Lower equity prices could make miners attractive – Jefferies

Equities in the UK-listed mining sector could become more attractive from a value perspective after a long period of underperformance, analysts at Jefferies said in a note on Wednesday June 5.

Equities in the UK-listed mining sector could become more attractive from a value perspective after a long period of underperformance, analysts at Jefferies said in a note on Wednesday June 5.

“These equities have been affected by the relatively weak macro environment and negative sentiment towards the sector,” they said.

“While we may not be in deep value territory yet, we foresee at least 15% upside to share prices of BHP Billiton, Rio Tinto, Glencore Xstrata and First Quantum over the next year.”

After a longstanding bull market, the macro environment has been challenging for miners, according to the analysts, as slow global growth and an acceleration of supply growth of some key commodities led to a period of balanced markets and marginal cost-based commodity prices.

“High capex spending and lower commodity prices should imply limited free cash flow for the sector before 2015,” they said.

“But share prices already reflect a weak outlook – while the consensus earnings downgrade cycle for the UK-listed miners has further to go, the sector has underperformed the broader equity markets over the past two years and is already discounting a weak fundamental outlook.”

Even if commodity prices are not likely to be supportive for mining share prices in the near-term, they added, it is possible that some opportunities have emerged that could be significant for investors in the longer-term.

For example, price-to-book (PB) ratios at miners such as Anglo American, BHP Billiton and Rio Tinto are very low compared with historic levels.

“However, we would attribute these low PB ratios to a combination of lower returns on equity over the past two years and significant increases in book value over the past decade,” the analysts added.

“We are therefore not convinced that these low PB ratios alone fully support the argument that these miners are trading at very inexpensive valuations.”

Instead, they said, the PB ratios might be consistent with what the market should expect from a sector coming to the end of a prolonged bull market.

“We continue to recommend that investors buy shares of BHP Billiton, Rio Tinto, Glencore Xstrata and First Quantum,” the analysts said.

“In the case of BHP and Rio, returns on equity should be reasonably high even in a lower commodity price environment, operating risk is low, geopolitical risk is low, and valuations are inexpensive.”

In the case of Glencore Xstrata, they added, upside brought about by the merger, free cash flow growth, and dividend growth should be supportive of the share price.

Finally, First Quantum shareholders should see some benefit, as the company continues its programme of large organic growth in copper – one of the analysts’ preferred commodities in the long-term.

“Unfortunately for the mining industry, [however], the macroeconomic environment has deteriorated for the sector over the past two years,” the analysts said.

Chinese growth slowdown
“Chinese economic growth is decelerating as China’s economy is on the verge of transitioning from an investment-driven to a consumer-driven model, and a still-sluggish US economic growth recovery is, perhaps by default, one of the most positive dynamics of the global economic landscape.”

Furthermore, a wave of supply growth following major investment spending in new projects is finally emerging, and could lead to a long period of comfortably supplied markets.

In a balanced market, the analysts said, commodity prices ought to be a function of their marginal cost of production.

“Based on our analysis, most commodity markets have already balanced and prices for most commodities already reflect their marginal cost,” they said.

“In other words, the normalisation process in many commodity markets is already in advanced stages.”

There is a risk, they added, that cost curves will flatten because of cyclical cost deflation in the mining industry.

The strengthening of the US dollar against resource currencies such as the South African rand and the Australian dollar could also lead to flatter cost curves, reduced marginal costs of production, and therefore falling commodity prices, according to the analysts.

“The stronger US dollar versus currencies of commodity importing regions such as Japan and Europe is also a negative for demand as it leads to higher domestic prices for commodities when translated to domestic currencies,” they said.

“All things considered, we are neutral on the outlook for prices of most commodities, although we do see potential for copper prices to significantly increase mid-decade because of a renewed period of serious supply constraints.”

They believe, furthermore, that miners with high operating costs, operating risk and geopolitical risk are the most likely to be “value traps” as they will struggle to create free cash flow.

Without free cash flow, they will find it harder to reward their shareholders with improved dividends or share repurchases, the analysts said.

“If commodity prices do not go higher, shares of these higher-risk miners are likely to underperform, even if they may appear to be cheap based on conventional valuation metrics,” they said.

On the other hand, those with low operating costs, operating risk and geopolitical risk could be in deep value territory if their valuations remain cheap.

“Shares of BHP Billiton and Rio Tinto, for instance, may qualify as deep value,” the analysts said.

“Overall, we do not see any significant valuation anomalies within the sector, and we conclude that mining equities are relatively attractively valued but not compelling at current prices.”

Claire Hack
Twitter: @clairehack_mb

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