Mining swings from profit to loss quickly and without fear or favour. Its always been this way.
You might recall back in December (Dec 8, 2011) with FMG trading at $4.84 (now $2.94), BHP at $37.00 ($31.36 today) and RIO at $66.09 ($50.19 today) we warned
“I now wonder whether we are seeing the bubble slip over the precipice? Falling property prices (10 per cent of the Chinese economy) leads to lower construction activity, leads to declining demand for Australian commodities, leads to falling commodity prices, leads to big drops in margins for a sizeable portion of the [Australian stock] market index…”
Since the start of 2012, commodities have, on average, fallen more than 20%, and in some cases much more. This is a pace of decline matched only by that experienced during the financial crisis of 2008.
At current prices many mining companies will now be making losses. As analysts we question the viability of some companies and Atlas Iron for example, one of the largest Iron Ore producers outside of BHP and RIO, may not be without outside help – should prices remain at or below present levels.
With such material falls in both our listed miners and mining services companies, the question for value investors is naturally, are we at the bottom yet?
We do not believe we have seen the end of this mining (and mining services) sell off. EPS revisions are still heading down and at spot prices, the material sector’s forward earnings multiple is a whopping 18x. PE’s are expanding as earnings are declining at an even faster rate than plummeting share prices.
A recent research report by a large Australian investment house reported potential 30-50% per cent earnings downgrades at current spot pricing (yes this includes BHP and RIO). If this eventuates, our own scenario analysis has BHP worth $15-$20 a share and RIO $30-$40. If you don’t believe profits can decline this fast or this significantly, keep in mind we reported to you on July 26 here (http://rogermontgomery.com/is-this-the-fate-that-awaits-australian-iron-ore-producers/) that Rio de Janeiro-based Vale, the world’s largest iron- ore producer, said second-quarter profit plummeted 59 per cent after prices for iron ore, nickel and copper declined.
While we are watching this play out exactly as we have been warning for some time, we will continue to remain spectators rather than participants.
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.
Paul Rehill
:
Hi Roger
I listened to your latest ASX podcast describing Skaffold. I was struck by your comment that BHP has not added any value since 2006.
I calculate the average ROE (on ending equity, not starting equity) to be 31% for the 10 years to FY12. The 2012 to 2003 FY ROEs are respectively:
23.2%, 41.5%, 26.4%, 15.6%, 40.9%, 45.1%, 43.1%, 37.0%, 22.7%, 14.8%
The drop from FY06 from 43% to 23% in FY12 corresponds with your comments. But the nature of commodities is that even for the diversified BHP, the ROE will move around.
An advantage of Skaffold is that it responds to analysts’ future EPS expectations for 2 (or 3?) years ahead and factors these changing market expectations into IV to make its calculation sensitive to changing expectations. However, 2 potential disadvantages are it can generate more volatile (expectations-based) IVs that lead to higher portfolio turnover and for commodity stocks, these IVs may be affected by short-term movements in commodity prices rather than longer term movements. As you think commodity prices are falling, this is fine as it agrees with your investment thesis.
However, another way to look at BHP’s IV over time is to take Buffett’s approach with Berkshire Hathaway and inspect what is going on with book value per share over time as an approximation for IV changes. I calculate the book value per share from FY12 to FY03 respectively for BHP to be:
$12.38, $10.66, $8.72, $7.18, $6.89, $5.24,$4.07, $2.90, $2.42, $2.01
This equates to the following percentage changes from FY12 to FY04 on the prior year respectively:
16.0%, 22.3%, 21.5%, 4.2%, 31.4%, 28.7%, 40.3%, 19.8%, 20.3%
I think this gives a better idea of how BHP’s IV has changed recently. However, if your commodity price slump thesis takes hold for a long period of time, this of course would impair IV as reflected by revised estimates of proved and probable reserves based on lower future commodity prices estimates by BHP. Any asset impairments would reduce book value per share.
The net investing CFs from FY12 to FY03 respectively in millions are:
32036, 16464, 9985, 10042, 9064, 8313, 6143, 9166, 2653, 1950
Some benefit of the larger 32bn and 16bn investing CFs won’t be visible in EPS estimates over the next 2-3 years so Skaffold may not pick this up.
I will say that FY12 was by BHP’s standards, a shocker. Looking through the 9 customer segment groups (CSGs) for the 10 FYs, BHP averages 5 CSGs with a ROE greater than 20% (again on ending equity). The number of CSGs with a ROE greater than 20% for FY12 to FY03 respectively were:
1, 6, 5, 4, 7, 7, 4, 6, 5, 4
So only 1 CSG performed well in FY12. Obviously that is the Iron Ore CSG which contributed 12% of the total 23% ROE. Petroleum contributed 5% and Base Metals 3% with the other 6 CSGs contributing a paltry 3%. So iron ore was the saviour for FY12.
Another glaring problem with FY12 can be seen by calculating Operating CF – Net Investing CF – Dividends – Shares Purchased for Employee Plan (treated as dividend to be funded from operating CF). For FY12 to FY06 respectively in millions, the surplus/(deficit) was:
-14009, 8003, 1736, 2674, 5595, 5140, 2869
Historically, CF management has been excellent with surpluses often applied to buybacks as seen by outstanding shares from FY12 to FY03 (in millions) respectively:
5323, 5323, 5564, 5565, 5565, 5660, 5945, 6055, 6223, 6216
But the calculated FY12 deficit of $14009 million can be explained by the shale gas acquisitions totalling $15bn. This really stands out as stretching the balance sheet by taking on more debt (net $8.9bn with the balance met with a reduction in cash of $5.1bn).
The impact of this is that FY13’s results will be impacted more by BHP’s ability to target natural gas liquids to boost ROE of the Petroleum CSG which has dropped significantly. For the 7 years to FY11, Petroleum amounted to 18% of equity but for FY12, it was 35%. Iron ore is about 20% of equity allocated to the the 9 CSGs. In FY11, natural gas liquids average US$ revenue was $49.79 per barrel compared to an average production cost of $6.34. Hence, this is why BHP is switching away from dry gas drilling to liquids whilst the Henry Hub price is depressed. The latest presentation suggested BHP is targeting a 10% p.a. supply increase in petroleum boe over the next decade.
The Aluminium CSG is looking woeful with an average ROE of 1% for the last 4 years and 8% over 10 years. Diamonds and Speciality Products CSG and Stainless Steel Materials have also struggled averaging 13% over 10 years.
Looking back, BHP’s CAPEX allocation to iron ore is one of its successes with the CSG generating the following ROEs from FY12 to FY05 respectively:
43%, 72%, 36%, 30%, 45%, 44%, 60%, 48%
with supply increasing from 96.7 mtpa to 159.5 mtpa and CAPEX averaging about 24% of annual CAPEX over the 8 years to FY12. CAPEX to Aluminium and Stainless Steel Materials haven’t yielded good results.
I have made approximations in my calculations and they may be subject to errors. This is NOT a recommendation to buy BHP. I do hold BHP as an inflation hedge against a depreciating USD relative to AUD that may or may not be reflected in future commodity prices. Inflation isn’t rearing its ugly head yet but if you believe Bill Gross of Pimco (listen to his latest podcast), it is on its way (but who knows when). As Gross points out, both equities and debt fail to do well in a high inflation environment.
Roger Montgomery
:
Hi paul,
Well done. Pages 210-216 of Value.able may provide some grist for you.
ashley.little.581
:
Below is a link which shows BHP historical share price.
http://www.bhpbilliton.com/home/investors/shareholderinfo/Pages/OnlineServices.aspx
Looking back at the last great hard commodity bull market of the 1970’s we see BHP’s Share slide from $25 to $4.20 by September 1974.
That bull market was driven by the Industrialisation of Japan which powered on until the early 1990’s but the prices for Iron coal copper et al was pretty much over by the mid 1970’s.
Prices fell as a function of supply catching up with demand. We continuously, shipped more coal year in year out to Japan but the prices in real terms kept falling.
I am not sure if this story is true but I have been told that annual price negotiations from the Japanese steel mills with BHP in the 1980’s involved BHP executives waiting outside a locked conference room and a piece of paper with a price on it would be slipped under the door by the Japanese. That’s the price, take it or leave it.
My point being that those that rely on the argument that China will stimulate thereby getting iron ore prices back to silly levels may not win the school debate.
The problem with commodities is that they are………….. “Commodities”………. History suggests that when supply meets demand (and it’s looking like this may overshoot) the price settles at slightly above the average marginal cost of production. I would be guessing at this figure but to me an iron ore price of $50 would be ballpark. Overshooting supply obviously means a lower price than $50.
BHP has not put all new projects on hold for no reason.
It is just my view but hitching your wagon to a possible rebound in iron prices may not be the best use of your capital
Cheers
Hiten Ravani
:
Ashley, I think there is a difference in BHP of 1974 to BHP of 2012. Today BHP is the worlds largest diversified miner. Just compare the price drops of RIO/FMG over the last six months to BHP price drop. How many companies can make a profit from iron ore at $50 bucks? Only BHP and RIO…maybe Vale. So are you telling me that at $50 only 3 suppliers in the world? That would create a monopoly business IMHO. The volume growth would more than offset the lower price.
Secondly, BHP has already started focussing on expanding it’s Petroleum assets which contributes around 25% of it’s profits, and it’s margins are very healthy on petroleum. It’s forecasting boom in copper prices over the coming decade as China moves from industrialisation to consumer driven economy.
Being diversified is the key. There is still Potash and Natural Gas. BHP has so many options. One of these commodities is going to be the next iron ore. But by the time the majority of the people identify the next commodity boom BHP would have moved on from $30 to who knows where? Invest for the long term…the odds are in your favour…Buffett knows this…he doesn’t care about 6 months or 2 years when he makes an investment. Investment in BHP should be viewed as long term not 6 month.
Gary Rutter
:
Costs of production in the iron ore game are everything. I worked at the bhpb iron ore mine for four years and was shocked how much their costs blew out. High prices have alowed the iron ore players to get lazy and inefficient. Bhp may be a big company, there’s no denying that, but they are defenetly not a good company. Advice from Roger has always been, invest in good companies. We all know how many progects Bhp has blown a couple of billion on each in the last decade, then they took their winnings from the iron ore tabble and blew it on shale gas in USA. Their spruking of spending $80 billion on progects only 4 months ago, and now cancelling it all just highlights their bad management. At the iron ore mine, we had 6 good men die in 3 years, a small reason for the massive cost increases, but again highlights their very poor management. Bhpb will servive, only because they have a monopoly on the best high grade ore in the pilbra, not because it’s a good business. The days of watching Bhp shares go up are gone for a decade. To finish where I started, costs of production ; Rio Tinto is at $38 incl royalties and shipping, Bhpb is at $41 and Fmg is at $86 including interest on their massive debt. Rip Tinto, when they get to the mining rate of 350mil tonne year, are saving $1 billion just in that $3 less in costs. And as for Fmg, well they are just “dead man walking” , nothing surer than that. Thanks for reading, Cheers Gary
Hiten Ravani
:
Roger, what would happen to the price of commodities if US, ECB and China’s central banks all decided to introduce stimulus packages to kick start growth?
What is your fair assessment on China’s growth over next 5 years? Do you think China can grow at 7% or not? Can China afford to not grow at 7% to avoid any unrest.
As expected supply side is already being pushed or canned by recent annoucements from several mining companies. But question is for China to grow at 7% with excess supply being halted will the price of IO keep falling?
You have to consider the possibility that by just being a spectator and not a participant until you see certainty you might never get chance to buy the best resources company (BHP) for $30. Buy the time you get your certainty market would have taken BHP to above $45.
Just putting a balanced view. For every txn where someone is selling BHP shares there is another person buying as well. Only time will tell who is right.
Just my 2cents.
Roger Montgomery
:
Hi Hiten,
We are not watching the macro picture but corporate cash flow and balance sheet statements. We reckon just as the turn down was preceded by a deterioration in these items, so too will be any turn up. In any case, just as the Aussie market was slow to react to the turn lower, so it will be again.
ashley.little.581
:
Hi All
This is cut from zero hedge
“There have been four mega bubbles in the past 40 years. In the 1970s it was gold; in the 1980s it was the Nikkei, and in the 1990s it was the Nasdaq. Bigger than all of them, though, has been the iron ore bubble, a tenfold increase in prices in less than a decade.”
This was a Mark Faber comment…
A very interesting comment from Zero Hedge
Julia Gillard’s denial seems to confirm the inevitable:
“Australia’s mining boom is not over and its ‘death’ has been exaggerated.
That is her “subprime is contained“ moment”
Cheers all