment of rising costs, the large-scale producers with access to low-cost assets will be the competitive players.

Among the JSE-listed commodity stocks, Booysen’s picks for 2012 are Anglo American and BHP Billiton.

“Since 2009, Kumba, Exxaro and African Rainbow Minerals have outperformed these bigger players and are now relatively more expensive. I expect Anglo and Billiton to catch up during the coming year.”

Groenewald agreed, pointing out that his preference was for Cynthia Carroll’s Anglo American. “Both stocks, and Anglo in particular, offer good value, even when normalised commodity prices are substituted into our valuation models.”

Anglo American, the operations of which are largely in base metals, iron ore, thermal coal, diamonds and the platinum-group metals, has been hit harder than its heavyweight peers, possibly because of its sizeable relative exposure to platinum, an underperformer since 2008.

Matt Brenzel, portfolio manager at Cadiz, was similarly comfortable with the two big diversified miners. His money, though, was on BHP Billi­ton because it was “in a better place to handle an uncertain and bipolar world”, thanks to what he viewed as a more defensively structured basket of commodities. That structure included an exposure to energy — which Anglo lacked — and which could stand BHP Billiton in good stead as rising tension in the Middle East kept the oil price elevated.

When the future is this uncertain, track record counts more.

“BHP Billiton’s returns performance during 2008-2009 was a lot better than Anglo’s,” Brenzel said. “Since then, of course, Anglo has done much more than Billiton to improve its balance sheet, although it was in need of this adjustment.”

With the exception of Sasol, fundmanager interest in the rest of the resources sector looks tepid.

The way Groenewald saw it: “You can get Sasol’s current business at a reasonable discount, without paying for the benefits of a higher oil price ahead.” Should the oil price clock up gains, the share price would lift to reflect not only revenue and earnings growth but also the higher value attached to Sasol’s technology.

Topping Groenewald’s list of stocks to avoid was Kumba, which he said was expensive and vulnerable to a drop in an unsustainably high iron-ore price. “Iron ore is the second most abundant element in the Earth’s crust. New production from India, South Africa and Brazil is due to kick in over the next five to 10 years and, even if demand remains firm, is likely to pressure prices lower.”

Other counters that were unappealing were gold stocks Goldfields and Harmony, which he dismissed as having cash flows that were not sustainable, as well as the burden of a history of being destroyers of value.