Join Rudi’s Journey: Boom Here, Gloom There

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"The Super Cycle will lead to Super Losses for many investors in Australia"
(statement first made in mid-2008)

By Rudi Filapek-Vandyck, Editor FNArena

I continue to be amazed by how (most) commentators and stockbrokers in Australia continue to cling on to their beloved Resources Super Cycle theme when asked about where investors should park their investment funds. Don't get me wrong: I am all-in for leveraging off the capex boom that has started to dominate the Australian economy, but explicitly not in the "let's stick with what did not work in the years past"-way of doing this.

Pick and shovel service providers to miners and the energy sector are currently in the early stages of a once-in-a-generation boom time. However, the companies that are financing these truly unprecedented expenditures are NOT.

Investors who fail to understand this difference (a la the commentators and stockbrokers I referred to earlier) are setting themselves up for serious disappointment.

The first group is experiencing a boom, the second group will see more gloom in the months ahead.

This is why shares in the world's largest mining company, BHP Billiton ((BHP)), in price today unchanged from July 2009 (!) and trading on an implied dividend yield of circa 3%, are still not a good Buy opportunity. As far as Rio Tinto ((RIO)) is concerned, things could get quite ugly in the months ahead. Rio Tinto's share price, by the way, is today around the levels of April-June 2009 which means, yes, they doubled since the trough from November 2008, but loyal shareholders have barely benefited from the rally off the March lows for the Australian share market in general. Rio Tinto is expected to pay out a measly 2.3% to shareholders this year, and this is after lifting its dividends incrementally over the years.

So what's happening to Australian miners? Why is all this talk about "elevated prices" and "continued high demand from China" and a "once-in-a-generation lift to Australia's terms of trade" not translating into a genuine boom for loyal shareholders?

In short: margin pressure.

Last year I warned investors the internal dynamics for the mining industry were turning for the worse. Post the February reporting season, things are only getting worse still. That's not just my opinion. Analysts at Macquarie this morning suggested in a comment on the outlook for corporate earnings in Australia, they expect the broad, average earnings per share (EPS) for fiscal 2012 to decline to minus 5% between now and August (from +3% now), but for BHP Billiton they predict market downgrades won't stop until EPS sits at 20% below last year's comparable figure. At least.

The latter two words are not mine. Macquarie analysts are truly suggesting the minus 20% negative growth projection for Australia's largest index contributor is likely to be exceeded to the downside. FNArena's up-to-date consensus calculations show the market is now anticipating BHP's EPS will fall by 10% this year, so if Macquarie is correct, there's a whole lot in downgrades yet to come through.

Citi analysts in London are not as negative as Macquarie, but they still believe there's probably another 7% in EPS downgrades coming for BHP this financial year.

It doesn't matter whether these calculations are accurate or not. Bottom line is the pressure is firmly to the downside for miners in Australia and as market forecasts are being adjusted downwards, Price-Earnings ratios will look a lot less attractive.

Contrary to general perception, mining companies in Australia are not detached from the factors that are causing pain and grief in most other parts of the Australian economy. The difference is that miners are experiencing these negative factors in a different manner. For shareholders with a longer term horizon, however, it'll still translate into more pain first, before any genuine prospect can emerge of (finally) some gains.

The four main factors keeping the pressure firmly to the downside for miners' profit margins are:

– the strong AUD
– high oil price
– tight labour market
– below par global growth

In some cases there's the added pressure of large investments being made in large projects for which cost overruns continue to occur. In other cases there's also some additional weather impact on operations.

Under all circumstances the lack of ongoing rises for commodity prices does not imply mining companies are standing still. With the Australian dollar now also supported by international yield-hungry funds managers and crude oil pricing in a risk-premium from potential Middle Eastern escalation, the pressure is on for the miners. Why else do you think we're increasingly reading about loss-making operations being closed?

What investors casually tend to forget is that mining operations are big users of diesel. A diversified giant such as BHP Billiton has an in-built hedge because of its energy division that today represents about 25% of group profits, but that still leaves 75% of remaining profits suffering from high oil input prices.

Let's shift the focus to Rio Tinto for a moment: practically all iron ore and no built-in hedge. Those aforementioned analysts at Citi believe Rio Tinto's profits for shareholders for the year to December could well fall by 30% or more. Again, this will make the current share price a lot less attractive than it might appear. According to FNArena's consensus calculations, current market expectations are for a fall in EPS to the tune of -3% only.

The irony of all this is that companies in the sector that have as yet no earnings will feel no impact from any of this at all. Yes, that is a hint about which companies will outperform in the sector in the months ahead.

To properly understand the key difference between miners and their service providers one has to travel back to the period 2003-2007 when the same factors were in play, yet margins and share prices went through the roof. This is what happens when companies are experiencing a boom; all the headwinds merely impact on the fringes. However, when the boom is no more, these headwinds become serious obstacles. Just ask retailers, media companies, banks and insurers.

Now you also know as to why the outlook remains very different for the service providers. Their problem will come in 2-3 years' time, when the big flood in work flow has been awarded and costs become the ever so annoying problem.

For now, however, the risks remain in most cases to the upside. Earnings estimates will continuously increase, similar as to what happened for miners and the Australian share market in general between 2003-2007.

This realisation is gradually kicking in across the industry. List of Top Picks and Conviction Buys at major stockbrokers are increasingly populated with names such as Boart Longyear ((BLY)), Cardno ((CDD)) and NRW Holdings ((NWH)).

The stockbroking industry does not move fast, though, and that is a grave understatement. Monadelphous ((MND)), not only the best performer in this sector for years but also the best stock to own in the Australian share market over the past decade, is still only covered by five out of eight stockbrokers FNArena monitors daily. Most other companies in the sector, with exception of some large caps such as Leighton ((LEI)) and Adelaide Brighton ((ABC)), are still sparsely covered today. I do know many a second-tier stockbroker is ramping up coverage of these stocks and no doubt the larger players are making similar preparations.

I couldn't help but notice Monadelphous' share price has now fallen back to circa $22, which puts the PE at 16.7 and the implied dividend yield at 5.1%, fully franked. This is why corrections in the share market serve a specific purpose: they allow investors to get in solid, high quality growth stocks with a healthy dividend that otherwise would remain too expensive.

Those among you that do use the current share market correction as a buying opportunity, I do hope you're looking in the correct direction (while avoiding the wrong ones).

In broad terms, and in line with my views developed since late 2007, I maintain the three key success themes for long term equity investment portfolios are:

– solid dividends
– "all-weather performers"
– growth companies leveraged to the boom in capex from miners and energy companies

For more information: see e-booklet "The Big De-Rating. A Guide Through The Minefields" (available to paying subscribers only – if you don't have your copy as yet, send an email to info@fnarena.com)

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website. 

P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

 

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