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..and so it goes

..and so it goes

As you already know, despite the enthusiasm for mining service companies back in April, we sold our holdings substantially and in some cases completely.  We have not shared our peers’ – some of whom include themselves in the ‘value investing’ camp – enthusiasm for BHP.  Our reasoning for this is our thesis regarding iron ore prices, which is unchanged from late last year.

Back then it was simply the classic investment response to higher prices.  Iron Ore prices between 1985 and and 2004 have traded between $11 and $15  and in real terms since the 1920’s prices have traded between $30 and $45. In 2004 the price of iron ore started rallying and hit $187 in 2007.

Putting aside the fact that iron ore experts now ‘guess’ $140 is the new medium term price and $100 the long term price, the rally in price from 2004 to now has produced a huge investment boom and turned millionaires into billionaires as they revalue their reserves (or other bulls value them for them).

It follows that  the investment boom will now produce additional supply.  The impact of this additional supply cannot be anything but falling prices.

Well, that was our thesis.  And then China began slowing down.  We wrote about that too

If you have been a regular to the Insights Blog, you will be familiar with some of our recent thoughts on iron ore here:

April 3)  http://rogermontgomery.com/mining-services-a-crowded-trade/

April 18) http://rogermontgomery.com/building-heaps-piles-at-bhp/

APril 11) http://rogermontgomery.com/will-china-demand-iron-or/

And you can watch this video I published here on December 8 last year:

Since July last year BHP is down 30% and RIO down 36%.  Since April and early May they are down 15% and 20% respectively.  Many investors are now thinking they are cheap.  But there is the possibility of a classic Value Trap.

Forecast valuations may yet decline further, even if share prices bounce. Here’s our thoughts…

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 at least 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.

This article was first published on May 16, 2012


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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  1. China just cut their interest rates did anyone predict this because everyone seems to know whats going on so did they know this was coming. Commodities are up and markets have bounced back. There is more scope to cut if need be.

  2. Macca McLennan


    In mid April BHP announced the closure of one of their
    coal mines in QLD This woke me up !!

    So i put together a spreadsheet on Iron Ore
    (Roger has been sent a copy)

    It appeared that in 2011 with Ore at $150 pt
    That BHP profit was $102 production cost $48
    RIO was $111 profit, production $39
    FMQ at $87 & $63

    Moving on 4 years
    With an ore price of $95 & production costs increasing
    by 10% per year

    Profit per tonne
    BHP $25 RIO $38 FMQ $3
    To maintain their current profit
    Tonnage would would need to increase by
    BHP 413% Rio 293% FMQ 3150%

    In April all of the companies had plans to increase production
    BHP & RIO expected to double production, FMQ by 5 times

    On these predictions on production increases occurred
    it is possible that
    BHP ore profit would drop by about 50% (20%of total profit)
    RIO a drop of 40% (80% of total profit)
    FMQ by 80% (100%of profit)

    Since putting this together Jim Chanos a well known US hedge fund manager has called FMQ the “Big Short”
    BHP has announced they are reviewing future investments

    The assumptions & outcomes in this analysis may well turn out to be incorrect However i think they point to what could broadly happen to iron ore

    You should make your own enquires & seek professional advice
    before investing or shorting any of these companies


    • In terms of Iron Ore, The report by Port Jackson Partners presentation to Minerals Council of Australia on May 30th can be Googled and is worth reading. Amongst other things, it shows the trend re Au share of global production and cost competitiveness, the cost competitiveness of Australian thermal coal projects, competitive position of iron ore projects.
      The graphs speak for themselves and unless unless rising costs can be contained across all aspects of a given project AU will lose its competitive advantage to lower cost projects elsewhere in the world.
      There is some interesting – and concerning – information on Australia’s coal industry as well. For those who are interested: Go to Australian Coal Association website and read the address delivered by Dr N Williams on June 4th at Coaltrans in Bali.

  3. Hi Roger
    Surely if BHP start deferring capital projects they will give some of that money they have in the bank to shareholders?. I read an article by the CEO of RIO recently that they have the message loud and clear that shareholders want a better payout – and their peers (ie BHP et al) have heard the same message. On that basis I’m not rushing to sell BHP. I’m not sure what % of BHP’s business is from iron ore?


    • Interestingly, when a company generating a high rate of return on equity increases its payout ratio, its intrinsic value declines – all things being equal.

      • I’d love to know how many shares in ASX SWL you picked up today Ash!
        I let you know how many cuts I have on my hands from catchin’ falling Knives tomorrow when SWL share price falls another 3%.

      • Zero Simon,

        I was going to have a bit of a captain last night but I looked at something else instead.

        I will have a look tonight but I am guessing I will find that I wont be in a rush to Invest.


      • Up 8% today in a falling market I guess dead cats do bounce, still holding on to my shares as I believe that SWL is a cat with several lives left.

      • Hi Simon,

        Its performance may drop so that it is an A2 after the full year result. On present metrics, the probability of it going bust is small, hence its high rating. Remember the scores are about catastrophe rather than normal business-related upgrades and downgrades.

  4. Michael Horn

    Your opinion reflects my thinking, and I have substantially exited mining. I still hold BHP, but I am sorry that I did not exit when I sold RIO.

    On mining services, I have exited Fleetwood and Monadelphous at reasonable capital gain, and have not bought into new ones for about two years. Much the same can be said of other market sectors and themes. The only theme I still like is what I call poverty stocks – CCP, CCV, TGA and the like (I hold and like TGA). I hold SGH for much the same reason as I hold TGA (non-cyclical and grubby), but its lack of liquidity makes it difficult to recommend, plus it must prove that it has shuffled off its old habit of growing by acquisition.

  5. Hi Roger & Team

    BHP overpay for acquisitions? At the top of the market?

    My thought goes to Petrohawk.

    31 December 2011 accounts

    NPAT $174M

    Equity $4,648M

    ROE (yes I’m lazy I am going to use ending equity) circa 3.75%

    They actually have large carried forward losses so if you define equity as the amount put in and left in its much worse.

    ROC (Same lazy) circa @2%

    And what a great business with a huge moat. Since the purchase and even more so since the 2011 accounts have come out we have seen the price of US gas prices fall faster than a Greek bond.

    This is due to the supply response that Roger refers to above.

    And what did BHP pay for this cracking business that earns such a great return?

    Given the maths most value.able graduates would just say next!! Move on ….. not for me….no point swinging at this one.
    It’s a fastball at the body….slightly lower than waist high. Right at an area you don’t want damaged. We can just swerve, sit back, adjust our box and wait for the inevitable long hop or two.

    But no, not BHP They paid $15,000M for this business. Roughly 4 times equity. Absolute madness.
    This makes Brambles look like a great investment.

    KPMG are Auditors, Let’s see if they make them write down this overzealous position.

    But I don’t think it’s entirely BHP’s fault.

    BHP was sitting there with an idea of making a huge investment. Elephant style. They had fired off some elephant guns in the past (i.e. Potash et al.) but none had hit the mark. The crowd ( fund managers and media) where yelling out “have a go you mug”….you’re a bum, what are we paying you for.

    So what happened. Like most mugs BHP just closed their eyes and swung. It’s very sad because I believe many long hops are coming and BHP will take advantage of these. Just not as any as they could have.


  6. Roger,

    China’s GDP is around $7.74 trillion, and GDP per capita $5184.
    USA’s GDP is around $15 trillion and GDP per capita $48387

    What are your views on China’s economic growth over say the next 10yrs? Do you believe China can grow at say 7% over the next 10years? China has been growing at 10% over last 30years.

    So if you believe China can grow it’s economy at 7% for next 10 years the economy will double over the 10yr period. How much iron ore will it need over the next 10yrs to double the size of it’s economy?

    What about India? and rest of the world? Things to ponder…

    • One report from Morgan Stanley said that at 7% Chinese smelters will require another 40-50 mln. Far far more than that will now add to existing production.

      • Ah..the same company that thought facebook was worth $38.

        Surely, mining companies know what the iron ore supply pipeline looks like and how much more demand they can expect from their biggest customer which is China.

        If the Iron Ore price starts to fall companies will adjust..only the highly profitable companies (BHP/RIO) will survive. A lot M&A activity will happen and I believe BHP will be in much better position to benefit from such an activity. All that would mean is 5 years from now BHP will be an even stronger and bigger company than it is now.

        Also, regarding BHP’s price for Petrohawk, I believe the price they paid was based on Natural Gas in low $4 with supply worth atleast for next 40years.

        I think ppl forget that price of Natural Gas peaked at $12 and started falling due to discovery of new gas supply. At around $4 BHP’s thinking would have been that surely we are closer to the bottom than the top. There is no way on Earth BHP or anyone could have accurately predicted the bottom for NG.

        US Industries are making a transition from using oil to NG. I think we have seen the bottom of NG and from here on it’s price is only going to rise. With demand for energy only going to increase and depletion of oil I think BHP will make a lot of money over the next 40years from selling NG. Business often go through a rough patch every now and then BHP happens to be going through one right now.

  7. Hi Roger,
    Regarding the comment “Forge is a business that has a significant exposure to second-tier miners, especially those expanding their iron ore operations”, I would like to know your thoughts on FGE presentation where they have mentioned total $1200M of order book as off 14/02/2012. Out of those 1200M only 340M belongs to Iron ore that is 28% of the order book. Rest of the order book is from other minerals, power-stations and LNG. Also what I get from the recent announcement from Mining companies is, there main big concern is cost of labour and capital in Australia apart from commodity prices. In that case they are/will be looking for resources in Africa and FGE has got excess to resource companies in Western Africa. Also when commodity prices were at record high Australian dollar was also at record high, and both has fallen so far, isn’t that a natural hedge against Iron Ore prices? would like to know your thoughts on this.

    • Hi Prerak,

      The exposure outside of iron ore is due to Ctec acquisition and 28% exposure is not insignificant. Its illuminating to look back in time and see what can happen to order books when large customers simply decide to defer or delay projects. On your other point, yes, to a certain extent there is a marginal benefit but the supply means greater competition and margin pressure. The best kind of business can raises prices even in the presence of excess capacity. Does that sound like an iron ore miner? Of course just as rallies are prone to go too far, share price sell offs can swing too far.

  8. Roger

    I take all forecasts and commentaries with a grain of salt (yours included) as they are all just one persons view of the unknowable – by the time we get to the predicted future we have all moved on and are talking about the next great fad or crisis.

    However, having said that, I am happy to make my own prediction that BHP will still be here in 10 years time and probably 100 years as well. And I am even more sure that it will be significantly bigger than it is today in terms of earnings and no doubt have noisy shareholders arguing that they should be paying out more in dividends rather than digging holes in the ground.

    If you have gone short on BHP and the mining services companies, thats great as no doubt an equal number have gone long. I guess we will find out who was right in 10 years time, by which time it will no longer matter as we will be talking about the slowing growth in the United States of Europe.

    And probably wondering who will take over Berkshire if Warren ever decides to pass away.

    • You are right Ron and thanks for the perspective. Of course, in 100 years time, I am not going to be too concerned about the intrinsic value of BHP or any other stock for that matter. I suspect Warren however will still be sipping Cherry Cola at the Berkshire AGM. The preservatives in that stuff are sure to still be working.

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