FYI | Apr 18 2007
Sometimes being right only gives you half the satisfaction.
While the bulls are ruling once again in the commodities sector, a general view is again creeping into the market that most securities analysts will have to start increasing their product price forecasts for the year. This will lead to higher earnings forecasts for the likes of Rio Tinto (RIO) and BHP Billiton (BHP).
So far the trend of earnings estimates in 2007 has been negative for the sector as higher costs, production losses and a stronger Australian currency have been incorporated into the various earnings forecast models at stockbrokers.
The fact that earnings forecasts have been trending down at a time when prices for crude oil, copper, uranium, nickel and molybdenum (to name just a few) are once again trading at a significant premium to most experts’ forecasts is quite ironic. Unless you are a shareholder of BHP Billiton and you’re desperately waiting for the stock to move to the mid-$30s (every bull will agree that’s where they should be on historical guidance).
But what if we won’t see BHP Billiton trading at $35 anytime soon?
A few weeks ago I suggested that investors had started to zoom in on lower prices for most commodities. Ultimately, history shows, the supply response kicks in and prices fall to much lower levels. I believed it was this change of market focus that would prevent shares of Rio Tinto, BHP Billiton and others to reach their full capacity again in the foreseeable future – regardless of whether the conservatives and the bears would be proven wrong again.
This week I find myself in good company as the resources team at Smith Barney Citigroup has effectively come to the same conclusion.
The team at Citigroup uses more sophisticated measurements and indicators, such as an inverted yield on the US bond market, to come to the conclusion that the whole sector has fallen victim to a gradual de-rating since May last year. The team also thinks this process is unlikely to change anytime soon.
So while most securities analysts are likely to be forced to start increasing their price assumptions in due course again (Citigroup firmly believes this is going to occur) this will no longer provide the sector with the same share price boost as it did in the pre-May 2006 era..
To prove they truly believe in the conclusions of their analysis, the team has downgraded BHP Billiton and Anglo American to a Hold rating. In BHP’s case this downgrade comes with a reduced twelve month price target: to $33 from $36.
The message seems clear: investors in large diversified commodities companies are not going to push up prices to the max anymore.
So where to from here?
Citigroup believes investor focus has already shifted to what each company can and will do in terms of financial management. This implies that the direct share price prospects of companies such as CVRD, Xstrata and the three names mentioned previously will be dependent on announcements of share buybacks, special dividends, acquisitions and divestments.
In Australia, BHP could well decide to separate its oil and gas division, the analysts argue, and create extra value while doing so. For Rio Tinto a divestment of the Industrial Minerals business seems the logical way to go.
According to the report, the large diversifieds will find it tough to keep up with smaller, more focused companies in the sector. A trend that has already become apparent over the past few months.
One of the reasons for this, says Citigroup, is because mid- and small-cap players in the sector have received a potential takeover premium, while companies such as BHP Billiton, even though not very active as a predator so far, have not received such a re-rating (despite speculation that private equity would not necessarily shy away from such an opportunity).
Another reason would be, of course, because the differences between the various commodities are becoming more pronounced with the supply response developing faster in some sectors than others. Buying Rio Tinto for its iron ore exposure, for instance, also implies one has to take on board the relatively underperforming industrial minerals portfolio.
All this comes at a time when it begins to dawn to most experts that the long anticipated supply response will come at a more gradual and slower pace than previously anticipated. The reason for this is meticulously dissected and explained in the Citigroup report, but can be easily summarised as: higher costs are increasingly a problem.
Investors usually require a so-called internal rate of return of at least 15%. Citigroup’s analysis shows this has become increasingly difficult to achieve on the basis of long term price assumption and with costs creeping up steadfastly.
It is a theme that featured prominently in Deutsche Bank’s recent reports on the iron ore industry as well (see Weekly Analysis this week: Iron ore – the silent achiever).
The problem is, as we’ve pointed out already a few times in some of our uranium stories, most of these long term price projections seem arguably archaic and out of time. The Citigroup report offers that due to higher costs miners nowadays simply require higher prices for their products (BHP for instance believes that some marginal producers of iron ore will be squeezed out of the market once prices start to drop).
But as we have observed over the past few years, only a small number of resources experts have taken the step of increasing their long term price assumptions.
This doesn’t mean that the industry has adopted the same approach. But what this does mean is that not every developer with an inferred resource under its tenement will successfully make the transformation to becoming a fully operational miner.
It is my best guess that once spot prices will start plateauing, and that moment should not be too far away, many a small cap explorer will find it increasingly difficult to keep the enthusiasm among its many shareholders alive.
Till next week!
Your not too keen on reaching plateaus myself editor,
Rudi Filapek-Vandyck
(As always supported by the Fabulous Three: Terry, Greg and Chris)