Blue chip escape

Rio and BHP are reviewing their capex programs, and the outlook is deteriorating for mining services too.

PORTFOLIO POINT: BHP and Rio’s review of capex programs represents a stark turnaround from comments made just two months ago, and it's a worrying sign for the rest of the sector.

BHP is trading at three-year lows, Fortescue is down 17% from recent highs and Rio is visiting lows last seen in 2008. If you own shares in any of these companies, only Telstra would have saved your portfolio from a shellacking.

The big caps, however, are not the only stocks that have suffered. Over recent years, it is likely that you would have observed my interest in mining services. That interest was a product of the presence of value for money.

This is a sector I know well and have covered numerous times. I have discussed and brought listed businesses – including Decmil Group (DCG), Forge Group (FGE) and Matrix Composites & Engineering (MCE) – and IPOs – GR Engineering (GNG) and Maca (MLD) – to your attention.

This was mostly at a time when there was little market interest, despite their apparent growth profiles, quality aggregated balance sheets and (now with the exception of MCE) management.

Today, however, that story is very different and I find myself erring on the side of caution when it comes to 'picks and shovels’.

Each week, a stronger case is building that a key growth engine for capex spending by our miners is slowing – that is, commodity prices are falling.

Take one commodity I have discussed recently: iron ore.

In 2010-11, world iron ore production grew 8.1% (or 227mt) to 2.80bt. Assuming similar growth levels in 2011-12, iron ore production will grow to 3.04bt, an increase of about 237mt. (In a classic supply response, BHP production is forecast to grow by 20%, Rio by 30% and FMG by 25%.)

And assuming China consumes 60% of global production again (highly optimistic), its demand would increase by 136.2mt. However, moderating growth means current estimates for China’s iron ore requirements are half this level. With few other countries growing or competing heavily with China, who will pick up that supply overhang in a low-growth environment?

By 2015, two entire Pilbara regions (700mt) in supply terms are estimated to come onto the market. It’s a far stretch to expect China to absorb 420mt (60%) of that.

The impact, I expect, is pressure on iron ore prices.

Many other commodities are looking like they are set to suffer a similar fate. Record prices over a decade have created an investment boom that is climaxing at a time when global demand is losing interest. And you need two to tango. When soaring supply meets softening demand, lower prices follow.

So what are the implications? Put simply, for those who dig stuff out of the ground and export it, margins and cash flow will be squeezed (a situation I have been monitoring closely and alerting readers to for the past six months). It’s why I haven’t bought BHP.

In previous periods, a revenue squeeze has been a precursor to capex plan deferrals or delays lasting years. Barely economical projects are shelved as miners focus instead on financing core (capital-intensive) operations, rather than aggressive growth targets.

Indeed, the 1990s was a very different period for miners, and those who serviced the mining sector barely made it onto investment radars. Companies struggled to cover their cost of capital and total annual capex was less than $20 billion for the entire mining industry.

Today, many miners are generating returns on equity in excess of 30% ('super profits’?) and capex runs in excess of $60 billion per annum. Are such numbers maintainable forever? No. And if it can’t go on forever, it must stop.

Just a few days ago, BHP Billiton and Rio Tinto announced that they are re-evaluating their capital expenditure programs. These comments are in stark contrast to their latest financial reports and presentations made just two months ago.

In those reports, confidence was effervescent and the deployment of $40 billion in a global cash capex spree was on the cards. Today, as China’s growth rate slows and some investors lobby for a greater focus on cost control and returning funds to shareholders, tens of billions of dollars of an extensive development project pipeline is under review.

When the two leading businesses that account for about 35% of total industry investment start to make noise, it’s time to sit up and pay attention.

We are bound to see many other miners follow suit and the chorus is growing louder by the day. Citigroup conducted a survey in April and found that 50% of all miners were considering lowering their investment budgets.

That compares to less than 20% in January.

Figure 1. A picture tells a thousand words

At the start of the financial year, capital expenditure was forecast to rise 34%, with an increase of 18% in 2013.

The forecast today is for a rise of only 13% this year and a fall in 2013. This represents a material deterioration in market conditions in a very short period of time. All of this weighs on the 'bright prospects’ that once surrounded those companies which service the miners.

This brings us back to Decmil, Forge and investing. I bought both of these businesses in the Montgomery [Private] Fund near its inception.

Forge is a business that has a significant exposure to second-tier miners, especially those expanding their iron ore operations. Decmil, on the other hand, has around 43% of its business exposed to resources and the balance to oil & gas.

While plenty of work is still forecast to be in the pipeline for mining services companies, there are also plenty of companies trying to win it.

If we are at the peak of the current capex cycle, this is as good as it gets in terms of margins for mining services businesses and also workloads.

With that in mind, and coupled with prices increasing to levels I deem attractive for what are businesses with high operating leverage, I have decided to read the writing on the wall and position our investments in a more conservative manner. I sold our Forge holding some weeks ago and also scaled back our holding of Decmil.

It is possible I am early to leave the party – the band is still playing. But the mining industry is bracing for a pullback in investment spending, as the biggest companies reassess their capital expenditure plans amid escalating costs and an uncertain growth outlook. I anticipate that analysts will revise their earnings forecasts lower for 2013 and beyond.

The valuations I look at in Skaffold will also fall, I expect, as those earnings revisions are fed through. Of course, I could also be completely wrong but I reckon the big mining companies’ historical predilections for over-paying for acquisitions (another reason I have been loath to invest) may just revisit them.

The combination of a contracting market and high operating leverage means I simply prefer the safety of cash. Better to be confident of a good return than hopeful of a great one.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.