Weekly Broker Wrap: Digging The Oz Mining Space

This story features SILVER LAKE RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: SLR

By Andrew Nelson

Last week saw brokers take advantage of the lull between the run of quarterly production reporting and the onset of FY reporting that begins to heat up this week to focus on the domestic mining scene. The Diggers and Dealers conference captured a lot of attention, as did capex plans, the outlook for China, WA iron ore and a sector call from Macquarie.

This year marked the 20th anniversary of the Diggers & Dealers annual mining conference in Kalgoorlie, Western Australia. With so much of the Australian economic outlook hinging on the health of the materials and resources sector, this year’s conference was highly anticipated.

In the first day of its ongoing coverage of the event last week, JP Morgan noted the proceedings started with a “buzz” even before festivities had officially kicked off. What got tongues flapping was news that two local favourites, Silver Lake ((SLR)) and Integra ((IGR)), announced a hook up that has been expected for the past few years.

The broker thinks the deal will put the combined company amongst the top handful of Australian gold producers by production. In JP Morgan’s view, the move is a logical step that boasts numerous operational synergies.

There were a few other presentations of note over the course of the first day, with the broker especially interested in comments from Doray Minerals ((DRM)), which was highly discussed. The broker notes the company enjoys a high grade resource with short payback period for its initial development that should help self-fund further exploration.

The second day also featured sector consolidation talk, but many were more interested in Intrepid Mines ((IAU)) given the recent developments at its Tujuh Bakit mine that served as a timely reminder of the risks of foreign investment. The good news was the company is still confident it can sort out the situation in Indonesia, although if it gets as far as the courts, resolution could take several years.

JP Morgan heard quite a bit of note on the last day, with speakers ranging from emerging junior developers through to Tier 1 gold producers, with some quality iron ore stories to boot.

The broker notes the conference really took interest in Northern Star Resources ((NST)), a gold producer from the Paulsen’s mine. What was liked was a lean and mean cash flow focused management, which is turning an unloved asset around on the back of superior operational management and intelligent exploration. This is one to watch, says JP Morgan.

Western Areas ((WSA)) also held the broker’s attention, who notes the company’s low cost profile is shielding it from the current low nickel price. Although, the broker admits a rise in the nickel price will ultimately be required to turnaround market sentiment.

Atlas Iron ((AGO)) was also still looking good in the eyes of the broker, with balance sheet strength and a bullish view on the longer-term prospects on China supporting the stock. And while there was little in the way of new news from Fortescue ((FMG)), the broker still likes the risk reward trade off the stock offers.

Overall, the broker was pleasantly surprised by the mood. JP Morgan had expected a more sombre tone given the current market sentiment towards small to mid cap miners because of the macro issues in Europe and the slowdown in China. However, the broker notes the conference was more about resilience despite the challenges posed by tight funding, rising costs and volatile markets.

Citi had a slightly different take on the proceedings, noting the mood of this year’s event was one of cautiousness given the currently opaque outlook for commodities prices. Although, the broker admits there was a bit of bullishness about the supply implications of current commodity price weakness and uncertainty about the global economic outlook.

Cost inflation continues to be a much scrutinised factor, notes Citi, given labour and other input costs continue to rise, which erodes cash flows and competitive positions. Higher capex is needed to get projects into production, but it isn’t easily accomplished given the weak view on the outlook for commodity prices.

The broker notes the high AUD/USD isn’t helping matters as commodity prices in A$ terms are pressured, at the same time as the competitive position of domestic miners in USD terms erodes. Funding is becoming a real problem, with depressed equity prices making for some very unattractive prospects for funding any material component of capex with equity.

Citi is of the belief the macro concerns stemming from Europe and the read-through to growth in China and the currently very tight funding conditions are unlikely to improve in the near-term. Thus, investor sentiment for the sector will take some time to recover.

In the meantime, for those companies lucky enough to enjoy stable balance sheets and profitable operations generating steady free cash, M&A is moving to the front and centre as market uncertainty starts to generate attractive value. Citi believes this trend will likely continue as those able look to bolster growth, while those facing funding difficulties start heading to the negotiating table.

In summing up the conference, the broker notes investors and managers know well the all about the volatility of the sector, so the underlying tone has remained optimistic on the belief that market conditions are more likely to improve than deteriorate. “Grin and bear it,” says Citi.

In a separate note, Citi spells out its concerns about global mining capex, noting that with comments about moderating capex levels from majors like Rio Tinto ((RIO)), BHP Billiton and Brazil's Vale, mining capex is now at inflection point. This view underpins its cautious view on mining capex.

In a worst case and admittedly unlikely scenario, the broker notes that if global mining capex declined by 18%, implied group EPS cuts for mining equipment suppliers would range between 0%-23% , depending on the company. Now if mining capex were to come back to the 2010 and 2008 levels, EPS cuts could range between 6%-53%.

The broker’s current forecasts assume mining capex declines by 10% in 2013, with Citi noting the risks to consensus forecasts lie to the downside.

Citi has a few answers, at least on the macro prospects of China, after taking a trip out there last week. The broker notes the bulk of officials and experts it met with believe GDP growth in year-on-year terms had troughed and a mild rebound is likely in 2H. The broker estimates this will have to happen later in the half, as its own numbers a pointing to a flattish Q3.

Still, the broker expects further credit and fiscal policy supports in the months ahead and notes these should go a long way to stabilising the Chinese economy in 2H. Look for things such as increased loan quotas, drawdowns on the stabilisation fund, relaxed borrowing restrictions on local government and possibly property price restrictions and capital gain taxes if property prices advance faster than the GDP growth rate.

After rebalancing the economy for ongoing urbanization and financial reform, the broker thinks the longer-term GDP growth rate could be back to 9% in the medium-term.

JP Morgan noted some good news for WA iron ore exporters, with Port Hedland statistics continuing to show an upward trend in terms of the sizes of iron ore export ships using the port. The broker estimates that the average ship size is now at least 12% above what is used in the capacity calculation to work out allocations.

This means that allocated capacities could rise, which is a positive for both Fortescue and BHP Billiton, which may be able to save some money by delaying the Outer Harbour expansion in order to fully utilise actual harbour capacity.

Lastly, we look at Macquarie’s newfound belief the commodity boom is over. The broker reasons that the industrialisation of China has driven commodity prices to higher base levels over the past ten years or so. The same thing happened with Japan in the 1970s, the post WW2 boom in the late 1940s through the early 1950s and if you look way back, the 1915 to 1922 boom after WW1, notes the broker.

However, the end of the boom isn’t really bad news in the broker’s view, as firstly it doesn’t expect commodity prices to fall back where they were before the boom. In fact, Macquarie doesn’t see prices falling in real terms.

What the end of the boom will do is remove a major headache for the US, as it has exerted severe downward pressure on profit margins in sectors without pricing power, given raw material costs rise at a faster pace than consumer prices. Share prices thus perform poorly during the boom years as companies struggle to keep pace with the constant rise in input costs. This means earnings volatility.

In general terms, equities should begin to perform much better with the boom over, as operating conditions become much easier. This flows on to more dependable company earnings, which should in turn lead to PE expansion.

How to take advantage?

Macquarie suggests being overweight in net consumers of commodities. Looking at the US market, the broker would buy the SPDR S&P 50 and Homebuilder ETFs. Given the ongoing housing recovery combined with a strong USD, the broker likes domestic cyclicals.

 
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