Mining stocks offer price opportunity, dividend threat

-- | 20/03/2020 Text size Decrease

Glenn Freeman: In this "Ask the Expert" we're speaking miners of iron ore, coal and coronavirus, with our equity analyst, Mat Hodge. Mat, thanks for your time today. Mathew Hodge: Thanks, Glenn. Freeman: Amid the sell-off a number of miners have moved into undervalued territory, into buy territory, for the first time in a long time. What are some of the names that are really standing out to you at the moment? Hodge: Yeah. So, I think, if I come at it the other way, the iron ore miners generally are still overvalued, so Fortescue and Rio Tinto, and really the market is thinking that China is probably going to stimulate again, and that will create demand for iron ore. So, still overvaluation there. Looking at the whole, we're about a price to fair value of 0.8 for the coverage we have. If you roll back to the last kind of update in mid-January, it was about 1.1. So, it's been quite a sell-off. Most hard hit have been kind of the base metal miners, so those that are copper exposed, so the Sandfire, OZ Minerals, Whitehaven, which is exposed to coal, that are already being getting hit before this and now has been hit even more. Iluka Resources, South32, they're some of the names that are coming up as relatively undervalued. Freeman: Sure. What's happening with dividends? They were some of the highest dividend payers in recent times. Will that continue? Hodge: So, we talked about this a few times and our view has been that these stocks should not be considered dividend paying stocks. And the action that we're seeing in the market is exactly why. The key drivers of shareholder returns for these stocks will be capital value, which is mostly influenced by commodity prices and over the longer term, how they invest. If they invest well, they should be able to generate returns. But the problem with mining stocks is, they tend to invest when times are good and not have money to invest when times are bad. So, getting back to your original point around dividends, if this commodity price sell-off lasts and if there are more disruptions, then cutting dividends is definitely – it's likely. I mean, these things are based on payout ratios. So, if earnings are less, they will get cut anyway. And it's also a mechanism that management may use to ensure that the balance sheets are solid which is correct in my view. But ideal world, they should have been solid in the first place. Freeman: So, no one's announced any cut to dividend or cancelled any buybacks yet? Hodge: Well, those that use a payout ratio, if earnings fall, then those dividends will fall. That's just the mechanism. Freeman: And are only buybacks going to be taken off the table? Hodge: So, we've been pretty critical of share buybacks, particularly the miners, they tend to have cash flow when times are good and when times are good, their share prices tend to be high. That's also the time when they're buying back shares, which is counterproductive in our view. So, a lot of the buybacks that have been undertaken recently, we think they're going to go away. And we're probably not going to see any of those for some time. Freeman: And even if stocks are undervalued, something that people are watching closely is debt. What are the debt levels like among some of these names you've mentioned? Hodge: Yeah. I mean, not to be pollyannish about it, they're generally pretty good for the industry. The industry got a pretty big scare in 2015 and again in 2009 with the GFC. But in 2015, in particular, some were into that downturn with a bit more debt than they thought. Fortunately, the markets recovered and as the markets recovered, they used that cash flow to repay debt. So, the balance sheets are pretty good. Whitehaven is probably the one of all the miners that we cover in Australia that has a bit more debt. We've had a look at that, and we think they should be okay though relative – they've got lower debt than they had relative to heading into the 2015 sell-off. And in that occasion, they managed to avoid having a dilutive equity raising. So, that's the one where there's the most risk. But we still think based on what we know now they're going to be okay. Freeman: At the other end of the scale, are there also some that have no debt? Hodge: Yeah, there are quite a few actually, like Sandfire, Regis, Iluka has got very little, if any, debt. Some of that might swing around a little bit, depending if there's some disruptions to production or working capital, or things like that. But there's quite a few and I'd just point out that we just put our special – we didn't put a special – we've just put out a report, looking into the balance sheets of all the miners, and we highlight those names in that report.  Freeman: Yeah. And some of the other ratings that people are watching quite closely at the moment is uncertainty ratings, but also, I noticed that none of these names have moats. Hodge: Yeah. Really, the challenge with the miners is, when times are good, they tend to have the cash flow but it's also when asset prices are high or where it's expensive to build new mines. So, it's very, very difficult for miners to be disciplined to not invest high when they have the money, and to actually invest low when they generally don't have the cash flow. So, that natural cyclicality and the capital intensity of the industry, it's very capital intensive, with long lead times. So, you're investing – you kick off the ball to invest now, and maybe cash flow starts in one year, two year, three years from now, and you don't know what commodity prices are going to be. So, we think that makes it quite challenging. And if you look at the track record of the industry, it's tended to be very procyclical. And if you take just the China boom, for example, companies like BHP and Rio Tinto invested a lot of money in things that didn't return very much. So, that's the reason why we've got no moat, even though some of the individual assets within those companies are mostly in isolation. Freeman: And finally, Mat, how do you think commodity prices are going to behave? Hodge: I think there's no doubt that there's an impact on the demand side, right? You're seeing what's happening in the Europe and the U.S., what happened in China in terms of closing the economy, stopping people moving around and stopping goods moving around. So, that impacts demand. But this is quite different in that it could impact supply as well and if the coronavirus breaking out in individual mines and if you take iron ore, for example, high concentration of the world's iron ore comes from the Pilbara, geographically pretty small region. So, it's not entirely clear that the impacts to commodity prices will be necessarily down if you get some of those impacts on supply playing out. As far as companies go, if you've got companies that have just got one or two mines and if they do get hit by coronavirus, they have to shut for a while, then that impact is going to be pretty significant in the short term. If you have a company like a BHP that's more diversified, then you're spreading that risk around. There's probably a little bit more safety in something like that. Given that they – if one side is down and that impacts supply, then maybe they're still producing somewhere else and they can take advantage of any price response that there might be.

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