Mining shares: are they undervalued after digging deep in 2018?

The mining industry is used to the ups and downs of commodity markets, but lessons are still being learnt. The last downturn in 2015 to 2016 revealed the greed that took hold when the going was good: exposing the largest players as bloated businesses that had blown budgets by using vast sums of debt to expand. Suddenly, as commodity prices collapsed, the industry was left with burdensome debt it could no longer afford and a slew of new expensive assets that were acquired in what quickly proved to be value-destroying deals.

Both miners and the market have transformed dramatically since then. The ‘Big Four’, Rio Tinto, Glencore, BHP Group and Anglo American, have all dug deep over the past few years to cut costs. They have all downsized, cut budgets and lowered debt to emerge as leaner businesses in an even better position to benefit from the rebound in commodity prices. But the industry has made it clear it has no intention of repeating the same mistakes and is now focused on improving the bottom line rather than the top, allowing them to enjoy times of higher prices but, more importantly, survive when the next downturn comes around.

For now, the combination of higher prices and leaner businesses means miners are generating more cash than they know what to do with, exacerbated by the huge sums pocketed from selling off assets. Trust among investors is scarce, so convincing them that ploughing billions into lengthy developments in the hope of a long-term return is difficult, and appetite for big acquisitions is low. This has left them with staggering sums in the bank with little justification for why it is there. With disgruntled investors to woo, they have had little choice but to spray shareholders with cash over the past two years, with more to come in 2019. Dividends have trebled in the last two years (the 66% growth in 2018 represented the biggest improvement of any UK sector in 2018) and sweetened with share buybacks.

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Balance sheets may have been strengthened, earnings improved and returns raised but this has not helped support mining shares. The FTSE 350 Mining Index is still trading lower than it was this time last year. This is because the wounds of the last downturn have healed but the scars are still there, confidence in the industry is low and its prospects uncertain amid the global slowdown in growth and the US-China trade war.

Rio Tinto shares: Value over volume

Having sold off $9 billion worth of assets in 2018 alone, Rio Tinto has almost finished restructuring its portfolio built around platinum, copper and its core commodity iron ore, which currently accounts for over 60% of its earnings. The sales last year, including the last of its coal operations, has left it flush with cash which, because of the miner’s new ‘value over volume’ strategy, has largely been returned to shareholders.

There is also more to come. It is yet to reveal what it will do with a large portion of the proceeds, including that from selling its interest in the Grasberg copper mine in Indonesia, but investors are sure to receive the bulk if not all of it. Some analysts have forecast Rio could return between $3.5 billion to $4.4 billion when it releases its annual results on February 27, 2019.

Chief executive Jean-Sebastian Jacques vowed the miner was aiming to 'deliver superior returns to shareholders in the short, medium and long term' upon releasing its annual production results for 2018. He also threw cold water over the idea Rio could look to strike a big merger with rumours centred on US miner Freeport McMoRan. Although appetite for large M&A is almost non-existent some saw Rio as a potential exception because a merger with the likes of Freeport (currently valued at nearly $17 billion versus Rio at $54 billion) as a way of boosting its copper business to diversify from its reliance on iron ore, particularly at a time when growth in China – the key market for the steelmaking ingredient – is slowing down.

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However, Rio’s plan to raise iron ore output in 2019 has been taken as a bullish move at the right time following the fatal incident at Vale's Feijao operation in Brazil that has taken up to 10 million tonnes of annual supply out of the global market.

Rio Tinto shares are up 6.6% over the past year and 3.3% over the last six months.

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Anglo American shares: U-turns with upside

Anglo American is the most diversified of the Big Four miners but not so long ago it planned to phase-out exposure to iron ore, coal and nickel to focus on its three core commodities of diamonds, platinum and copper. It was forced to make a U-turn on those plans after the commodities that had fallen out of favour became the earnings engine of the business following a rebound in prices. Iron ore, nickel (and manganese), and coal generated more than half of Anglo American’s earnings in the first half of 2018. Coal was by far the single-biggest driver and the Glencore generated more than double the amount of earnings from coal than it did from any other commodity.

Although it has been pragmatic to retain these assets and leverage the cash generated to pay down debt the decision has hurt confidence in its longer-term strategy and invited calls for it to sell off these assets in the future. These assets are safe in Anglo American’s portfolio, at least until prices drop and they suddenly become a burden once again.

Regardless, the short-term future for Anglo American looks bright. It has the most immediate upside to offer, giving its share price a potential propellant in 2019. Its key iron ore assets hit trouble last year – the Kumba mine in South Africa has been hit by rail capacity constraints while Minas Rio in Brazil was shut for nine months due to a broken pipeline. While these incidents have hurt Anglo American in 2018 (the closure of Minas Rio is to cost the miner around $320 million in annual earnings before interest, tax, depreciation and amortisation (Ebitda) in 2018), it also means there is opportunity to rebound this year. Operations at Minas Rio have already restarted and will produce nearly seven times more iron ore in 2019 than it did in 2018. Output could reach up to 20 million tonnes this year and it recently secured approvals to help expand the operation to its full capacity of 26.5 million tonnes per annum further down the line.

Copper was the standout performer for Anglo American last year, rising 15% year-on-year. Fourth quarter production was up 23% to hit its highest level in five years, although it is expecting an overall decline in output in 2019. The longer-term outlook for its copper business is still strong following the $5 billion-plus development of the Los Bronces and Collahuasi copper mines being signed off last year. Those developments would take Anglo American from producing 670,000 tonnes of copper to over 1 million tonnes in the years to come.

Anglo American will report preliminary results for 2018 on 21 February.

Anglo American shares are up 15% over the past year, and 14% in the last six months.

Anglo American fundamentals: key metrics

Glencore shares: Paying for its mistakes

Glencore has always been the pushed the boundaries and stood out from its peers. It’s huge commodity trading arm means it not only mines commodities but trades them, as well as commodities produced by others. It is also known for having a greater appetite for risk by working in some of the most unstable and difficult jurisdictions around the world.

But its willingness to operate where others daren’t is backfiring and while peers are trying to clean up their act Glencore is slowly slumping back into a murky shadow. Canadian regulators recently fined its subsidiary in the Democratic Republic of Congo (DRC) for misreporting, accusations of bribery have surfaced in Brazil and the US is in the very early stages of investigation into Glencore’s operations in the DRC, Venezuela and Nigeria.

While the US investigation could prove to be a very lengthy ordeal, immediate attention is on the DRC where the firm’s subsidiary Katanga Mining operates key operations for Glencore’s cobalt and copper supplies. Glencore’s troubles in the DRC, which have spilled over into the country’s controversial elections, prompted it to task two of its senior executives to get a firmer grip over the unit.

Cobalt has been another differential for Glencore. Nearly two-thirds of the world’s cobalt reserves are concentrated in the DRC, which is troublesome enough to keep most of the competition away despite the vast resources the country has to offer. But operating in the DRC comes with high risks, which are becoming clearer. The material’s price has risen exponentially on the back of demand from electric vehicles and energy storage, but investors were shocked last November when it was revealed cobalt could no longer be exported out of the country because it contained uranium that had to be removed. But the DRC government has now told Katanga to stop its plans to build facilities to extract uranium 'until further notice', which it has said it will comply with.

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Output of cobalt jumped 54% in 2018 while copper production rose 11%, both largely thanks to its DRC operations. The export ban does not prevent production, meaning Katanga is having to stockpile material in the meantime. It has said most of the 26,000 tonnes produced this year won’t be sold until 2020, pushing around $650 million revenue (at spot prices) into 2020.

Still, Glencore is raising production of metals across the board this year, and at significantly higher rates than its rivals. It also doubled its $1 billion buyback earlier this year after net debt dropped to $9 billion, below its $10 billion -$15 billion target and dramatically lower than the near $35 billion in 2012 after its acquisition of Xstrata. It has said adjusted net debt would be $2 billion higher when it releases its annual results on 20 February because of lower prices and volumes within its oil trading unit. Glencore will need to keep out of trouble to convince investors but the buybacks, with Deutsche Bank estimating a $3 billion programme being announced later this month, will help sweeten them.

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Glencore shares are down 23% over the past year and 3.9% lower over the past six months.

Glencore fundamentals: key metrics

BHP Group shares: has the punch but not the power

BHP has a new name with the hope of a fresh start with investors. The company drew criticism for its spending and investment plans, so much so that activist investor Elliot Management took a stake with the aim of reforming the miner.

That led BHP to finally sell off its oil business onshore the US to BP for $10.5 billion, after investors ran out of patience with its failed attempt to move into unconventional oil. It was the prime example of what unhappy investors called mismanagement: BHP had invested somewhere in the region of $40 billion into the assets and the sale price was also below the $14 billion carrying value. While these are prized by BP, which has promoted the assets to the centre of its portfolio for growth, BHP just couldn’t make it work. Plus, BHP has had little choice but to return all the proceeds from that deal to investors, who simply don’t support the idea of BHP making major investments or acquisitions anytime soon.

At its peak BHP was operating 30 of its own projects but that has since fallen to just 13. Debt stands at around $10.9 billion, at the bottom of its $10 billion-$15 billion target range, and it has introduced a more 'transparent capital allocation framework', basically being more open and clear about how it will spend its money, to reinstall trust among shareholders. Plus, a 'more appropriate' payout ratio has been introduced that means 50% of underlying earnings will be paid out to investors.

The other 50%, therefore, can be invested. But BHP will still need to convince investors that such an investment would generate returns worth waiting for rather than returning it through dividends or buybacks. BHP has said its undervalued share price and healthy cash position gives it little choice but to buyback its own stock.

It seems BHP will have a hard time getting its investment ambitions across to some of its sceptical shareholders, which will lead to more funds being returned. However, if it can rebuild that trust then it could prove to be a sleeping giant: it has 2 million tonnes of latent copper capacity that could be developed for $4 billion over 5 years, with another $15 billion worth of further developments it could pursue for other commodities.

But, considering $21 billion has been returned to shareholders over the last two years, it is safe to say BHP has a way to go in convincing them it can balance the books between sustainable developments and sustainable returns. Capital expenditure has been capped at $8 billion per year for the current financial year and the next. Unlike its peers, BHP’s financial year runs to the end of May. Interim results for the six months to December 31 2018 will be released in the early hours of 19 February.

BHP Group’s London shares are up 8.3% over the past year but down 0.7% over the last six months.

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