Mining sector still has plenty to yield

Sep 16 2009 by Andrew Miller, The Journal

MINING companies' earnings fell sharply in the first half of this year. But the sector remains well positioned to benefit from global recovery. With demand now picking up, growth in supply of many metals is still lagging.

This imbalance will underpin growth in mining companies' earnings.

Capacity constraints on output will be relaxed, but only slowly. Mining companies are still waiting for prices to stabilise before re-starting their idle capacity.

The short to medium-term "buffer" of stocks from which higher demand must be serviced remains generally low, and this should also be positive for prices. Further helped by companies' ongoing cost-cutting programmes, we believe company earnings could double within the next 12 months.

Rising commodity prices could also accelerate merger and acquisitions (M&A) activity within the sector. Various miners have been involved in deal discussions in the past few months including BHP Billiton, Rio Tinto, Xstrata and Anglo American.

Prompted by a continuing recovery in commodity prices, and company share prices, other players could be willing to get involved and snap up assets before it is too late. China is also likely to play an important part in this game.

In the UK, BHP Billiton remains our favoured large, diversified miner. The group's already clean balance sheet and low-cost operations give it less gearing to higher commodity prices. (In other words, companies with thinner operating margins may benefit proportionately more.) But we continue to see BHP as one of the best in class, in terms of asset operations, capital structure and growth opportunities. BHP offers the highest yield among diversified miners, but its distribution policy remains undemanding, meaning it will be very well positioned to participate in opportunistic M&A.

Meanwhile, Rio Tinto's turnaround story should continue to unfold, with the $15bn rights issue providing some relief to the balance sheet. The recently-announced disposal of the majority of the Alcan packaging business and higher-than expected volumes sold in the first half are signs of Rio's ongoing improvements.

The implementation of the joint venture with BHP in Western Australia next year should also create significant synergies.

For investors wishing to gain explicit emerging markets exposure, Vedanta remains the most straightforward play on demand growth in India, with its existing high-quality asset portfolio in copper, zinc and aluminium expanding considerably in the coming years.

Profit growth should remain underpinned by high-quality resources, low capital costs, and financial flexibility, However, we expect yields to remain fairly unattractive, as cash flows will be used for capital expenditure.

Finally, with a relatively high cost base compared to some other diversified miners, Xstrata offers high operational leverage to rising commodity prices. The company also benefits from a very good competitive position in coal and copper in particular, with good geographical diversification and a successful operational track record. M&A is also likely to be an important part of Xstrata's growth strategy. The proposed merger of equals with Anglo American would generate significant synergies in our view. Should the merger fail to go through, other value-creating acquisitions could be on the cards. Here, as elsewhere in the sector, there is much to play for.

Andrew Miller is regional office head of Barclays Wealth in Newcastle