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.
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Do New Hope Corporation (NHC), Northern Star Resources (NST), Mt Gibson Iron (MGX), Navarre Minerals (NMC), Allmine Group (AZG), Credit Corp Group (CCP), Matrix composites (MCE), Coffey International (COF), Data #3 (DTL), Breville Group (BRG), UGL (UGL), QR National (QRN) and Seymour Whyte (SWL) make Roger’s coveted A1 grade? Watch this edition of Sky Business’ Your Money Your Call broadcast 14 April 2012 to find out, and also learn Roger’s current insights into the Mining Services sector. Watch here.
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.
Do Lonrho Mining (LOM), Integrated Research (IRI), Hawkley Oil and Gas (HOG), Boart Longyear (BLY), Forge (FGE) and Environmental CleanTechnologies (ESI) achieve Roger and coveted A1 grade? Watch Part 2 of Sky Business’ Your Money Your Call 10 April 2012 program now to find out. Watch here.
Do Thorn Group (TGA), Maverick Drilling (MAD), Campbell Brothers (CPB) and Galaxy Resources (GXY) achieve Roger’s coveted A1 grade? Watch Part 1 of Sky Business’ Your Money Your Call 10 April 2012 program now to find. Watch here.
We have been prattling on about the value in mining services businesses for a long time and I am sure you are familiar with names like Forge, Decmil and Maca. What concerns me a little is that these names are now familiar not only to the few that read this blog and keep up to date on my facebook page here: https://www.facebook.com/montgomeryroger but also to just about every broker with an analyst team. There are now analysts solely dedicated to mining services and if the widely expected M&A/IPO wave hits later in the year, I wonder whether it won’t be full of mining services contractors.
Make no mistake, on the one hand there appears to be some real value in this sector. On the other, these businesses suffer from the ‘feast or famine’ syndrome, require a mining boom to be able to generate a sufficient rate of return to cover their cost of capital (and therefore increase there intrinsic value) and finally, their operating leverage ensures that any turn down in activity will have a significant impact on EBIT, EBITDA cash flow etc…
One to keep a close eye on…
I was interviewed on CNBC about this very subject and you can watch the video here.
What do you think? Do you own any of the mining services companies? Can the high rates of return on equity be maintained? What do you think Australia’s future looks like in the event the mining boom ends?
Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 3 April 2012.
Roger Montgomery discusses with Ticky Fullerton on ABC1’s ‘The Business’ how the ever-increasing climb of Apple’s share price is likely to come under pressure. Watch here.
This edition of The Business was broadcast 4 April 2012.
Roger Montgomery discusses the prospects for Gold-Miner Red5 (RED) in this Money Magazine article published in April 2012. Read here.
In the April 2012 issue of BrokerNews.com.au‘s EMag, Greg Campbell of ARAP discusses property valuation issues, and how Roger Montgomery’s Value.able approach to assessing asset values highlights that what someone is prepared to pay can bear very little relation to the true worth of an asset. Read here.
Roger Montgomery expounds upon his Value.able investing approach to illustrate how Big does not mean Best when choosing companies in this Australian article published on 31 March 2012. Read here.
Roger Montgomery discusses how using Skaffold will allow you to learn the intrinsic value of stocks even during periods of high market volatility. Read here.
