Wising up to resources

You tend to find conviction for some of your ideas in the strangest places. Take for instance the other Friday evening when one of my colleagues, Doug Grant, went to pick up some takeaway from his local Chinese restaurant.

Doug has been going to this establishment for the past 20 years and has come to know the owners and staff quite well. On his arrival and after ordering the obligatory fried dim sims and spring rolls for the kids with the red MSG sauce and some form of prawn and chicken combination dishes for the adults, he was invited to have a Tsing Tao and a bit of a chat while waiting for the food.

Normally such discussions revolve around family, local business and the horses. On this occasion, however, it turned to Doug's profession and the stockmarket. Thinking he was about to get told the latest Hot Tip or get asked for the same he became fairly hesitant about the whole topic and was about to pretend to become deeply involved with a text on his mobile when something twigged his antennae.

The restaurant owners didn't want any hot tips and certainly weren't about to give any. They wanted to talk about BHP to begin with! Not only did they know its fundamentals incredibly well, they knew that there had been broker upgrades in the past week due to iron ore and base metal upgrades as well. They knew where it had traded over the past few weeks and amazingly were also aware that the UK listing of BHP Billiton traded at a discount to BHP in Australia (Why? was their question; "both same stock", their reasoning).

Thinking that this was a bit of a one-off Doug decided to delve a little deeper. ”What about iron ore stocks,” he asked, thinking that besides BHP they will probably know Rio Tinto but that would be it. Not the case; again he was informed about broker upgrades on iron ore prices, the Fortescue Metals investment case, and a smattering of junior iron ore producers.

Doug then pondered a fairly obvious question in his head. How and why they were so well informed? Before he really had a chance to put the question forward the owner basically answered it for him. He explained that they had been investing heavily in the resource sector for quite some time.

They favoured the sector mainly because they were more than aware of the effect that China was having on the commodities market as a whole. Where did they get this knowledge from? First, from their relatives back in China (whom, the owner says, "want everything we have and are determined to get it"); second, when they went back to China themselves to visit and therefore see with their own eyes the transformation the country is undergoing and the massive demand for raw materials (as you may remember World Bank projections indicate that as income grows to $US15,000 per head by 2015, China's per capita steel and energy demand will triple and copper consumption double); and finally, from educating themselves via broker reports/research with whom they have professional relationships.

To say our Doug was slightly taken aback would be an understatement. It's one thing to work at Southern Cross Equities and bang the pro-resource drum every day, but it's another to hear the same story from Chinese restaurant owners who are reinvesting the profits from their business into Australian resource stocks.

Insiders are buyers, outsiders are sceptics

It is amazing that Chinese restaurateurs are ploughing into high-quality Australian resource stocks, yet Australian investors remain very dubious about the potential longevity of the resource cycle as implied by the forward price/earnings (P/E) multiples of our basically debt-free resource sector. You may think we are crazy, but we would back the views of Chinese restaurateurs with relatives in China ahead of most Australian market commentators.

I think the macro fundamentals for resources have never been stronger, however the latest statistics reveal Chinese economic growth is actually accelerating. Despite two interest rate rises and five increases in the bank deposit ratio already this year, Chinese industrial production growth for May was 18.1%, well ahead of the 17% consensus forecast. As a result, the average for the first five months of this year is 18.2%, well ahead of the 16.6% industrial production growth for 2006.

There is every sign that the "Goldilocks" economic scenario, of strong synchronised global growth with contained inflation, is going to be the overlay for the medium term. It's quite hard to see what will undermine Goldilocks; particularly given the world is working out that bond yields have risen to reflect better than expected global growth, not inflationary pressures.

The perfect storm

I think about this Goldilocks scenario and I just can't get out of my head that resource stocks are going to go nuts on the upside as investors reprice near-term earnings and dividend prospects. Yes, resource stocks have done quite nicely in recent weeks, but I reckon that move will prove to be very small compared to what is coming. All you have seen is some of the 12-month underperformance ending, not outperformance starting.

It's hard to see a scenario where the commodity prices we have today are lower in 12 months time. However, it's not hard to see a scenario where they are the same or higher. My resource strategy doesn't revolve around commodity prices going dramatically higher from here in absolute terms. The upside I see in the Australian resource sector can be released via commodity prices simply staying where they are today, or in some cases being lower than today.

Just to reinforce this point I have done some scenario analysis on P/Es using today's commodity prices and simply averaging them for 2007-08 in my models.

I want you to focus on the chart above. Using only today's spot commodity prices in my models, the P/Es of metal stocks range from 11 to 4.3 times. If you look at investing in risk-adjusted terms as I do (including the risk of default), these companies are ridiculously cheap as they have net cash on their balance sheets and no hedging.

The fact you can buy the worlds biggest resource stock (BHP Billiton) on potentially eight times’ 2007-08 earnings – a year that starts in only 12 trading days – is truly amazing. It shows you the market simply doesn't believe that anything we are seeing in commodity pricing is in any way structural or permanent. The market simply doesn't believe that there is a paradigm shift in commodity supply and demand fundamentals, yet the local Chinese restaurant proprietor does.

All we are currently seeing from broker commodity analysts is classic "catch-up football" with their forecasts. This has gone on for four years now and we still don't have any real analyst "buy in" to the stronger-for-longer or stronger forever commodity cycle. They all talk about it but none of them have the fortitude to forecast it.

The Australian resource sector will only peak when we have consensus forecasts for commodity prices that are above spot prices. That day will be June 2023, in my view, because it's going to take that long for the average analyst to "get" what is really going on! Until then we can live happily in the knowledge that consensus commodity price estimates and commodity stock earnings will be revised up every quarter using the favoured tool the rear-vision mirror. Valuations absolutely underpin the sector, and we are clearly watching "the perfect storm" scenario unfold for the sector, and the catalyst will clearly be large scale global M&A. So let's go looking for some under-priced M&A targets.

Don't stand in the way of the Ox

A Chinese proverb says "Don't stand in way of angry Ox”. If ever there is a stock where all the investing stars are aligned it is Oxiana. Yet, here we are and the market is allowing you to buy the stock on less than eight times next year's probable earnings. Have a look at the technicals below: the Ox is about to go for a huge run into uncharted territory. It's about to be The Year of the Ox.

The technicals currently support strong upside for Oxiana with the stock poised to break through the $3.58–3.60 resistance level. However, we think the fundamental view is even more positive for the mighty Ox.

Oxiana is a mining house with a good track record of developing and acquiring value-adding projects. The group is not short of organic growth opportunities; however it believes that with future acquisitions it can deliver future annual production of some 500,000 tonnes of base metals and 500,000 ounces of gold. Oxiana has an aggressive mantra for growth and seeks to double the scale of the company in the next five years to $10 billion, warranting an inclusion in the ASX 20.

Oxiana has a strong future growth pipeline, however the market has been focused on the lack of production growth before the Prominent Hill copper/gold project delivers first production in the second half of 2007-08.It is worth noting that the same concerns were voiced before the Golden Grove base metal acquisition in 2005. Unsurprisingly, the non-believers are now singing the praises of the now, low acquisition price, and the opportunistic timing of the purchase from Newmont.

There is no doubt that the equity market re-rates companies seeking and achieving successful growth by acquisition. The classic example is Xstrata, which has a market cap of $US52 billion compared to $US1 billion just five years ago. It is worth remembering that Oxiana's market cap was less than $150 million in 2002 compared to $US5.4 billion currently. We have been very big supporters of Oxiana, and considering his strong track record of successful value-enhancing acquisitions we are supporting Owen Hegarty to deliver on the aggressive strategy for future growth.

Strong organic growth

In the short term, however, Oxiana has a strong growth profile and 100% exposure to spot metal prices considering production is totally unhedged. However, its earnings growth is not simply dependent on rising base metal prices. Oxiana highlighted an impressive portfolio of growth projects and exploration opportunities at the recent quarterly presentation. It has two major copper/gold projects expected to come into production by the second half of 2008 through to 2010, which are expected to deliver a substantial increase in volume growth.

The Sepon project in Laos is expected to result in a significant increase in copper and gold production after the completion of the current expansion plans. The recent drilling has yielded some encouraging results at the Sepon gold project, pointing to an increase in the oxide resource. This is expected to support gold production of 100 ounces a year for three years from 2008-09.The recent results from Thengkham are expected to underwrite the expansion at Sepon copper supporting initial production of 70,000–80,000 tonnes a year in the second half of 2008. rising to more than 100,000 tonnes a year. The recent acquisition of Agincourt now provides Oxiana with critical mass, and a new gold growth option at Martabe. Gold production is expected to be in excess of 200 ounces a year for nine years from 2010. In addition, it provides very complementary exploration opportunities in Indonesia.

Oxiana's second major copper/gold project is Prominent Hill near BHP's massive Olympic Dam project in South Australia. At the recent quarterly briefing Oxiana confirmed Prominent Hill remains on budget and on schedule with plans to expose the ore body in the open pit by late this year. First production is targeted for the September quarter of 2008 and recent drilling below the current resource indicates the potential for underground mining after the open pit, which could extend the mine life well beyond 10 years.

In addition to the suite of copper/growth projects, the existing Golden Grove and Scuddles mines continue to provide Oxiana with diversified base metal earnings generating significant cash flows before the big projects are commissioned. I expect Oxiana to generate $500 million in operating cash flow this year and a total of nearly $2 billion out to 2009.

This supports the current and future aggressive exploration strategy, and provides management with the balance sheet flexibility to make a substantial value enhancing acquisition.

Despite the strong tracking to the copper price, little credit is ascribed to Oxiana being a major zinc producer, with current production of 130,000 tonnes a year expected to continue for the next seven to 10 years. In addition, in the March production report, deep drilling revealed promising results supporting future extensions of current mine life enabling the utilisation of spare mill capacity with extra material from the Scuddles mine.

On current forecasts in 2008-09 I forecast Oxiana will produce up to 250,000 tonnes a year of copper and up to 400,000 ounces of gold with the successful commissioning of the current organic growth profile.

This will increase further with full production in 2010. Oxiana is set to become a world class base metal producer, which I expect will fill the space left by the takeover of Western Mining. In this context Oxiana is a genuine takeover target for a global major seeking exploration upside and production growth. It is worth noting that recently, Xstrata confirmed it was actively seeking an acquisition capable of delivering copper production of 250,000–300,000 tonnes a year. Hmmm.

I think Oxiana has the best of both worlds in the mining sector. First, it has an impressive profile of long-term growth projects supporting a significant increase in production growth that is 100% leveraged to the "higher forever" commodity super cycle. Second, in the short term, it has a diversified base metal earnings stream generating more than $500 million a year, supporting a big exploration program and the opportunity for a major acquisition.

Dividend yields

My theory remains that Australian companies are priced in the longer-term off a grossed up dividend yield multiple. I also believe you should be buying resource stocks for dividend yield growth.

The top five companies with the fastest-growing dividends in Australia over the past three years are Zinifex (up 212%), Incitec Pivot (138%), Seek (138%), Oxiana (100%), and Minara Resources (90%). Interestingly, and unsurprisingly, all these stocks are in the list of best absolute share price performers over the same period.

Yes, dividend growth is driven by earnings growth, but it still requires a board to see that a higher payout ratio driving dividend growth is the way to generate a higher market rating.

Using today's spot copper, zinc, and gold prices, and averaging them for the next two calendar years, and taking into account Oxiana's production growth profile, we can see "what if" Oxiana earning EPS of 45¢ in calendar 2008 and up to 78¢ in 2009. A 30% payout ratio sees Oxiana paying a dividend of 23¢ in 2008-09. The market will pay 10 times 2008-09 (perhaps more) for the stock, seeing a potential price target of $4.50 in 2008 and up to $7.80 in 2009. Even shaving that calendar 2009 EPS number down to 65¢, to be conservative, and then putting those earnings on a multiple of 10 times, sees a 2009 potential price target of $6.50.

Oxiana will be capitalised at $10 billion within the next few years, and will fill the gap in the market left by WMC. Oxiana's stated goal is to become an ASX20 company, and I believe it will achieve that. I haven't used this line for a while, but if you don't own Oxiana shares you don't like money. Oxiana remains a strong buy and a core portfolio holding. It remains very under-owned by Australian institutions, yet we see that changing over the next few years.