Material Matters: Pressure On Dividends, Steel & Iron Ore

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Stock picks and commodity forecasts; declining payout ratios for miners; new research coverage for steel companies; and iron ore forecasts. 

-Morgan Stanley’s commodity forecasts and stock picks
-Diminishing payout ratios for miners
-New coverage of BlueScope Steel and Vulcan Steel
-Price forecasts for iron ore and regional steel 
 

By Mark Woodruff 

Morgan Stanley’s commodity forecasts and stock picks

Metals and mining equities across the globe have missed out on the record Cyclicals versus Defensives rally and have de-rated to GFC/covid lows relative to the market, new research from Morgan Stanley concludes.

To take advantage of this underperformance, Morgan Stanley's commodities team suggests investors focus on stocks with exposure to commodities that will benefit from lower interest rates and are exposed to fundamentals displaying either supply discipline or supply disruptions.

This disparity between outperformance by cyclicals and market-relative metals & mining valuations has never been this extreme, and Morgan Stanley points out a growing divergence has also emerged within the metals & mining sector fueled by a strengthening narrative around copper.

According to the broker, the market's bullish views on copper and scepticism regarding overall Chinese demand for commodities have rarely been as uniform. 

Copper moves to the top of the broker’s order of preference on commodities as supply disruptions push the market towards a large deficit. These supply challenges will be hard to resolve and the deficit will persist into 2025, while a further boost for demand is expected from data centres/AI.

This outlook for copper may support pure-play miners in the near-term, yet Morgan Stanley cautions current share prices are already pricing in steep commodity price rises. Diversified miners offer greater value over the medium-term, suggest the analysts, but a shift in China sentiment is needed.

Despite China’s current lack of appetite for iron ore, the broker outlines a compelling value case for Rio Tinto ((RIO)). Not only does the miner possess low cost/high quality assets, but Rio Tinto also maintains a best-in-class balance sheet with superior volume growth, mainly derived from copper.

Morgan Stanley is forecasting US$10,200/t for copper by the third quarter of 2024.

For iron ore, the broker has lowered its second quarter 2024 price forecast by -21% to US$110/t on stronger shipments, but sees prices rising from the second half of 2024 due to cost support and normalising inventories. FY24-FY26 price forecasts are increased by 22%, 25% and 25%, respectively.

Behind Rio Tinto in the iron ore space, Morgan Stanley prefers Deterra Royalties ((DRR)), followed by BHP Group ((BHP)), and Fortescue ((FMG)).

While Mineral Resources ((MIN)) also has material iron ore earnings, the broker recommends this company based on its lithium credentials in preference to investing in Pilbara Minerals ((PLS)) or IGO Ltd ((IGO)).

As part of its commodity strategy update, Morgan Stanley has downgraded its rating for IGO to Underweight from Equal-weight and lowered the 12-month target price to $5.95 from $7.20. The current mine plan for the company’s Greenbushes mine continues to be reworked and the analyst sees risk around future expansions.

Among battery metals, nickel is preferred due to the rapid supply side response to low prices. The analysts believe lithium share price valuations have potential to correct further, though a floor for lithium prices may be approaching.

Valuations for the lithium pure-plays on the ASX remain elevated and the broker is wary around battery supply chain inventories and offline supply which can be restarted.

Gold should also see further upside as rate cuts come through. Apart from falling real yields, strong physical demand from central banks provides a tailwind to support prices, according to the analysts. Evolution Mining ((EVN)), Regis Resources ((RRL)) and Northern Star Resources ((NST)) are the preferred exposures.

Amongst base metals, the broker likes copper (as noted) and nickel on supply tightness and, in order of preference, nominates Evolution Mining for its copper exposure, followed by Nickel Industries ((NIC)), 29Metals ((29M)) and South32 ((S32)).

While the target for Alumina Ltd ((AWC)) rises to $1.30 from $1.10 on higher forecast alumina prices in 2024/25, Morgan Stanley downgrades to Equal-weight from Overweight on valuation.

Evolution Mining is Morgan Stanley's recommended way to play both gold and base metals, noting around 30% of the company’s revenue derives from copper. 

The broker suggests investors apply caution when considering the coals. Thermal coal is thought to be lacking near-term catalysts, while improved Australian supply and a seasonal lull for Indian steel may weigh on the hard coking coal price.

Regarding uranium, here the 2024 balance looks tight on Kazatomprom's production guidance cut, but Morgan Stanley turns more cautious as supply responds to elevated prices, resulting in the 2026 forecast flipping into a small surplus.

Diminishing payout ratios for miners

The December half last year proved a bountiful period for investors in BHP Group, Rio Tinto and Fortescue as consensus forecasts for dividend payouts were exceeded, but for some miners under coverage by Morgan Stanley there are risks to upcoming returns.

BHP Group’s current dividend payout policy is for more than 50% of earnings per share, yet the broker anticipates a second half FY24 ratio of 55%, falling further to 50% in FY25, due to an elevated debt position and ongoing risks posed by legal action surrounding the Samarco dam failure in Brazil.

Ongoing volatility in lithium markets also poses a threat to dividend payouts.

For Mineral Resources, the analysts forecast a FY24-25 payout of 20%, well below the company's payout policy of 50% of underlying profit.

Despite a recent cut to FY24 capex guidance by Pilbara Minerals, Morgan Stanley forecasts no dividends across FY24-25 versus the company payout policy for 20-30% of free cash flow (FCF), because of significant capex plans in place for P680/P1000 expansions at the Pilgangoora lithium project.

The broker currently forecasts FY24 and FY25 payouts for IGO of 20% and 25%, respectively, also toward the lower end of this company's payout policy for 20-40% of FCF.

RBC Capital’s new coverage of steel companies

This week RBC Capital Markets initiated coverage on Australia’s largest listed steel company BlueScope Steel ((BSL)) and on Vulcan Steel ((VSL)), one of the country’s biggest domestic steel and metal distributors.

Vulcan operates as a key link in the steel and metals value chain between producers and bulk traders, and end-users. Main commodity exposures include prices for carbon steel, stainless steel, engineering steel and aluminium, with the company’s product demand in A&NZ impacted by activity in construction, manufacturing, and mining industries.

While Vulcan continues to expand its product suite and geographic reach, RBC explains near-term earnings and margins remain under pressure with both demand and prices impacted by slowing economic activity and increased import competition.

BlueScope’s geographic footprint extends further with steel manufacturing capabilities in Australia, New Zealand and North America at respectively Port Kembla, Glenbrook and North Star. Management operates a largely vertically-integrated portfolio of steel making and downstream assets across A&NZ and the US, as well as the ASEAN region including China and India.

The company is also a mid-to-downstream distributor of value-add steel.

By making investments to improve value chain integration, BlueScope aims to grow margins by adding capacity via such value-add products as cold rolling and metal coating lines, explains the broker.

As is the case for Vulcan, BlueScope’s volume and sales exposures relate to demand for construction, both non-residential and residential. Demand also arises via automotive, manufacturing and agricultural industries. The analysts note key commodity exposures relate to inputs and outputs of steel, which includes prices for iron ore, coke and coal, vanadium, ferrous scrap, hot rolled coil (HRC) steel, and coated and painted products.

RBS rates Vulcan and BlueScope as Sector Perform, or Neutral equivalent, with 12-month target prices of $9.00 and $24.50, respectively.

The macroeconomic backdrop remains a concern for Vulcan, explain the analysts, after first half results revealed depressed earnings due to softening economic conditions, lower global pricing, and de-stocking activity.

Given the Vulcan share price has rallied by 14% post these interim results, it appears to RBC the market is supporting management’s claim the business is “well positioned to capitalise on an uplift in the cycle”.

Nonetheless, RBC will await a clear inflection point in domestic activity before adopting a more constructive view. It’s also noted the stock is currently trading at its highest multiple post listing.

Regarding BlueScope, RBC highlights uncertainty around the Asia-Pacific outlook with Chinese oversupply an ongoing concern, with circa 90mtpa of steel net-exports flooding into the seaborne market and compressing East-Asian steel prices and spreads.

Import parity pricing (IPP) pricing is also under pressure and would be lower if not for the weak Australian dollar, explains the broker.

Management is actively pursuing increased exposure to the highly protected North American steel market to offset the compression in Asian pricing and spreads, which are combining to weigh on the A&NZ and ASEAN businesses, explains RBC Capital Markets.

Forecasts for iron ore and regional steel pricing

Heading into the Chinese construction season, Citi anticipates the country’s production of steel will lift from current levels. Steel producers are expected to raise output, with steel exports remaining high, or increasing further.

The broker is confident around increasing steel production because lower iron ore and metallurgical coal pricing is allowing blast furnace mills to make positive margins again. Moreover, the upcoming April-August period represents the high season for Chinese production rates.

By way of background, Citi notes iron ore prices have come under pressure in 2024 from a combination of a slow start to the Chinese construction season, high Brazilian iron ore exports and a high level of exports into China from non-traditional suppliers, thanks to high iron ore prices in late-2023.

Of the iron ore imported into China over January and February this year, 17.5% came from non-traditional sources compared to the 10-year average of 14%.

While China's apparent steel consumption is down -2.6% year-to-date, the broker points out Chinese steel production is up 1.6% on high net steel exports, which have increased by 35% so far this year.

The analysts forecast an improvement in iron ore pricing to a attain a US$120/t average for the second quarter of 2024.

Given high Chinese steel exports, Citi predicts regional steel pricing will remain under pressure.

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