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Aussie investors in iron ore stocks may be beginning to feel like the Bill Murray character in the US 1993 film, Groundhog Day.  In the movie, Murray wakes up to discover he has been condemned to live the events of the day over and over again.  

So here we go again with yet another round of collapsing stock prices preceded by “sneezes” in the Chinese economy and bottoming iron ore prices.  In early March of 2014 the iron ore price recorded its biggest fall in 18 months.  Here is a chart:

The drop to $US104.70 per tonne sent the benchmark price for iron ore for immediate delivery into official bear market levels.  In response, shares of BHP Billiton (BHP) fell 4.14%; Rio Tinto (RIO) dropped 5.76%; Fortescue Metals (FMG) slipped 9.39%; Atlas Iron (AGO) shares fell 10.14%; and shareholders of BC Iron (BCI) lost 8.18%.

While there are some new wrinkles in the rationale for the decline in the price of iron ore, they all lead back to the same place – Chinese demand for iron ore.  The latest explanations include a potential collapse in China’s “shadow banking” system that facilitates the flow of credit to non-SOE (State Owned Enterprises) in China.  Add to the mix the usual suspects of recent vintage; from the death of the mining boom to an oversupply of iron ore to a recently reported trade deficit in China to the never-ending catch all of “slowdown” in Chinese economic growth.

We have heard it all before, granting the exception of the shadow banking system.  Here is how the share price of two of our largest iron ore producers fared over the last five years, spanning the transition from boom to alleged bust:

Note the volatility but more importantly note the steep drop in the 2012 period when the price of iron ore crashed below US$100 per tonne, and the subsequent recovery as the doomsday predictions at that time did not come to pass.  Some would argue the demand for iron ore is cyclical and producers sometimes stock up for a variety of reasons.  In common sense language, if one has too much “stuff” on the shelves, one curtails buying the “stuff” and the price may fall.  The following chart showing Chinese steel inventory at port is worth noting:

Contrarian investors can find some solace in the recent statements made by global advisory and ratings agency, Fitch, offering the opinion Chinese steel demand is still strong, despite the current stocking oversupply.  The company stated a mix of “seasonal and one-off factors have clouded market conditions.”  Fitch points out current inventory levels are at a two-year high while the fundamentals supporting China’s commodity demands are still in place. The agency has “few concerns about the profitability of RIO, BHP, or FMG.”  Fitch bases its case on continued growth in Chinese steel demand through 2020; the eventual shutting of higher cost Chinese iron ore mines; and the lower cost production capabilities of Australian miners.  US investment bank Morgan Stanley chimed in on 17 March, offering the view that the “current price weakness represents a buying opportunity.”

The Fitch and Morgan Stanley comments preceded a 20 March report out of China that the government is planning to consolidate its highly fragmented network of iron ore miners into a mining giant conglomerate in order to reduce China’s current level of importing, at 70% of its needs.  While this is a potential cloud on the horizon, it’s expected to take some ten years to implement.  In addition it remains to be seen whether the current iron ore production cost in China of $US70 per tonne be driven low enough to compete with the $30 to $60 cost of imported ore.

Meanwhile back in Australia, some experts have focused solely on the “death” of the mining construction boom, but others point to a boom in production as past expansion projects begin to produce.  In a November 2013 report entitled Mining in Australia 2013 to 2028, industry analyst and economic forecaster BIS Shrapnel predicted iron ore mining production will grow 41% over the next five years.  The report notes the construction boom is over and iron ore miners have abandoned an “expand at any cost” mentality and are now focusing on lowering production costs.  

In the last several months, the majority of Australia’s top iron ore miners, including RIO, FMG, BC Iron, Mt Gibson Iron, and Atlas Iron have reported record production levels and lower cash operating costs.  Leaving the professionals aside for the moment, common sense suggests producing more at a lower cost provides protection against falling prices.  In addition, falling prices can stimulate demand leading to higher revenues.  Add to the mix the declining Australian dollar and one could make a strong case that lower cost iron ore miners can remain profitable at prices as low as $US90 or even $80 per tonne, as some are forecasting in the next few years.

With that in mind, let’s take a look at the top six ASX iron ore miners by market cap.  Here is the table, with one high risk speculative entry added for the punters.  

Company

(CODE)

Share Price

3 Month % Change

Dividend Yield

Forward P/E

2 Year Earnings Growth Forecast

5 Year Total Shareholder Return  (Average Annual Rate)

BHP Billiton

(BHP)

$35.20

-5%

3.67%

13.18

0.5%

5%

Rio Tinto

(RIO)

$60.80

-9%

3.51%

10.17

-14.9%

8.7%

Fortescue Metals

(FMG)

$4.90

-15%

3%

4.9

32.4%

15.6%

Atlas Iron

(AGO)

$0.925

-22%

3.24%

7.71

187.2%

-3.3%

Mt Gibson Iron

 (MGX)

$0.77

-24%

5.19%

9,62

11.7%

13.6%

BC Iron

(BCI)

$4.77

-7%

7.13%

5.68

13.2%

64.6%

Iron Ore Holdings

(IOH)

$1.02

+12%

44%

34.6%

 

In theory, the broader base of diversified operations should have protected BHP Billiton (BHP) shareholders better over these turbulent times, but the price of the other commodities BHP extracts, including copper and coal, has suffered along with iron ore.  In addition the company is investing heavily in a Canadian potash operation and has yet to realize major benefits from its entry into the US oil and gas sector.  However, income investors would no doubt like BHP’s dividend yield and its commitment to divest more assets to allow greater dividends for shareholders.  UBS reports the company has hired US investment bank Goldman Sachs to manage the sale of one its nickel producing assets.  Despite its very low cost of iron ore production – reported to be about $US45 per tonne – BHP will not benefit from more stable iron ore prices to the same degree as a pure iron ore play like Fortescue or a near pure play like Rio Tinto (which generates 90% of its earnings from iron ore).  Thomson/First Call lists no analysts with Underperform or Sell ratings on BHP, while four have Strong Buys, ten have Buy ratings, and five recommend holding the stock.  

Right now Rio Tinto (RIO) is the largest producer of iron ore in Australia with the lowest all-in production costs, reported to be $US43 per tonne.    With costs that low, Rio’s iron ore operations can remain profitable even if the price of iron ore drops to $US90 or even $US80 per tonne over the next two years.  Rio reported Full Year 2013 results in February, highlighted by a 26% decrease in capital expenditures, record production levels, and cost and debt reductions exceeding the company’s own forecasts.  Underlying net profit rose 10% and dividends increased 15%.  Analysts are also largely bullish on RIO, with Thomson/First Call showing 2 Strong Buys, 11 Buys, and 3 with Hold ratings. However, the Neutral ratings for both RIO and BHP include a recent downgrade from Citi, who expects the price of iron ore to drop to $US80 per tonne within two years.  The analyst believes the increased production and lower costs will not be offset by the drop in the price of the commodity.  Since the early March fall, the price of iron ore has rebounded slightly but the share price of RIO and Fortescue Metals could not keep pace with the rebound.  Here is a one month price chart for the two companies:

Fortescue Metals (FMG) – of the big three ASX players, Fortescue embarked on the costliest expansion program of all.  If you look back at our table, FMG has the best numbers of the three, with a Forward P/E of 4.9 and a 32.4% earnings forecast over the next two years.  What’s more, the company posted a very respectable average annual rate of total shareholder return of 15.6% over five years.  

In its recent rash of downgrades, Citi dropped FMG to Neutral while Deutsche Bank maintained a Sell rating following financial results based on ongoing concerns about the company’s debt levels.  However, the Half Year Results were stellar, with a 77% increase in revenue and a 259% increase in profit.  Dividends were stable with the company restating its commitment to raise dividend payout ratios to between 30% and 40%, an indication of management confidence in the future.  Analysts are impressed with Fortescue’s massive production increases and substantial reductions in debt, but unlike Rio and BHP, Fortescue’s break-even point is around $US72 per tonne.  Break-even includes not just cash operating costs, but all costs related to production, resulting in a figure that marks the point at which the company makes a profit at a given price.  Typically, iron ore miners report C1 cash operating costs, which can exclude a variety of expenditures from royalties to marketing to overhead.  UBS estimates a breakeven point of $US72 per tonne for FMG.

Atlas Iron (AGO) operates in the iron ore rich Pilbara region of Western Australia, where over 40% of seaborne Australian iron ore originates.  Atlas is nearing the end of an ambitious expansion program designed to make the company more competitive with the big three of BHP, RIO, and FMG that dominate the region.  The company reported Half Year Results in February, which boasted a 104% increase in revenue as well as a swing from a loss in the first half of last year to a net profit after tax of $61 million.  Atlas shipped a record 5.1 Metric Tonnes, with 53% of that coming from the company’s newer mines.  The company’s capital expenditures are dropping as its Horizon expansion project is expected to begin producing iron ore in mid-year.  As you can see from the table, analysts are anticipating substantial earnings growth over the next two years, even more in five years, as evidenced by the five year expected P/EG of only 0.11.  Yet the UBS estimate of Atlas Iron’s breakeven point is $US82 per tonne, far higher than the reported cash costs of about $US50 per tonne which is limited to the actual cost of extraction.  The higher all-in costs make the company more susceptible to steep drops in the price of iron ore.  

Mt Gibson Iron (MGX) reported Full Year 2013 Results back in August of 2013, prompting BA-Merrill Lynch to maintain an Underperform rating due to the lower achieved iron ore price resulting from the company’s sales of more low-grade ore.  In February 2014 Mt Gibson reported Half Year 2014 Results and major broking houses at Credit Suisse, Deutsche Bank, JP Morgan, and Macquarie all pointed to the same issues plaguing Full Year Results – lower achieved pricing due to lower grade ore.  In addition, Mt Gibson has a new chairman, coming from the company’s largest shareholder.  MGX has expansion projects coming into production and has a strong balance sheet.  However, the company elected not to pay a dividend for the Half Year, disappointing brokers.

Smaller rival BC Iron (BCI) also disappointed brokers with a lower than expected dividend payout ratio and lowered forward dividend guidance; this despite a relatively strong balance sheet with cash of $196.7M and debt of $65.6M as of the most recent quarter.  This appears to have overshadowed what was otherwise an impressive report, with a net profit increase of 813% over the Half Year Results reported a year ago.  The company also had record revenue for the period, up 186%.  Management attributed the strong result to solid iron ore prices for the reporting period along with the declining Aussie dollar.  Cautious investors will take note that the price of iron ore over the coming months may not be as solid.  In addition, the company reported Cash Operating Costs for the period of about $US37 per tonne.  The breakeven point calculated by UBS is $US70 per tonne.  BC Iron has a joint venture with Fortescue in Australia and an additional J/V in Brazil.  BCI was added to the ASX 200 in December of 2013 and the share price is up around 40% year over year.  Here is the chart:

Over five years, the company has rewarded its shareholders handsomely, with a 64.6% average annual rate of total shareholder return (dividends plus share price appreciation.)  The stock price has risen 1000% over five years.

Punters may want to take a look at Iron Ore Holdings Ltd (IOH), a junior miner with a market cap of only $16.4 million.  The company has promising prospects in the West Pilbara region.  The share price has risen and sputtered with announcements of promising discoveries over the last ten years.  The share price was around $2.50 back in 2006 and again in 2010.  Here is a ten year chart for this high risk speculative play:

The most recent uptick began in August of 2013 when the company announced that the Western Australia Department of Mines and Petroleum (DMP) had approved Iron Ore Holding’s proposal for its Iron Valley Project in the Central Pilbara.  The share price has risen from $0.71 on 01 August 2013 to its current price of $1.02.  Iron Ore Holdings expects the project to begin production in 2015, operated by ASX mining services provider Mineral Resources (MIN).

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