Material Matters: Weak Iron Ore Prices, Resource Sector Models Updated

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

 – Weak iron ore prices pressuring margins
 – Would impact on earnings and valuations if maintained
 – Goldman Sachs reviews resource stock models

By Chris Shaw

Since mid June iron ore prices have fallen 35% to US$93 per tonne for 62% fines, a decline UBS notes is exposing the margins of all Australian producers. The greatest tightening in margins has been for the junior producers, UBS noting the likes of BHP Billiton ((BHP)) and Rio Tinto ((RIO)) are less vulnerable given better ore quality and lower unit costs.

[Note: Since the UBS analysts wrote their report, prices have fallen to below US$90/t.]

An important point in assessing margins according to UBS is the fact benchmark prices cannot be compared with cost guidance from producers. As an example, the current spot price for iron ore of US$93 per tonne would equate to a price received by Fortescue ((FMG)) of around US$66 per tonne, which is just above the group's cost base of around US$57 per tonne post royalty.

Based on its analysis, UBS suggests the likes of Atlas Iron ((AGO)), Grange Resources ((GRR)) and Mount Gibson ((MGX)) are currently operating at negative EBIT (earnings before interest and tax) margins, as detailed in the table below:

Short-term UBS sees further downside risk to iron ore prices given a buyer's strike and the fact marginal cost supply cuts take some time to flow through to the market. By the final quarter this year UBS expects spot fines prices should return to levels above US$125 per tonne.

Macquarie agrees current iron ore spot prices suggest significant cuts to earnings expectations for Australian producers. This reflects not only the weaker iron ore price, but an increase in unit operating costs of around 60% in the Pilbara since iron ore prices were last at current levels in 2009. 

Over the same period, the Australian dollar has appreciated against the US dollar by around 15%, further squeezing Australian producers. This leads Macquarie to suggest the current spot iron ore price of around US$90 per tonne equates to a price of around US$53 per tonne under 2009 conditions. 

If it was assumed current commodity prices remain for the next 12-18 months, which is not the view of Macquarie, the likes of BHP and Rio Tinto could see cuts to earnings of 50% to 80% respectively in 2013 given Macquarie's base case iron ore price forecast for next year stands at US$169 per tonne.

If earnings fell by such an extent earnings multiples would increase significantly for both stocks, the one-year forward multiple for BHP increasing to around 22 times from 11 times now. Rio Tinto is more exposed to iron ore and would see a larger increase in multiple to around 37 times in 2013 from seven times now.

Such an earnings impact would also become apparent in valuations. Macquarie notes if all commodities remain at current spot levels for the next 12 months, valuations for both BHP and Rio Tinto would fall by 4% respectively, while if the current price environment continued for two years valuations would decline by 7% for BHP and by 10% for Rio Tinto.

At present the greatest funding concern among the Australian iron ore majors is Fortescue given its expansion plans, but Macquarie points out there would be impacts for BHP and Rio Tinto as well from ongoing iron ore price weakness.

At present Macquarie expects both companies would be in net cash positions by 2014, but if current spot commodity prices were carried forward over the medium-term both BHP and Rio Tinto would experience negative free cash flow over the next 12-18 months assuming current capex plans are maintained.

This would push gearing for both companies above 40% on a net debt to net debt plus equity basis. For Macquarie this would bring pressure on dividend payouts, as assuming both commodity prices and dividends remained flat for the next 12 months BHP's payout ratio would increase to 74% and that of Rio Tinto's would rise to 116%. Both would be unsustainable in Macquarie's view, especially given limited borrowing capacity while attempting to retain A credit ratings.

For Fortescue things look even worse, as on Macquarie's numbers the company could require a further US$1.5-$2.0 billion in external funding if the current iron ore spot price was to be maintained for the next 12-18 months. 

In contrast, minimal external funding would likely be needed if iron ore prices rose to US$115 per tonne or more. Macquarie suggests the current Fortescue share price implies a five-year average iron ore price of around US$115 per tonne.

With respect to ratings for the three main iron ore players in Australia, Macquarie rates BHP, Rio Tinto and Fortescue as Outperform, with a slight preference for BHP over Rio Tinto among the two heavyweights. The FNArena database shows Sentiment Indicator readings for the three stocks of 1.0 for Rio Tinto, 0.9 for Fortescue and 0.6 for BHP.

Elsewhere, the end of reporting season has seen Goldman Sachs review its models for resource stocks, taking into account the results announced during the period and expected going forward and updated views on commodity prices.

In general, Goldman Sachs notes Australian resource companies met or exceeded expectations at the EBITDA (earnings before interest, tax, depreciation and amortisation) level, while most results showed evidence of increasing cost pressures across the sector.

Gold stocks in particular lowered volume growth expectations, to the extent Goldman Sachs notes the likes of Newcrest ((NCM)), Kingsgate Consolidated ((KCN)) and Teranga Gold ((TGZ)) now no longer offer material earnings growth upside. 

To reflect this, Goldman Sachs has downgraded Teranga to Neutral from Buy, as the new outlook of limited volume increases removes enough upside potential to make it difficult to justify a positive rating. 

In contrast, Goldman Sachs has upgraded OceanaGold ((OGC)) to Buy from Neutral as the Dipidio project offers earnings upside as the new output is added to existing operations in New Zealand. Increases to commodity price estimates in coming years have also boosted earnings forecasts, justifying a more positive rating in the broker's view.

Outside of gold, Goldman Sachs has downgraded nickel play Western Areas ((WSA)) to Sell from Neutral. The change accounts for lower nickel price expectations, which imply a less than 10% return for Western Areas relative to price target compared to a sector average of around 35%.

Post the changes to its commodity price assumptions Goldman Sachs retains a favourable view on the outlook for minerals sands. This sees the broker add Mineral Deposits ((MDL)) to its conviction list, having already had the stock as a Buy rating. Price target has been increased to $7.40 from $7.25.

Aside from the rating changes Goldman Sachs has adjusted price targets across the sector. In total, Buy ratings are ascribed to Base Resources ((BSE)), Lynas Corp ((LYC)), Iluka ((ILU)), Fortescue, Sandfire Resources ((SFR)), Regis Resources ((RRL)), Mineral Deposits, Kingsgate Consolidated, OceanaGold and Medusa Mining ((MML)). 

In contrast, Goldman Sachs has Sell ratings on OZ Minerals ((OZL)), Western Areas, Independence Group ((IGO)) and Discovery Metals ((DML)). 

Technical limitations

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.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms