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The big miners have been the cornerstone of investors’ portfolios for years but as the mining boom fades should this position be reassessed?

Just this month Australia’s largest iron ore miner, Rio Tinto (RIO) reported Half Year earnings, notably an 18% drop in profit. Given that iron ore sales account for around 88% of RIO’s earnings, not even a 6% rise in iron ore production and a falling Aussie dollar, shielded Rio from the fallout in the iron ore price.

Rio had cut costs and capital expenditures, with $1.5 billion in cost savings and an 8.7% reduction in capex versus the previous corresponding period (pcp).  In addition, investors were awarded a 15% dividend increase.  The healthy dividend and cost cutting measures saw the share price rally as reflected in the one-month chart:

RIO did not lower guidance for Full Year 2013, but management outlook was vague.  Chinese growth has decelerated in the first half and is unlikely to recover in the second; management, nevertheless, does not anticipate a hard landing. 

The price of iron ore has rallied, rising above $140 a tonne in recent days as Chinese steel producers replenish inventories.  But the precipitous drop in iron ore prices just a year ago, tumbling below $100 per tonne in September 2012, are still fresh in investors’ memories?

In the coming weeks four of the top five iron ore producers will report earnings.  What should be we watching out for? 

The table below lists current valuation measures, share price information, and forward looking growth estimates for the top iron ore producers, along with RIO for comparison:

Company (Code)

Share Price

52 Wk % Change

P/E

(TTM)

P/B

(MRQ)

P/S

(TTM)

Forward P/E (2014)

5 Yr Expected P/EG

2 Yr Earnings Growth Forecast

Div Yld

BHP Billiton

(BHP)

$37.33

+13%

20.75

2.93

2.93

14.25

6.48

-8.5%

2.9%

Fortescue Metals

(FMG)

$4.20

+3%

10.58

3.26

2.02

5.25

0.46

30.5%

1.6`%

Mt. Gibson Iron

(MGX)

$0.70

-30%

9.59

0.71

1.12

5.83

-0.39

-18.39%

5.9%

Atlas Iron

(AGO)

$1.01

-45%

17.5

0.59

1.66

9.18

-0.52

102.2%

3%

Rio Tinto

(RIO)

$61.40

+13%

12.93

2.44

2.25

11.37

3.41

1.4%

2.7%

 

In theory BHP Billiton (BHP)’s broad resource diversification has defensive qualities, but in practice falling commodity prices across the board can compound the negative impact.  BHP’s FY 2012 profit was $USD17.1 billion with profit forecasts likely to come at $USD12.5 billion; a 26% drop.  

Going into Full Year 2013 earnings release, scheduled for 20 August, investment analysts aren’t in agreement.  Macquarie, UBS, Deutsche Bank, and BA-Merrill Lynch have BUY or OUTPERFORM recommendations on BHP. 

Of note is BHP’s solid 17 July production report, which was so optimistic that the company’s forward guidance appears conservative.  BHP reported record production levels in iron ore and copper, on top of impressive increases in thermal and metallurgical coal.  A Deutsche Bank analyst speculates on possible upward revisions to BHP’s 2014 guidance based on the strength of this production report.  

Of particular interest in this upcoming release is BHP’s plans for its Jansen Potash project in Canada. After adding US and gas shale oil operations to its asset base, BHP went after Canada’s Potash Corporation.  That failed and BHP proceeded with plans to build its own potash operation in Saskatchewan with the expensive Jansen Project.  The price of potash is in free fall so the question remains whether BHP will continue to invest in an attempt to further diversify itself.

Despite BHP’s broad diversification, investors focus on its iron ore operations.  In the past three months BHP’s share price, along with rival Fortescue Metals, has risen alongside the rally in the iron ore price.  Here is the chart:

Fortescue Metals (FMG) is a pure play iron ore producer.  The company also released a blockbuster June production report on 23 July 2013, including a 24% increase in shipments for the current quarter and a 41% increase for 2013 year to date.  In addition, the company announced 17% cost improvements and decreasing capital expenditures as its major Port Hedland expansion nears completion.  A project update issued on 14 August announced the completion of the project which should allow Fortescue to increase its export capacity to 155 mtpa (million tonnes per annum).  This leaves the company on track to complete its total expansion package tripling production by the end of this year.

Investors applauded as reflected in its share price.  However, debt is the major problem for Fortescue with Gearing, at over 300%, for the recent quarter.  Fortescue had been pursuing plans to sell minority positions in its infrastructure assets.  There is some speculation that FMG may be delaying a decision to assess market conditions.  FMG chairman Andrew Forrest is interested, but only at a “good price. “

According to analyst estimates, FMG has a healthy 2 year earnings growth forecast of 30.5% and a 5 year expected P/EG of 0.46.  However, estimates are only educated guesses and these are based on a reasonably healthy iron ore price. 

An oversupply of iron ore coupled with dwindling Chinese demand is the big worry for Fortescue. The company is also a high cost producer.  The following graph from Metals and Mining Consulting Firm Woods Mackenzie and HSBC compares the cost of producing iron ore across the world’s top producers, including RIO, BHP, and FMG:

According to Morningstar, FMG produces lower quality iron ore at higher production levels and needs a price of about $90 per tonne to stay afloat.  Granted FMG is committed to lowering its production costs, but with costs already below $50 per tonne, BHP and RIO can remain profitable at much lower iron ore prices; Goldman Sach’s predicts the price of iron ore tumbling to $USD80 per tonne by 2015.

Costs of production are especially concerning for Atlas Iron (AGO) and Mt. Gibson Iron (MGX).  Mt. Gibson’s trailing 12 month operating margin, at 13.69%, is less than half of BHP’s, at 29.96%, and significantly lower than RIO’s, at 22.49%.  Yet both companies saw share price rises following positive quarterly production reports.  Here is the chart:

As you can see, even these two smaller players followed the pattern of the top three.  MGX and AGO released positive quarterly production reports and the share price rose.  Investors like rising iron ore prices on top of a falling Aussie dollar. 

Atlas Iron has a 2 year expected earnings growth forecast of over 100%. 

MGX has a ten year old operating mine at Tallering Peak, scheduled to cease operation in 2013.  The company is exploring for additional deposits around the site.  The Koolan Island mine has been in production since 1959 and still has about 68.9 million tonnes and 29.3 million tonnes in reserves at different ore quality levels.  The company’s third mine is its newest, Extension Hill at Mt. Gibson that began producing at the end of 2011.  

Unlike Mt Gibson, Atlas has substantial exploration projects underway – Horizon 1, 2, and 3.  The company has three mines in operation, Pardoo, Wodgina, and the Mt. Dove mine.  Despite the company reporting record quarterly sales in its latest production report, analysts are cautious.

Credit Suisse downgraded the stock from OUTPERFORM to NEUTRAL because water problems will shut down the Pardoo mine for 18 months.  JP Morgan also downgraded Atlas to NEUTRAL from OVERWEIGHT based on the shorter life expectancy at Pardoo and a market that’s increasingly averse to large-scale development projects. 

For contrarians, AGO has attractive valuations and is trading below book value. 

A recent research note from JP Morgan claims that last year’s disastrous price drop in iron ore is unlikely to be repeated; destocking of inventory that led to the September 2012 crash left Chinese port inventories too low.  As of July 2012 Chinese iron ore stocks at ports stood at 100 million tonnes and fell to 75 million tonnes by April 2013.  Morgan claims current iron ore stock in Chinese ports stands at 76 million tonnes.

Morgan cites a later than expected production increase date for Rio Tinto’s Pilbara 360 Project, delaying the “wall of supply” about which so many experts are concerned.  

The Metals and Mining Team at JP Morgan is also raising demand forecasts for Chinese steel production annualising at 800 million tonnes in the first half of this year.  The teams’ marginal cost analysis points to higher iron ore prices over an extended period.  While JP Morgan investment analysts do not agree, this Metals and Mining research team suggests their cost curve forecasting model indicates marginal cost of production will remain above US$125 per tonne CFR (cost and freight) China to 2015 and above $US100 to 2020:  The note ends with the statement: ‘Given a weakening A$, we believe the Australian producers are likely to be significant beneficiaries of stronger iron ore prices.’

Obviously not everyone agrees.  A commodities analyst at UBS reckons seasonality in Chinese steel production at Summer’s end (northern) could see the price of iron ore fall as low as $US70 per tonne by October. So there you go.

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