Material Matters: Re-Rating, Sustaining Capex And Chinese Demand

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-Earnings recovery in Indonesian coal
-Better outlook for aluminium stocks
-Gold support emerging?
-China still main game in industrial metals
 

By Eva Brocklehurst

Is it time for a cyclical re-rating of resources stocks? CIMB suspects it might be. Not so much in the case of the big miners – BHP Billiton ((BHP)) and Rio Tinto ((RIO)) – for which the broker expects earnings growth will come from cost reductions more than from top line growth. An earnings recovery is considered most likely in the Indonesian coal miners. The broker thinks Indonesian coal will be a supportive factor for the market this year, as cost reductions finally slow down production growth. The broker recommends investors be Overweight in Asian resource stocks, ex Japan. CIMB's top pick of Indonesia's coal miners is Adaro Energy.

The broker is also expecting low aluminium prices to continue forcing the closure of uneconomic western capacity. This should also lead to a slower build up in new aluminium capacity in China. Coupled with the recent ban on Indonesian bauxite exports, this should support the aluminium price over the next 12 months. CIMB thinks this is favourable for Alumina ((AWC)), and the broker also likes India's National Aluminium Co and Hindalco Industries.

The gold price has recently held on the top side of US$1,200/oz and the broker suspects there may be some support emerging here. In that context, gold equities are considered severely oversold. Newcrest Mining ((NCM)) is CIMB's preferred sector exposure.

Goldman Sachs has also looked at the focus of the big two diversified miners, as both BHP and Rio Tinto wind down capital growth and pay more attention to sustaining capital expenditure. The broker notes the squeeze on capex is unprecedented in recent history, given the quantum of capital spent over the "super cycle" of 2004-2012. Having analysed 30 years of historical data, Goldman has found that long-term capex assumptions have been too low. This analysis does not change the investment theme but does reduce the broker's absolute valuation level. Given the reliance on net present value (NPV) for valuation in the Australian market, long-term capex assumptions and depreciation figures are considered extremely important.

For BHP, sustaining capex is calculated at US$6 billion and Goldman's estimates have been lifted, having previously modelled US$3.5-4bn. The broker has reduced its 12-month target price to $40.00 from $42.00. With Rio Tinto the sustaining capex spend is calculated at US$5bn per annum, slightly above prior forecasts of US$4.5bn. The stock's share price target has also been reduced by $2.00, to $65.00. BHP remains the broker's preferred resources exposure with a Buy rating, because of its quality and diversity as well as the energy exposure. Rio Tinto remains on a Neutral rating.

For resources, 2014 is still the Year of China. Macquarie expects a slowdown in the contribution to demand growth in the ex-China emerging markets in the first half of this year. This will combine with the effect of the credit squeeze in China to provide some headwinds. Still, for many of the industrial metals, China accounts for most of the demand growth as manufacturing continues its inexorable march from the western world to the east. Macquarie offers a few statistics to show just how significant this is. China's share of global consumption has grown to over 40% of all industrial metals. China's recent process of restricting loan growth may hamper real commodity demand but this is not making much of an inroad into absolute demand growth, in Macquarie's opinion.

The direction of other emerging markets does matter but they, in total, still amount to less than half China's contribution to global demand for the majority of industrial metals.Where other emerging markets have most impact is in aluminium, copper and thermal coal, Emerging markets ex-China account for 20% of global demand and any prolonged reversal could challenge fundamental expectations, in Macquarie's opinion. The broker observes that steel is the most emerging market-focused of the industrial metals, not surprisingly, and is most at risk of a pull back if construction cycles weaken. These emerging markets ex China account for 41% of Macquarie's expected steel consumption growth this year. Macquarie emphasises that this is not a non-growth story. Emerging markets are still growing. It's just the pace that's slowing.
 

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