Will China demand Iron…or…?

Energy / Resources, Manufacturing | Comments (28)

Will China demand Iron…or…?

PORTFOLIO POINT: A fall in China’s demand for iron ore, combined with a boost in supply, will lead to lower prices and put the margins of Australia’s big producers under pressure.

Like a thief in the night, it crept across our news screens a two weeks ago: “The rate of China’s iron ore demand has peaked…”

This report from Dow Jones’ wire service follows recent comments by BHP that Chinese demand will be weaker than previously anticipated.

But Peter Richardson, Morgan Stanley’s global metals chief economist, is putting forward a strong investment case for the “crucial” steelmaking commodity. Remember; Never ask a barber whether you need a haircut.

For what it’s worth (and I know it’s not a widely accepted view right now), I think commodities are cyclical. When prices are low, there’s precious little investment in building productive capacity; the lack of investment and long production lead times result in supply lagging demand. As prices rise, investments are proposed, delayed and then made, and this pattern causes prices to extend their rise. Then just as prices peak, marginal operators come on line, backed by NPV calculations that assume the high prices will be sustained. It’s in their interest to be bullish about the future, because their jobs and reputations – as well as the dollars they have attracted as capital – are all on the line. But eventually, supply increases and prices stop going up; if it can’t go on forever, eventually it must stop.

And a commodity company has no competitive advantage, no compelling reason for people to pay more for their product or service. Their customers arrive at the counter with a price and say: ‘This is the best price we can get from someone else – can you beat it?’ The commodity business, which lacks any competitive advantage, has no option but to say ‘yes’, otherwise it runs the risk of underutilising its production capacity and its machinery sits idle. This is the antithesis of the business with a true competitive advantage.

The most valuable differentiator or competitive advantage is one that allows the business to simply raise the price each year without losing any business at all, even if excess productive capacity exists. Clearly, I am not describing the iron ore business.

In 2010, global mine iron ore production amounted to 2590mt. Of this, China produced 1070mt. By 2011, global mine production had grown to 2800mt, or a growth rate of 8.1%. Australia’s production from 2010 to 2011 grew by 11% to 480mt, and China’s production grew by 12.1%.

In 2010 China imported almost 60% of the world’s total iron ore exports and produced about 60% of the world’s pig iron. China’s significant participation is the main factor upon which sustainable expansion of the global iron ore industry depends. But China’s demand is slowing.

Peter Richardson (the barber for the purposes of this story) reckons even though the growth rate of iron ore demand from the world’s second-biggest economy has likely peaked, the sheer size of China’s requirements means the market will remain imbalanced until 2014 at least. Because of the very large numbers, he says a 3% or 4% year-on-year increase on China’s existing steel production base still requires close to 40 to 50mt more iron ore this year than last year.

The statistics that I have, however, suggest iron ore production globally could grow by 8% again. If China were to import another 60% of the world’s total iron ore exports, that would mean China imports an additional 136mt, but as Peter Richardson speculates, China will require 40-50mt. If China doesn’t buy the extra production, what does the additional production – that which isn’t imported by a slowing China, whose iron ore demand has peaked – do to prices? The pressure is, of course, for prices to come down.

Morgan Stanley and I agree on this. They are, of course, quite precise about just how prices will fall. Their latest forecast is that iron ore will trade at $US151 per metric ton, $US160 and $US140 in 2013 and 2014, respectively, and $US125 in 2015, $US110 in 2016 and $US105 in 2017. And if iron ore prices actually do that, I am the Tooth Fairy. Commodity prices don’t rise and fall so smoothly. They fall in fits of fear.

Either way, declining prices put pressure on margins unless capital expenditure is scaled back. Correction: even if capital expenditure is scaled back. And that’s what I think could be the outlook for some of Australia’s big iron ore producers.

Fig 1. Iron Ore Price chart

This is occurring at exactly the same time as analysts and brokers get very bullish about the large order wins and full pipelines for many mining services businesses. In the Montgomery [Private] Fund, we have owned mining services businesses for a year, but suddenly our once-comfortable train has become very crowded.

Fleetwood is one such business, providing manufactured accommodation to the resource industry, including BHP’s iron ore businesses. The company will also produce manufactured accommodation for caravan parks, as well as transportable homes. It is also the second-largest manufacturer of caravans in Australia.

And if you didin’t already know that I use Skaffold a lot here

Figure 2. Skaffold’s current Fleetwood Intrinsic Value Chart.

Source:  www.Skaffold.com – be sure to register for next week’s webinar by clicking here

Fleetwood’s recent results met the market’s expectations at the earnings level. Indeed, the $26.9 million profit for the first half of the 2012 financial year was slightly better than some analysts’ expectations. The balance sheet was also very strong, with net cash of $13 million, and operating cash flows were equally strong, increasing by 210% to $47.6 million. But revenue was down; manufactured accommodation revenue fell by 7%. For recreational vehicles, revenue was down 12% and EBIT for this business fell 61%.

With timid and shy consumer sentiment putting pressure on Fleetwood’s recreational vehicles business, the company’s near-term future results will depend very much on resource companies.

Tellingly, the company’s half-year outlook statement revealed just how dependent on the resource sector many companies like Fleetwood have become: “demand for manufactured accommodation for the West Australian resources sector is expected to continue to strengthen as more projects are approved and moving to the construction stage.”

Analysts talk about current high levels of tender activity from resource projects that are likely to emanate over the coming 12 months. Mastermyne, for example, a company I wrote about here a couple of weeks ago, is seeking 900 people for which it has advertised in Poland to meet demand. But given my earlier comments about a slowing China and the impact that could have on iron ore prices, perhaps many of these companies and the analysts that follow them need to lower their expectations.

Many investors have seen planned projects shelved before and if any further declines in China’s demand for iron ore occur, the impact on the single cylinder of the Australian economy that is still running won’t have a happy impact on all those BHP and Rio shares that have been inherited by a generation of baby boomers nearing retirement.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 11 April 2012.

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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28 Comments

    • Andrew
      :

      Hopefully he makes a quick recovery. At 81 years of age (and based on what people say about his diet in the snowball) i am sure that these types of stories will unfortunatley become more frequent for the great man. I think he is already preparing the company for Berkshire post Buffet based on the announcement that they have a successor etc.

      As i said, i hope he makes a good and speedy recovery.

      • Andrew
        :

        May i also say that it also shows some more examples of good corporate governance as it is reported elsewhere that the MRI was only done today and as soon as he got a diagnosis he released it to the market rather than sit on it.

    • Simon
      :

      Relevance ? What impact did you think this will have on Berkshire Hathaway share price?
      Steve Jobs death hasn’t stopped Apple share price from rising . . . do you believe that this may also be true at Berkshire , they have had succession plans (Life after Buffett) in place as far back as 2003.

  3. Phil
    :

    Hi all

    I have to laugh when I watch various pundirs worry about the slow down in China and conclude that is why the market fell on a particular day. They all forget about compounding, one of the simplest and best concepts going around. Using 1 as a base, a growth of 9% gives you 1.09. If you then grow that 1.09 by 8.3% then you get 1.18. That is a “slow down” from 9% growth to 8.3% growth gives you the same actual increase. Presumably this means the same increase in iron ore demand and the demand for other commodities. So, I am a disbeliever in a slow down. That does not mean I am a believer in a continued high price for iron ore, as supply is another story all together.

    I have lost faith in BHP, not because of any worries about iron ore, but because of my belief that directors have lost the plot. It seems that growth for growth’s sake is the order of the day. What is in it for shareholders if a company does nothing but plow money back into capex of dubious quality, and shareholders get nothing. What is there to make the share price increase? I think my money is better employed elsewhere.

    Cheers

    Phil

    • Stevek
      :

      I agree with your sentiments Phil but your assuming that you can believe the data that comes out of China is accurate – I dont.

    • David King
      :

      I agree completely. My money is elsewhere. And unless I have missed a clue, I think Roger’s is too.

  4. Chris B
    :

    Hi team,

    As a holder of MTU I note the recent announcement that M2 has acquired Primus. I am not 100% sure on where I stand on this aquisistion, yet.

    Here are my reservations…

    To make the acquisition, M2 has taken on a fair bit of debt. M2 expects to have net debt of $137.7 million (up from $9.7m) and a net debt to EBITDA ratio of 1.42 times on a proforma CY11 basis.

    In buying Primus, M2 will be adding a team of around 500, which will double the number of employees on the books. Could this lead to a clash in cultures, if indeed the cultures of the businesses are different?

    They claim the deal will earn them $5m per year in synergies. Whilst they have in the past succesfully integrated many businesses I am not sure I can rely on yet another synergy claim???

    Yes the EPS will no doubt get a kick, but I fear the acquisition will have the opposite effect on ROIC.

    On the plus side, MTU will gain 165,000 customer contracts and the well-recognised iPrimus and Primus brands and it will provide more headway into cloud technologies.

    Overall, my main concern is the massive increase in debt and the fact that the cultures of the 2 businesses (M2 and Primus) may clash????

    Things to consider, but for now my instincts are telling me to get out of at least half my holdings…

    Take care all,

    Chris

    • Roger Montgomery
      :

      Some further comments:

      “Synergies of $5mln” is year 1. An additional $5 mln is being forecast in year two and another $5 mln in year 3.

      Part of the debt ($10) is a capitalised lease with Telstra. The company also suggested that the debt could be reduced to $108 million in year 3.

      Cash is higher by $10 mln if a bond with TLS is cashed in.

      Stated profitability for 2013 may be $35 mln + $20 mln amortisation of goodwill (to normalise the bottom line) might be about $50mln which might give an ROE of 30%.

      On the flipside, the cash flow will be used to reduce debt and the ROE of this move is just the interest on the debt.

      Flipping over again, the stock at 156 mln shares X $3.20 will give it a market cap that could put it into the ASX 200 (all going well). BUying or holding on this basis however has NOTHING to do with value investing.

      • Simon Stewart
        :

        Hi Roger,

        There has been a fair bit of share movement with MTU over the last two days, just wondering whether you are selling or holding given the Primus anouncement?

        Simon

      • Chris B
        :

        It may be true that ROE will remain high (30%), but this ROE will be artificially inflated due to the company leveraging up. I am no longer comfortable with my MTU holdings.

        Take care

  5. terry
    :

    I have it on good authority that BHP have torn up contracts for olympic dam in regards to removing the overburden. Personally I think BHP are trying to show the government what happens when there is too much instability and change on the legislation front. Your move Wayne swan.

    • Roger Montgomery
      :

      What happens when many of the nations most richly endowed with critical natural resources demonize resource companies, attack foreign ownership, and levy punitive taxes? In the imagination of many in Brazil, the politicians gain power, get reelected, and redistribute wealth to favored constituencies. In the eyes of resource companies, it becomes increasingly difficult to justify sinking billions of dollars and years of work into developing needed resources—fueling inflation, raising the risk of future scarcity, and risking future growth for not only the company, but the nations that assail them. Following taxation examples set by Australia and punitive actions purveyed by the United States, Brazil risks becoming an unfriendly destination for investment in the resource sector. Twenty-two billion dollars and seventeen criminal indictments: Those are the penalties Brazilian authorities are seeking to levy upon Chevron and Transocean. Chevron miscalculated pressure in an oil well, allowing an estimated 110,000 barrels of oil to leak from the floor of the sea late last year—and later, about one barrel’s worth of oil escaped the same well last month. The federal penalties come on top of punishment that may be levied by local, state, and industry officials—despite the recent spill being selfreported, largely contained, and production having since been sealed-off. If the $100,000-per-barrel fine sought for the leak last year were not draconian enough, the $11 billion per barrel fine for this year’s accident and criminal prosecutions demonstrate that reason, fairness, and justice are escaping Brazilian authorities. Quote, unquote.

      • Roger Montgomery
        :

        Rio have just announced their quarterly update (see below) and you will note
        their Iron Ore division supply will grow from 191.8m tonnes in 2011 to 250m (forecast 2012) – thats +58.2m or +30%. e.g. almost ALL of China’s additional consumption forecast by Morgan Stanley’s metals strategist… add China’s supply growth, add BHP, add Vale, add FMG, add MGX, add AGO add… add… add…

        Classic supply response.

        RIO first quarter 2012 operations review
        17 April 2012
        Chief executive Tom Albanese said “We had a solid first quarter with increased production of iron ore, coal, bauxite, alumina and titanium dioxide compared with the first quarter of 2011. This was driven by a combination of our consistently high operating performance and reduced impact from severe weather than in 2011. We were therefore well positioned for the relatively strong markets in the first quarter, albeit with continued volatility as we anticipated.”
        • First quarter global iron ore shipments of 54 million tonnes were two per cent higher than the first quarter of 2011.
        • First quarter global iron ore production of 59 million tonnes (46 million tonnes attributable) was 10 per cent higher than the first quarter of 2011. Production was five million tonnes above shipments as ports in Western Australia were closed during cyclonic activity.
        • During the quarter, iron ore production and shipping capacity in the Pilbara increased by a further five million tonnes to 230 million tonnes per annum (Mt/a), following the completion of the second debottlenecking project at the Dampier port on time and on budget.
        • Mined copper production was 18 per cent lower than the first quarter of 2011 due to anticipated lower grades at Kennecott Utah Copper.
        • Bauxite and alumina production were 10 per cent and 13 per cent higher than the first quarter of 2011. Aluminium was nine per cent lower primarily reflecting the orderly shutdown of two thirds of capacity at Alma, due to labour disruption, and the closure of Lynemouth.
        • Hard coking coal production was five per cent higher than the first quarter of 2011. Rio Tinto’s share of thermal coal production was three per cent higher following the increase in ownership in the former Coal & Allied operations.
        • Titanium dioxide feedstocks production was 14 per cent higher than the first quarter of 2011.
        • On 1 February 2012, Rio Tinto announced that it will increase its stake in Richards Bay Minerals to 74 per cent through the acquisition of BHP Billiton’s 37 per cent interest.
        • On 27 March 2012, Rio Tinto announced that it has begun a strategic review of its diamond business that will include exploring a range of options for potential divestment.
        • Rio Tinto completed its share buy-back programme on 26 March 2012. Since February 2011, 116.9 million Rio Tinto plc shares have been purchased at an average price of £37.47, for a total consideration of $7.0 billion.

  6. Paul Rehill
    :

    Just some food for thought. I’m plucking some numbers out of my head so sorry for any inaccuracies. Feel free to correct.

    – The world’s population has increased from 5 to 7 billion over appox 22 years and is predicted to peak around 9 bn.
    – If China grows at 5% p.a. going forward (a rate substantially less than it has in recent history), its economy will double in 14 years. The base might be slowing, but it is getting bigger.
    – China’s GDP per capita is about US$5200 and India’s is about US$1500. These 2 countries still have a long way to go to lift standard of living but at least, they still have a wage competitive advantage in many labour intensive industries to support future growth.
    – China produced 683m tonnes of steel and India 72m tonnes in 2011.
    – China’s steel use per capita is substantially less than developed countries like the US.
    – Likely future high inflation in the US, will not only impact gold, but likely other commodities priced in USD.
    – China has the potential to absorb such inflation in commodity prices by letting their currency appreciate or move towards a floating currency.
    – commodities are cyclical but are we investing for 5 minutes, 5 years or longer.
    – if you extend your investment horizon to 20 to 30 years, can you see the potential decline in iron ore prices in let us say 5 years as short term with global population growth, rise in GDP per capita of developing countries, increased global trade and increased productivity putting “later” pressures once again on commodity prices.
    – BHP has decreased the number of shares outstanding by 17% over the past decade. RIO has tried the same but its GFC capital raising messed things up a bit. If commodity prices fall, this is an opportunity for companies to continue their policies of returning capital to shareholders at cyclical lows.

    In a nutshell, if commodity prices collapse and BHP and RIO’s prices follow, I’ll be thinking about loading up and pulling the trigger as I favour commodity companies with long-life assets, higher profit margins than competitors and a large employee base to execute plans. Combined with a longer time horizon than most people and lots of patience, it should deliver a reasonable future return.

    Best regards, Paul

  7. Seany B
    :

    Hello everyone,
    Everyone seems to be getting on this bandwagon of the boom being over. I agree in the short term, but in the longer term India is the next boom market and I believe they will take up some of the slack going away from China, then after that Africa (I know, a big call) as China invests in that continent more and more.

    On another note, I am a holder of the stock GRR, and it’s intrinsic value looks to be far above the current share price. Am I missing something?

    Cheers

    Seany B

  8. Ann
    :

    China has generations of building to do. The people non major cities want what people in the cities have and this will create demand, nothing will stop it

  9. Matty
    :

    Iron ore…or …Gold, Gee some of the gold stocks must be getting interesting again. Who knows what is going to happen with the gold price, but even on a very conservative basis for Silver Lake’s new Murchison project of A$1400/oz, they are expecting a 2 year payback period. My cash return from my slashed QBE SPP is looking for a home. It may be a nice hedge as I think those two balance each other out…$US goes up, Gold goes down, QBE starts earning again. But maybe I am being an investing simpleton again.

  10. Hiten
    :

    Roger, not sure if you are after comments for Mining Services company or Miners.

    I assume it’s the later, so here goes my comments. I will mention few things I picked up from another stock market forum I visit along with my own views.

    I personally like BHP compared to any other miner due to it’s diversified business in which it is one of the best. RIO, FMG and few others will get hit pretty hard if China’s demand for Iron Ore reduces.

    Few facts that support my argument is

    -Only 30% of BHP’s entire business earnings come from China.

    -Even if Iron Ore demands slows, other metals/minerals like copper, uranium , petroleum, natural gas etc provide plenty of opportunities for growth. BHP is not only about Iron Ore.

    – For every $1 rise in the oil price, BHP’s full-year net profit after tax climbs by $40 million.

    – For every $1 rise a tonne of iron-ore price, BHP’s net profit would increase by $US95 million.

    – BHP is trading at P/E of around 8. For a company with quality assets and clients around the world. Strong balance sheet, I think current price is very attractive even if commodity prices were to fall. Long term BHP will continue to be a very profitable company IMHO.

    – Don’t you wish you bought BHP few decades ago for 70cents a share?

    • Chris W
      :

      I sort of agree. At the moment BHP’s dividend yield is about 3% at $31.90 and they are buying back shares (just a little). They have a proven track record. And if they don’t return money to shareholders, they know that they must invest it wisely so the pressure is on for management to get good returns for shareholders.
      If iron ore prices go right down, they will close iron ore mines and concentrate more on another commodity. They have a slight advantage in operating low cost long life mines to get to the customer cheaper. I know there are risks with BHP. And past track record isn’t enough to go on. It could all turn around tomorrow and BHP could turn out like many companies that have been large and fallen from their heyday but still surviving.
      Either way, I will hold on for a while and ride out this euro crisis. I still am a little bullish on China in the medium-long term, I’ll just wait till Europe sorts itself out and China to continue growing.

  11. Ash Little
    :

    Hi room,

    It looks like Downer are the contractors to the mine BHP are closing,

    Did someone at Downer walk under a ladder or run over a black cat or something. They keep having problems.

    Cheers

    • Andrew
      :

      Ash, if that is the case, do you think it should be listed on the balance sheet as a liability? Perhaps Intangible liability?

    • Yoel
      :

      I was surprised to see them close the mine, however I think it really was a case of BHP showing that they arnt just a cash train and higher costs (lower profit margins) will not be tolerated. Funnily enough my company was doing some work on a new building for the site and it went on hold 1-2 months ago, now it make sense why it never came back online. Also shows that it was a decision that was only made in recent times as we only won the contract 1-2 months prior to it going on hold.

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