The Mining Cycle – Booms and Busts

Unlike industrial companies such as Amcor or Transurban, profits for mining companies are inherently cyclical. The  earnings from mining companies are subject to booms and busts, largely outside the control of their management teams. This occurs as ultimately any company producing a commodity is a “price taker” not a “price maker”,  as there is no difference or brand premium between a pound of copper mined in Australia or in Chile. Due to the nature of the cycle, we see that mining stocks should not be viewed as buy and hold forever. Rather, investors should pick and choose their entry points based on where they consider that minerals are in the mining cycle.

In this week’s piece we are going to look at the five different points of the mining cycle and where in the cycle Atlas perceive that commodities are currently positioned. The chart below shows the commodity cycles over the past 200 years, with the peaks coinciding with major wars or industrialisations of large economies.

 

 

1. Demand for commodities drives up prices
In the short term, supply is relatively fixed for most commodities as miners have optimised their mines for a specific level of production and minimal exploration during the lean times has run down ore reserves. At stage 1 of the cycle memories of the previous bust are still pretty fresh, and there is likely to be an under supply of personnel such as mining engineers. Additionally, the few surviving mining services businesses and contractors are likely to have minimal spare capacity which could allow production to expand quickly. Further, management teams in the mining companies are unwilling to greenlight capacity expansions until they become convinced that higher commodity prices are permanent.

In recent times this occurred in 2004 and 2005 as the industrialisation of China delivered a new buyer for Australian materials. This saw copper increase from $1 per lb in 2004 to close to $4 per lb in 2008 as supply was relatively static despite increased demand.

2. New Exploration undertaken to add to supply and Takeover activity surges

At stage 2 of the cycle, management teams at the mining companies are likely to be running existing mines at full capacity and have developed some confidence that elevated prices will persist for some time. This incentivises new exploration and capex is allocated to bring previously uneconomic discoveries into production.

At this stage we also see surging M&A as companies use excess capital built up in Stage 1 to buy growth which can be delivered faster through a takeover than developing new mines.  An example of this was the 2007 acquisition of Alcan by Rio Tinto for US$38 billion.

3. New mines start producing at the same time results in supply being greater than demand 

Due to the long lead times, in my observation a range of projects tend to hit the marketplace at almost the same time. Additionally, from speaking to resource CEOs during stage 3, each of them are invariably convinced that they have the best project and that rival projects won’t go ahead or get financing. Quite often a range of similar projects are all developed, with banks falling over themselves to provide finance them. Prior to stage 3 these projects look to be quite low risk with short payback times if prices are maintained (which they won’t be). Further, the costs of these projects are inevitably higher than originally forecasted due to the competition for scarce resources such as skilled labour and capital goods. A great example of this can be seen in the decision of Santos, Origin Energy and BG to construct three LNG gas projects simultaneously at Gladstone in Queensland.

The long lead times between development and first production can result in new mines coming online in market conditions quite different from when they were first conceived. A great example of this is Oz Minerals’ Prominent Hill Copper Mine which started being developed in 2006, and then came online 3 years later in 2009 at a cost of $1.2 billion. During the construction process the Copper price had fallen from $4 per lb to $2 per lb at the time of mine opening.  Similarly the US$10 billion Roy Hill iron ore mine started initial developments in 2011, with full production only being achieved in 2017.

Due to the debt burden generally incurred to develop projects, despite the fall in commodity prices at stage 3 of the cycle, many mines will boost production to cover their cash costs (including debt repayments), driving down industry margins. Given the cost of actually closing a mine (redundancies and break fees for contracts written with rail and equipment suppliers), most mining executives are reluctant to put their projects on care and maintenance to remove capacity from the industry. We saw this in 2014 and 2015 where a range of smaller Australian iron ore such as Atlas Iron and BC Iron were mining iron ore, yet were losing close to US$20 on every ton of their ore shipped, with the iron ore price at $50/t. Additionally, higher cost Chinese state-owned iron ore mines continued production despite losing money on every ton,  due to the perceived political imperative to maintain employment.

4. High cost and less efficient mines close and late cycle projects abandoned until next boom

At this stage of the cycle the canaries in the metaphorical coal mine are the contractors servicing the miners. In an effort to avoid the finality of shutting production, costs are pared back with the services businesses serving the mines the first to feel the pinch. Exploration budgets are slashed and expansion plans put on ice. These actions can push highly geared services companies such as Boart Longyear into administration. Larger mining services companies such as Downer tend to see large declines in profit as services are taken in-house by the miners and bull market contracts are re-written.

The next step at this stage is for the higher-cost producers to mothball their mines in an effort to conserve corporate cash and keep the company as a going concern. In 2015 a range of higher cost iron ore producers such as Atlas Iron, BC Iron, Arrium and Mount Gibson shut production, some of which have since been reopened. The more established mining companies at this stage will slash dividends (BHP in 2016) or raise capital to stave off worried bankers (RIO in 2009).

Complex late cycle projects that get deferred included Rio Tinto’s controversial Simandou iron ore project in Guinea which was shelved in 2016 due to concerns about the iron ore price. To develop this mine, Rio Tinto would have needed to construct both new 670-kilometre heavy freight rail line to transport iron ore shipments from Guinea’s Simandou Mountain range to the coastal city of Conakry and a sea port to load this ore onto ships. Despite the size and quality of this ore body, this would have been a risky and costly venture at this stage of the mining cycle.

5. Capitulation 

At this stage sustained falls in commodity prices forces a range of second and third tier miners into administration with ownership transferring from equity to debt-holders. The remaining lower cost miners going into survival mode, focusing in on conserving cash.  Exploration will stop, as excess supply is now expected to continue almost indefinitely.  Here a range of professionals such as mining engineers and resources analysts at investment banks will start to leave the industry.  The last part of this circle of life is the conversion of the ASX-listed shells of mining companies into “new economy” companies to speed up their listing process. For example, in the late 1990s the ASX-listed shells of the defunct mining and exploration companies from the 1980s  were reborn as “dot.com” companies.

Where are we now?

Every cycle broadly follows the curve, yet looks a little different when you are in the eye of the storm. Two years ago, in January 2016 it strongly appeared that we were in stage 4 and staring down the barrel of a long winter for commodities prices, but 2017 did not follow the expected script as commodities prices strengthened. This occurred due to China’s efforts to stimulate their property sector, slightly stronger growth in the developed world, and supply disruptions to mines such as Samarco in Brazil. Additionally, structural reforms in China aimed at reducing pollution and improving the quality of growth have increased demand for higher quality grades of commodities. 

The 2017 recovery in commodity prices has pushed us back into the mid cycle, though both companies and the investment community are very cautious. There are few new IPOs coming to market outside the exotic commodities linked to electric vehicles, minimal significant corporate takeovers being announced, and expansion activity remains subdued. In the upcoming February, reporting season will show very healthy mining company balance sheets which will hopefully result in improved returns for shareholders, rather than value destructive empire building. 

We are more cautious than most, as being pushed back into this favourable stage has occurred to some degree by the desire of the Chinese government to stimulate their property market. Chinese economic policies will not always favour Australian investors and a cooling Chinese property market (as breaks are applied) could have a chilling impact on commodity prices. 

 

 

Monthly Newsletter December 2017

  • The Fund posted a gain of +0.6% over the last month of 2017, ahead of the underlying ASX 200 A-REIT index. December was dominated by the news of the potential takeover of Westfield by Unibail-Rodamco. Outside of Westfield, the overall performance of the index was weak.
  • The Fund remains positioned towards Trusts that offer recurring earnings streams from rental income rather than development profits, we see that this is likely to position us well going into 2018, as the property development market cools.
  • In December the Fund paid a distribution of $0.05; an increase of +2.9% over the September quarter distribution.

 

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in December and the fund’s strategy going into 2018.

Monthly Newsletter November 2017

  • The Fund posted a gain of +3.6% over the month of November, which was ahead of our expectations in an exceptionally strong month for the Australian Listed Property sector. The derivatives overlay which we use to both enhance income and protect capital will naturally cause performance to lag in very strongly performing months.
  • The Fund remains positioned towards Trusts that offer recurring earnings streams from rental income,  rather than development profits. After the McGrath profit warning in November (attributed to slowing off the plan apartment sales), we remain convinced that this strategy will outperform as the market gives a higher value to recurring earnings as development profits being to wane.

 

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in November and the fund’s strategy going into 2018.

Earnings Chicanery Part Two

Last week in part one of Atlas’ surprisingly popular series on financial statement trickery – Earnings Chicanery, we looked at the three financial statements and some measures a company can take to “dress up” their financial results. In part two we are going to build on this and take a look at some warning signs that there may be problems with a company’s financial statements.

Red Flag 1: The statements don’t match

On results day most attention is focused upon a company’s profit and loss statement. In particular, analysts and commentators scrutinise whether the company has achieved the expected profit or earnings per share guidance, which was usually given at the last result. Whilst the profit and loss statement usually provides good guidance as to how the company has traded over the past six months, as discussed last week it is also the statement most open to manipulation and should be read in conjunction with the cash flow statement. It is a good idea to compare a company’s operating cash flow with its reported profits. If there is a big divergence, then the accounts should be examined carefully.

The red flag that we are looking for here is when a company’s cash flow statement and profit and loss statements are moving in different directions over an 18 month period, and where a company is showing growing profitability, but declining cash flows. In the below table from the 2015 accounts, Dick Smith Holdings reported income growing from $19 million to $38 million, yet operating cash flow fell from $52 million to -$4 million.  This suggests that the sales generating profits reported on the profit and loss statement were actually pushing the company towards administration.

Another recent example of this can be seen in Slater+Gordon. In the below table from their 2015 accounts, the company reported that 2015 financial year profits were up +6% to $84 million, yet their operating cash flow had deteriorated by -25% to $41 million. Here it appears that the company was overstating its profits through the accounting of its “legal work in progress”, and was overly aggressive in anticipating the expected cash generated through won cases. Whilst the company was able to deliver the earnings growth the market was expecting, in reality the declining incoming cash flows showed signs that it was actually a business in trouble.

However there are exceptions to the rule
The earnings on the profit and loss statement for some businesses can diverge from the cash flow statement. For example, a construction company such as Cimic (nee Leightons) or Downer might not physically be paid until July in the next financial year for work done on a railway project. Here the profits at a point in time may be greater than the cashflows, though the lumpiness of the cash flows received from large individual contracts will even out over time.

Red Flag 2: A company has consistent extraordinary
Extraordinary items are gains or losses included on a company’s income statement from unusual or infrequent events. Importantly, they are excluded from a company’s operating earnings. These items are excluded from earnings to give investors a more “normalised” view of how the company has performed over the period. For example, if an industrial company such as Amcor books a $50 million gain from selling excess industrial land, including this profit would obscure information about how the company’s packaging businesses have performed over the past six months.

While reporting extraordinary items can be valid and useful, investors should be wary or make their own adjustments to company earnings where a company has frequent (and almost always negative) extraordinary items that they are seeking to exclude from their reported profits.

As a long-term observer of the Australian banks, almost every year they put through a write-off of software below the profit line. In my view, investing in banking software is a core part of their business model and it seems curious that the institution is willing to take the productivity benefits in their normalised earnings whilst ignoring a portion of the costs needed to achieve these gains.

Red Flag 3: Divergence from comparable companies
The warning sign we are looking for here is when a company consistently has higher average profitability, revenue growth or better working capital management than their industry peers. Invariably when management is asked they will give an answer that relates to management brilliance or superior controls, but realistically mature companies operating in the same industry tend to exhibit very similar characteristics. As such, their financial statements should to some extent correspond to the statements of companies operating in the same industry. For example, supermarkets such as Woolworths should have a similar cash conversion profile to Coles (operating cash flow divided by operating profits) and not dissimilar profit margins as they are selling identical products to largely the same set of customers.

Hollow Logs?
Occasionally management teams may be incentivised to under-report profits in any current period. This generally occurs when a company is under heightened union scrutiny due to wage negotiations with their employees, excessive government attention from perceived excessive profits, or expects a problem in the next year and wants to smooth their profits. For example, in the current environment of extremely low bad debts a bank could be incentivised to boost their bad debt provisions aggressively. This action would reduce current period profits, potentially a politically astute move when politicians are calling for a Royal Commission into Australia’s banking sector. These excess provisions, if not required, could then be written back at a later date to boost future profits.

Our Take

Earnings misrepresentation is difficult for investors to detect from the publicly available accounts, but when revealed can sometimes have extreme results for a company’s share prices. In my experience this is more an art than a science, as the investor gets a sense that something is not right with the accounts, rather than definitive proof of earnings manipulation. Normally actual manipulation generally only becomes obvious ex post facto, after management has been removed or a company goes into administration.

Banks Reporting Season Scorecard 2017

Over the last ten days the major Australian banks have reported their financial results for 2017, reporting collective annual profits of $31.5 billion. In comparison to the May reporting season (which saw the surprise introduction of a 0.06% levy on the liabilities and $50 billion being wiped off the bank’s collective market capitalisation), the results were mostly in line with expectations. A key feature that we noticed was how efficiently the financial impact of this “game changing” levy or tax was passed onto borrowers, something that we expected when we looked at the bank results earlier this year in the May Reporting Season Score Card.

In this piece, we are going to look at the common themes emerging from the November reporting season, differentiate between the different banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Across the sector profit growth was generally in-line with the credit growth in the overall Australian economy. ANZ reported headline profit growth of 7.6% when backing out the impact of the sale of the bank’s Asian retail businesses, Esanda and property gains from 2016. The solid profit growth displayed across the sector was achieved by improving economic conditions and lower bad debts. All of the banks reported lower trading income due to decreased volatility over the year.  During periods of higher market volatility, the banks can boost their income by both selling more foreign exchange and interest rate derivative contracts to their clients. However, they can also generate trading income by using their large balance sheet reserves to trade securities on the global markets.

Gold Star

Angry on costs: Reducing costs featured prominently in the plans of bank CEOs for the upcoming year, with much discussion about branch closures and headcount reductions. The removal of ATM bank charges and the migration of transactional banking from the physical bank branch to the internet is likely to deliver an efficiency dividend to the banks. NAB took the most aggressive stance, announcing that the bank will reduce its workforce by 6,000 employees due to business simplification and increasing automation. However, this will come at a cost with NAB expecting to book a restructuring charge of between $500-$800 million in 2018 and increases in investment spend by $1.5 billion.

Gold Star 

Bad debt charges still very low: One of the key themes across the four major banks and indeed the biggest driver of earnings growth over the last few years has been the ongoing decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay and that the outstanding loan amount is greater than the collateral eventually recovered. Bad debts fell further in 2017, as some previously stressed or non-performing loans were paid off or returned to making interest payments, primarily due to a buoyant East Coast property market and higher commodity prices. CBA gets the gold star with a very small impairment charge in 1st quarter 2018 courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

Gold Star  

Dividend growth stalled but may return: Across the sector dividend growth has essentially stopped, with CBA providing the only increase of 9 cents over 2016. With relatively benign profit growth a bank can either increase dividends to shareholders or retain profits to build capital (thereby protecting banks against financial shocks); but not both. In the recent set of results the banks have held dividends steady to boost their Tier 1 capital ratios. Additionally, dividend growth has been limited as the banks have had to absorb the impact of the additional shares issued in late 2015 to boost capital.

Looking ahead, there may be some capacity to increase dividends (especially from ANZ and CBA after asset sales), as the rebuild of bank capital to APRA’s standards is largely complete. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 8.2%.

Gold Star

Net interest margins in aggregate increased in 2017, despite the imposition of the major bank levy. This was attributed to lower funding costs and repricing of existing loans to higher rates. In response to regulator concerns about an over-heated residential property market and in particular the growth in interest-only loans to property investors; in 2017 the banks have repriced these loans higher than those repaying both principal and interest. For example, Westpac’s currently charges 6.3% on an interest only loan to an investor, which contrasts to the 4.4% being charged to owner occupiers paying both principal and interest. This has had the impact of boosting bank net interest margins.

One of the key things we looked at closely during this results season was signs of expanding net interest margin (Interest Received – Interest Paid) divided by Average Invested Assets), and this was apparent even after allowing for May’s Major Bank Levy

Gold Star Australian banking oligopoly

Total Returns: In 2017 only NAB has been the top performing bank, benefiting  from delivering cleaner results, after it jettisoned its UK issues with spin-off of the Clydesdale Bank and Yorkshire Bank. CBA has been the worst performing bank as it faces both the imminent retirement of its CEO and the uncertainty around possible fines from foreign regulators for not complying with anti-money laundering laws. This has resulted in CBA losing the market premium rating that it has enjoyed for a number of years over the other banks.

Gold Star

Our Take

What to do with the Australian banks is one of the major questions facing both institutional and retail investors alike. The Australian banks have been very successful over the past few years in generating record profits, benefiting from lower competition from non-bank lenders and record low bad debts.  Looking ahead it is not easy to see how the banks can deliver earnings growth above the low single digits in an environment of low credit growth, increased regulatory scrutiny and the sale of some of their insurance and wealth management divisions.

Competition amongst the big four banks is likely to increase, as for the first time since 1987 (NAB’s purchase of Clydesdale Bank) we have no Australian banks distracted by foreign adventures, with all four focused on the Australian market.  However, looking around the Australian market the banks look relatively cheap, are well capitalized and unlike other income stocks such as Telstra should have little difficulty in maintaining their high fully franked dividends.