Lean, Mean, Mining Machines

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

By Greg Peel

In the process of open cut mining, as opposed to underground mining, “stripping costs” are incurred. Stripping refers to the removal of mine waste and overburden material to gain access to the ore deposit and occurs during mine development and often during ongoing operation. Prior to now, notes UBS, accounting guidelines with regard to stripping costs have been non-specific. Most companies capitalise the cost and then amortise over many years. Others expense the cost up front and include stripped waste in inventory.

The Australian Accounting Standards Board has now laid down specific requirements which must be met before stripping costs can be capitalised. AASB interpretation 20 also sets out guidelines for stripping cost calculation and the amortisation period. UBS suggests mining companies will be forced to expense the majority of stripping cost as a result, and a lack of a stripping ratio approach will mean the potential for significant volatility of cost of production. This will translate, UBS warns, into potentially highly variable earnings results in future reporting periods.

Costs have become the resource sector’s biggest burden. Between 2006 and 2011, BHP Billiton’s ((BHP)) coking coal costs, for example, rose 136%, notes Goldman Sachs. While one might expect such a trend to ring a few bells it didn’t, given the coking coal price rose 122% over the same period and BHP’s coking coal earnings rose from US$1.5bn to US$3bn. Goldman is forecasting BHP coking coal earnings of a mere US$338m for FY13. Prices have fallen, but costs have not. Goldman suggests “the boom-bust cycle in BHP’s coking coal division offers a classic case study in the impact that loose cost control has on the sector”.

That’s the bad news. The good news is, as Goldman adds, “we think it also highlights the opportunity for increased profit if cost and production inefficiencies can be addressed”.

Whether by the front door or by the trap door, two of the world’s biggest diversified resource companies, BHP and Rio Tinto ((RIO)), have both lost their CEOs this year. A common theme in their departure was over-extended mega-project investment or acquisition, leading to significant value write-downs worth billions. As is often the case, the two newbie CEOs have immediately shifted their companies into consolidation mode. Consolidation means improving productivity, reducing costs and offloading non-core assets.

One is reminded that asset sales and cost-cutting, such a staff cuts and store closures, became the popular response across the spectrum of Australian and global stock market sectors to the GFC. The overwhelming intention was to reduce debt, the cost of which had become unmanageable. At the time, stock analysts warned that such exercises could go either way, depending on the circumstances. Either the newly streamlined company would emerge a lean, mean fighting machine, or it would emerge a mere shadow of its former self, with much reduced earnings potential.

BHP, Rio and Australia’s largest pure-play iron ore miner, Fortescue Metals ((FMG)), are currently all undertaking such an exercise. Investors can feel relieved. Analysts agree the companies are set to emerge as much more efficient operations with more manageable debt levels which should lead to market re-ratings of stock prices.

BHP has launched an attack on its coal mining costs, but as Goldman Sachs notes the exercise is more about increasing production volume for the same cost, rather than reducing costs per se, resulting in lower cost per tonne of coal sold. By closing high-cost assets, increasing productivity from remaining assets, and delivering new asset volume growth, Goldman believes BHP can shift coking coal unit cost down from US$160/t in FY12 to US$120/t by FY16. Assuming a US$200/t coking coal price, earnings can rise to US$2.2bn in 2015.

So focused is BHP now on consolidation that last week the company’s CFO hosted a stock analysts’ forum to discuss the topic. Graham Kerr highlighted a rigorous cost cutting strategy and noted further asset sales are highly probable. The first aim is to prevent costs rising any further, and BHP has already done better than that, Kerr suggested.

BHP is no longer interested, for the time being, in exploration or M&A. Existing organic growth opportunities will be exploited instead. The bad news for mining employees who have come to enjoy a high-paid FIFO lifestyle is that 2750 roles have already been cut and more will follow. The bad news for mining service contractors, many of them popular listed names, is that new contract negotiations will now start at a point of 20% reduction. BHP is nevertheless yet to offer any forward looking cost reduction targets, JP Morgan notes.

Simplifying the company’s portfolio of assets is a key theme, although Kerr admits more challenged assets will probably see potential buyers staying away in droves. Divestments can be opportunistic given BHP’s debt levels are not stretched, and the easiest assets to sell will be those in the Petroleum division. There is clear third party interest, for example, in BHP’s share of the Browse LNG project.

While BHP’s balance sheet may not be stretched, Deutsche Bank cannot see the company reducing its debt levels for 12-18 months without asset sales, while Rio has recently been placed on negative credit watch by ratings agencies. Hence Deutsche suggests new management at both companies “will not be tied to optionality and will clear out non-core assets with little hesitation”. A search through the portfolios of each leaves the Deutsche analysts believing BHP could potentially reap US$25bn in sales, or 13% of the analysts’ net present value calculation, and Rio US$10bn, or 8% of NPV. Among each portfolio, suggests Deutsche, there just might be some “hidden gems”.

If BHP management could have its time again, it would have sold out of aluminium and nickel assets much faster, by its own admission. For Rio, not divesting quickly enough of the non-core assets that came with the substantial Alcan acquisition was also an oversight. Neither will dilly-dally any further, Deutsche believes, but rather they will start jettisoning a liquorice allsorts of operations and deposits, many of which were never going to be developed this decade. Given their long-datedness, the market is presently ascribing little or no value to these assets, and nor is Deutsche. That’s why some, for the right buyer, might prove to be hidden gems of unexpected added value for BHP on sale. Iron ore, copper and oil assets will be the easiest to divest, but the whole process could take 2-3 years, Deutsche warns.

JP Morgan came away from the aforementioned BHP analyst forum assuming that capital management does not appear likely in the near term. Deutsche’s conclusion with regard to planned production growth, cost cutting and asset sales for both BHP and Rio is that “the KEY benefit is our view is that the companies will move more quickly to the point where they can provide additional cash returns to their shareholders and this in turn will lead to a re-rating of the stocks”.

When the iron ore price suddenly crashed late last year, it seemed Australia’s pure-play iron ore producers could go from being high flyers to road-kill within the blink of an eye. This was even true for Australia’s third largest iron ore producer, Fortescue, given the company’s rapid production expansion program, the capex involved in pursuing such a program, and the debt carried to fund that capex. If it were 2007 and not 2012, Fortescue’s whopping 70% gearing and extreme leverage to iron ore prices (which collapsed in 2008, as debt costs blew out) would have ended the story. There was a lot of blood draining from Fortescue management faces last year when the spot iron ore price plunged from around US$150/t to just over US$86/t.

Fortescue’s capex cost should peak before mid-year. But management is not ready to suffer another iron ore price scare. The company now plans to sell down a stake in its port and rail infrastructure.

Modelling by Credit Suisse suggests Fortescue could receive $3.5bn for a 35% stake. CIMB is working off a base case of $3.5bn received before end-June. While selling a minority stake in these assets means Fortescue will pay more for port and rail tariffs, third party fees coming in and interest costs being reduced means such a sale will provide the company with a significant benefit, brokers suggest. Gearing can drop from 70% to 58% by end-June and 50% by end-2013, CIMB calculates. The company’s ultimate top-end gearing ratio of 40% could thus be met by mid-2014 rather than mid-2015 as was the previous goal. The net effect on production costs will not be significant, but such an asset sale could see FMG re-rated to “investment grade”, Credit Suisse suggests.

The announcement of a preferred bidder and the financial agreement for the minority stake will see FMG reassessed against investors’ previous expectations, says Credit Suisse.

Perhaps consolidation will prove the catalyst needed to arrest the current trend of mining sector share prices, Note the trajectory of the ASX materials sector index below (heavily influenced by BHP and Rio, and to a lesser extent FMG) and bear in mind the ASX 200 has done nothing but rise since November.

 

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