Two sides to the mining boomMining companies have fallen into...

Two sides to the mining boom
Mining companies have fallen into two camps, those that are making so much money that they don't know what to do with it and those that are struggling in the high cost environment.
The reporting season highlighted the widening divide between the two, which is created by exposures to different commodities, project development and operational ability.
BHP Billiton, Rio Tinto, Zinifex, Oxiana and Jubilee Mines all reported excellent profits, albeit roughly in line with expectation, after high copper, nickel, zinc and iron ore prices in the December half. And these miners' main problem is how to spend all the capital they are accumulating.

"BHP took a very big step in capital management with its $US10 billion share buyback and Rio has taken some pretty good steps, but the question is: Are they in merger and acquisition mode?" asks Deutsche portfolio manager of Australian resource equities Lawrence Grech .
"Together with Zinifex they are definitely leaning towards M&A, but will they buy now or wait for a better opportunity?"
The very strong cash flows will continue for these miners for as long as the commodity prices do not collapse, and they will continue to look for the best uses for their capital, including acquisitions, organic growth and returns to shareholders.

By comparison, Newcrest Mining, Lihir Gold, Iluka and to some extent Alumina did not benefit from such strong prices in their commodities, yet were exposed to the same extreme cost environment that is pervasive across the mining sector. At the same time these companies are restructuring or struggling with new projects that are not yet delivering steady cash flows and are having to pay the significantly higher than usual project development prices.
Costs are a major focus for all miners, desperate to prove that they can keep them under control or that they will at least be removable should commodity prices ease and volumes stop being king.

It will be the ability of companies to manage costs that will determine which survive and prosper in a future downturn in commodity prices, according to analysts.

Despite the record profits and extraordinary returns to shareholders, the investment market is still lukewarm when it comes to the resources sector, as it tries to get a handle on where commodity prices are heading from here.

Even the miners seem unsure, with relatively conservative statements coming out of Rio Tinto and Zinifex during the reporting season. Oxiana's managing director and notorious bull, Owen Hegarty, abandoned the tired "stronger for longer" tagline in favour of "stronger forever".
"At present the market is groping to see which trend will emerge, either of strengthening growth and prices, or whether the past few years of demand strength from Asia and developing nations is now starting to wane," Grech says.

"There will be a period of volatility until we get an established trend and then the market will correct itself up or down."

In the meantime share prices could jump or fall by 20 per cent very quickly as the market reacts to small pieces of news that could signal the beginning of a trend.

The correction in copper and zinc prices at the beginning of this year is small, with current prices still many times higher than historical averages. At today's prices even pure play miners with exposure to the supposedly weakened metals of zinc and copper could still report record profits for the period ending June 30.

Analysts certainly expect BHP and Rio to beat their records again this winter, given that iron ore prices will once again have increased (by 9.5 per cent from April 1) and base metal prices continue to be stronger than at this time last year.

Even if commodity prices ease and earnings fall off in the 2008 financial year, the miners will still be generating a huge amount of free cash flow compared to the lean years of half a decade ago.

But despite repeatedly beating records, the resource sector has fallen out of favour with the wider investment community, particularly with foreign institutions.

While most Australian funds are expected to have some exposure to the resources sector, it is entirely optional for global investors, which have been de-weighting away from the miners, particularly BHP and Rio.

This is reflected in share prices, which, despite good financial, operational and capital management news, have remained far below the peaks of May last year when commodities were in vogue for generalist fund managers.

"There is a sense in the wider market that they have made fantastic money in resources and are not going to see such high returns again," ABN Amro portfolio manager Neil Boyd-Clark says.

As both Rio's Leigh Clifford and BHP's Chip Goodyear pointed out, these investment whims are beyond the control of mining companies and their management, who have instead focused on capital management.

In the 1980s miners developed a bad reputation for hoarding money or spending it on uneconomic growth projects rather than returning it to shareholders.

While this persists at the smaller end of the market, most of the majors have significant buyback programs in place or have boosted their dividends.

This was well received as "sensible and prudent" by fund managers given the strong cash flows being generated.

And with the exception of a crash in metal prices, it is expected to continue for at least the next couple of reporting periods.

"There is going to be another round of capital management initiatives, unless [the miners] go for M&A," Grech says.

"It is hard to see any major new greenfield announcements to absorb a lot of the free cash flow, because the resources to build projects are not available."


Friday, March 23, 2007