Material Matters: Post-Result Views And Outlooks

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– Brokers review sector preferences and conviction ideas
– Nickel price forecasts lowered, sector earnings impacted
– Project costs and risk mitigation key factors in energy sector
– Weakening IP numbers a threat to commodity prices

By Chris Shaw

With Australian profit reporting season over more and more brokers are conducting sector reviews, Credit Suisse among them in re-assessing gold stocks under its coverage.

The most common theme from reporting season according to Credit Suisse was an increase in cost pressures, primarily from labour and fuel. One surprise has been a lack of share price moves in the gold space despite the physical metal trading around US$1,900 per ounce.

Post reporting season Credit Suisse has gone through its preferred plays in each part of the Australian gold market, retaining Newcrest ((NCM)) as an Outperform pick on valuation grounds. This reflects continued underperformance relative to the gold price and other listed Australian gold stocks year-to-date. 

Elsewhere among the producers, Credit Suisse retains an Underperform rating on Alacer ((AQG)). The call is a valuation one as post result forecasts have been adjusted to reflect higher costs but unchanged production guidance.

Among emerging producers, Perseus ((PRU)) continues to be rated as Outperform by Credit Suisse, the profit result being of little significance given the focus is on a ramp-up of operations at the CAGP project in Ghana. The attraction with Perseus is leverage to upside from further exploration success, with potential for this to come from operations in both Ghana and Cote D'Ivoire.

In the explorer portion of the market Credit Suisse continues to rate Gryphon Minerals ((GRY)) as Outperform, partly as a result of positive parameters released for a proposed mine at the Banfora gold project. The project has the potential to grow in size, Credit Suisse noting there is scope for a resource of between 2.5-3.5 million ounces by the end of the year. 

Also supportive of the Outperform rating is the fact Gryphon is trading well below the broker's valuation and price target of $2.15. This implies solid value, especially given this valuation is based on conservative assumptions.

Kula Gold ((KGD)) is also rated as Outperform among the exploration stocks, Credit Suisse remaining of the view there is good potential for a resource upgrade towards the end of this year as exploration activity continues.

Citi has been similarly active but with respect to the nickel sector, adjusting earnings for both Mirabela Nickel ((MBN)) and Western Areas ((WSA)) to reflect changes to nickel price forecasts. Short and medium-term nickel price estimates have been cut by 11% in 2011 to US$10.73 per pound and in 2012 by 23% to US$9.50 per pound, this given Citi expects the nickel market will move from a balanced position this year to a modest surplus in 2012.

The impact with respect to earnings for both Mirabela and Western Areas is significant, as 2011 profit for the former falls 70% to US$20 million and for the latter by around 40% to $77 million. As Citi notes, consensus forecasts for 2011 for Mirabela stand at US$50 million and for Western Areas at $105 million.

The changes don't impact on Citi's Buy rating for Mirabela, which is based on both production and earnings growth potential. Target has been adjusted though, falling to $2.20 from $2.60. Mirabela is preferred to Western Areas, which Citi has downgraded to Hold from Buy. Target for Western Areas falls to $5.90 from $7.20.

Goldman Sachs has turned its focus to the energy sector, taking the view reporting season has shown the core focus remains LNG project costs and risk mitigation. Cost pressures are increasingly an issue, especially as declining production magnifies the impact on a per unit basis.

Projects in Western Australia face the most risk from a skills shortage and remoteness perspective, while guidance from Oil Search ((OSH)) suggests potential to make up time and costs where the project is currently behind schedule.

Near-term, Goldman Sachs notes base oil and gas production is falling as a portion of energy sector valuations as LNG growth projects will become increasingly important as more capex is sunk into these developments.

Goldman Sachs notes there are signs of some unit cost pressures for both Woodside ((WPL)) and Oil Search, the former due to planned maintenance, weather and production declines and the latter the result of currency movements and higher royalties and levies.

Given all the major energy stocks are developing large, capital intensive LNG projects, equity raisings in the sector are expected to continue. Goldman Sachs cautions value dilution from moves such as underwritten dividend reinvestment plans could become meaningful going forward.

In terms of ratings, Goldman Sachs continues to rate Woodside as a Buy and the preferred sector exposure. Oil Search has been upgraded to Buy given improved value following recent share price weakness, while Santos ((STO)), Origin Energy ((ORG)) and Caltex ((CTX)) all score Hold ratings.

Factoring in not only reporting season but the recent pullback in equity markets in general, RBS Australia suggests there is now significant value in the mining sector. The preference is for the upper end of the quality curve, with RBS suggesting the highly leveraged plays are best avoided.

The reason for such an approach is there remains uncertainty with respect to the macroeconomic growth outlook and high levels of volatility in markets in general. This is causing investors to take a more cautious approach.

In such an environment, RBS prefers the mineral sands sector and bulks. While noting gold continues to outperform as a commodity RBS cautions gold stocks under coverage are now trading at high multiples, implying gold prices beyond what are currently forecast.

The top 10 conviction ideas for RBS include a Buy on Iluka Resources ((ILU)) given an expected move to a net cash position this year, which means scope for a special dividend. As well the stock offers value on RBS's numbers given a current 11% discount to net present value and an attractive earnings multiple.

Fortescue Metals ((FMG)) is also a conviction Buy as RBS suggests the market continues to place a large discount on production expansion plans. As projects move from concept to reality, RBS expects the stock will re-rate significantly. Continued strong iron ore prices add to the investment equation in the broker's view.

Atlas Iron ((AGO)) is another conviction Buy rating, RBS noting management has developed a good track record with respect to operational performance in building a six million tonne per year producer in a relatively short timeframe. Also attractive are a solid growth outlook and a strong port position.

Rio Tinto ((RIO)) is also a Buy for RBS, as even though sovereign debt and Chinese growth issues may act as shorter-term headwinds for the sector, Rio Tinto is generating record cash flows, has aggressive organic expansion plans and offers significant production growth potential.

Oz Minerals ((OZL)) is currently unloved by the market but remains a Buy for RBS as there is potential from around $750 million still to be spent on M&A options. Oz Minerals offers relatively low-risk copper production, high margins, a strong balance sheet and an attractive valuation in the view of RBS.

Alumina ((AWC)) is also a Buy given the company is well capitalised and has finished capex spending on growth plans. Valuation and dividend yield are attractive and RBS notes the company offers exposure to a suite of refineries well positioned on the cost curve.

While Independence Gold ((IGO)) is trading on a multiple near 20 times in FY12, RBS expects this will fall to around five times by 2014 as new projects come online while a strong track record of over-delivering on expectations is a further positive. On RBS's numbers Independence is trading at a 26% discount to net present value, which justifies a Buy rating in the broker's view.

On the Sell side RBS continues to include Energy Resources of Australia ((ERA)) given ongoing uncertainty with respect to the Ranger 3 Deeps project and the possibility of no mine lease extension resulting in significant rehabilitation costs. No Ranger 3 Deeps project would leave ERA looking expensive in RBS's view.

OM Holdings ((OMH)) is expected to struggle given high manganese inventories will continue to depress prices, while there are also some corporate issues adding investment complexity according to RBS. With the stock trading 11% above net present value on RBS's numbers, a Sell rating is retained.

The final conviction Sell for RBS is Aquila Resources ((AQA)), which needs to raise $3 billion for its 50% share of the West Pilbara project. The current volatile environment is likely to make raising this sum difficult, this risk underpinning RBS's negative view on the stock.

In a broad comment for the resources sector, Morgan Stanley notes the August reading for the Global Manufacturing Purchasing Managers Index (PMI) came in at 50.1 the lowest reading since the start of the cyclical recovery from the GFC began in June of 2009. 

In Morgan Stanley's view this level highlights a clear risk to the sustainability of expansion in the global industrial production cycle. While this is worrying there is not enough evidence to suggest a recession will eventuate, though Morgan Stanley continues to suggest investors should be selective in exposures to the base metal and bulk commodity space.

For Morgan Stanley the preference remains copper and iron ore, while gold continues to be viewed as a safe haven asset.

A final word on the bulk commodity sector comes from Credit Suisse, which cautions there is some scope for iron ore market turmoil shorter-term as the Indian monsoon season comes to an end. This reflects the potential for the market to remain short of ore, especially given Asian market activity is now showing signs of picking up.

Credit Suisse continues to recommend staying long the bulks of iron ore, thermal coal and metallurgical coal given ongoing structural tightness in the Asian market.

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