|Summary: The rush to resources that we wrote about late last year is definitely on, and international investors are leading the charge. But it’s not commodity price driven. The attraction of miners, such as BHP and Rio, is about leveraging efficiency gains and tapping into an expected stream of higher dividends emanating from companies using their extra cash flow to boost payouts.|
|Key take-out: As value creeps back into the resources sector, mergers & acquisitions activity is gaining momentum. On this stage, China is playing a lead role – having launched takeovers for a string of Australian mining companies and assets in just the last few weeks.|
|Key beneficiaries: General investors. Category: Shares.|
BHP Billiton and Rio Tinto are showing the first signs of benefiting from a return to the radar screens of international investors, as both companies reveal the financial benefits of cost cutting, debt retirement and technology-led improvements in their mines.
Since being included in a general upgrade of the mining sector by the influential research team in the London office of the investment bank, J.P. Morgan Cazenove on Monday, both stocks have outperformed the wider Australian market.
BHP Billiton’s rise of 3% over the past five days and Rio Tinto’s 2.5% gain comfortably outperformed the 0.5% increase in the ASX All Ordinaries Index, with the only resource-sector news event of significance being the J.P. Morgan report which upgraded mining from underweight to overweight.
Unlike previous periods of resource-sector recovery when commodity prices delivered the uplift, this time there is little evidence of a commodity effect yet, with nickel the only metal to hit the headlines. Since the bank issued its report, nickel has fallen sharply and is of little importance to either company.
Copper, which is important to BHP and Rio, rose ahead of the report but has been flat since. Iron ore, the mineral which has dominated earnings of both companies over the past few years, has been in a downward trend for much of the year.
What the J.P. Morgan report appears to have done is trigger a reaction among European and North American fund managers, who have avoided resources for the past two years. They now see it as a time to revisit the sector, initially for the high yields on offer thanks to a shift in focus at the big miners from spending on new projects to rewarding their shareholders.
A return to resources by international funds, with buying power that significantly outweighs Australian funds, also is being influenced by:
- An expectation of higher future commodity prices, which will result from a decline in project development.
- Higher profit margins being generated by technology changes such as a greater use of automation and computer-controls in mining and processing operations.
- A series of high-profile takeover bids by Chinese companies for Australian-listed stocks, which is signalling a burst of industry-wide merger and acquisition activity.
For private investors and fund managers who have lost touch with resources during the last two down years, the easiest and safest re-entry point is through the two Australian leaders, BHP Billiton and Rio Tinto.
Once a beachhead is established European and North American investors will fan out across the sector, especially if M&A activity accelerates, and if commodity prices show signs of a sustainable recovery.
For regular readers of Eureka Report there should not be a lot new in the mining sector’s “dividend-plus-recovery theme” because it was first reported here late last year (Prepare for a resources rush, December 6) after I attended the annual Mines and Money conference in London.
Back then it was clear from speaking with fund managers at the event that the mining sector was seen as offering strong recovery prospects in 2014 and 2015, thanks to dramatic management changes at all of the big miners, and promises from the companies to be more shareholder friendly by boosting dividends and through share buybacks.
Those promises influenced the US investment bank, Citigroup, to change its view of mining in January with a report headed ‘Mining Fightback’, which included the advice that its research team was “turning bullish” about mining “for the first time in three years”.
This week’s J.P. Morgan Cazenove report is the most comprehensive analysis of the big miners, but not the only influential research document in circulation.
Last week, Deutsche Bank surprised its clients by releasing a comprehensive report into the largely overlooked aluminium division of Rio Tinto.
The focus of the Deutsche Bank document was the effect cost cutting has had on the financial performance of the aluminium division, which had previously cost Rio Tinto $40 billion in trading losses and asset-value write-downs.
That grim performance is changing, says Deutsche Bank. It reckons aluminium will soon be generating $US2 billion a year in free cash flow, thanks in large part to a growing focus on bauxite mining in preference to aluminium smelting.
What all recent research into the mining sector appears to be picking up is that the sector has spent long enough in the sin bin, with value starting to be created from increased operational efficiency with the potential for a commodity-price uptick later.
That view also seems to have taken hold in China, with state-owned companies leading a mining sector M&A revival that started with the $US6 billion purchase of the Las Bambas copper project in Peru from Glencore Xstrata by China Minmetals in mid-April.
Since that deal, the biggest ever overseas mining acquisition by a Chinese company, takeover bids have been launched for the Australian iron ore miner Aquila Resources by China’s Baosteel (in conjunction with the rail operator, Aurizon), and the Australian-listed copper miner, PanAust, by Guangdong Rising Asset Management.
Further down the mining food chain there has been a series of small mining deals that underline the importance of the M&A factor in re-attracting investors to resources, including:
- The $150 million purchase of a mothballed coal mine by one-time coal sector high-flyer, Nathan Tinkler, through his Singapore-based Bentley Resources.
- The return of the Gloucester Coal management team, led by former chief executive, Barry Tudor, who has attracted seed capital of $US200 million from the US-based Denham Capital for coal deals through the newly formed Pembroke Resources.
- The $82.5 million purchase of the Jundee goldmine in WA by Northern Star Resources from Newmont Mining, making it four goldmine acquisitions by Northern Star over the past six months, and
- Confirmation from BHP Billiton that it is open to bids for its Nickel West operation in WA and is moving ahead with the possible spin-off of other non-core operations.
The new-found investment bank interest in mining can also be found in a research report from Bank of America Merrill Lynch paper headed: “Maybe mining capex isn’t dead forever?”, which was partially based on an upbeat presentation at the Melbourne annual meeting of Rio Tinto.
That May 8 event was highlighted by comments from the company’s chief executive, Sam Walsh, who hinted that an era of austerity was coming to an end and that plans were being hatched to start growing again.
No details were revealed but for Walsh to even hint at a return to growth after two years of cost cutting is a sign that the resources worm really is turning.
J.P. Morgan’s view of mining is that the second half of the year will see the reporting of significant improvements in free cash flow, with capital returns possible and valuations that will be attractive relative to other sectors.
“Having been structurally bearish on mining for over two years (our) European equity strategy team has today upgraded the sector to overweight,” the bank told clients on Monday.
Among the reasons listed for the change of opinion was a recovery in steel demand in China, strong Chinese commodity import data, and low inflation in China which would give the government in that country flexibility to boost the economy.
Significantly for Rio Tinto and BHP Billiton, the view of J.P. Morgan is that any future fall in the iron ore price, perhaps to as low as $US80 a tonne, is already factored into the share price of both companies.