Metals' Boom Has Room to Run
By Jim Jubak
MSN Money Markets Editor
8/16/2006 8:50 AM EDT
URL: thestreet.com
A funny thing has happened to the bust that always follows the boom in metals and metal-mining stocks: It's been delayed big time.
That's why, despite the huge run in commodity prices and the stocks of metal miners, I think this is still a good time to buy the shares of mid-cap mining stocks. I think the global economic growth that ultimately feeds the commodity cycle will accelerate into 2008 before the danger of the train coming off the tracks peaks in 2009.
Boom/Bust, Interrupted
Here's what's supposed to happen. Mining companies, after underinvesting in exploration and production for years, get taken by surprise when demand for zinc, copper, nickel and tin suddenly surges as the cycle turns and a long industrywide slump comes to an end. Mining companies rake in the cash as demand soars, and mining companies struggle to increase production.
Finally, though, the boom proves to be its own undoing as mining companies finally figure out how to turn that river of cash into new production capacity. With every mining company adding capacity, the industry is set up for a bust as prices level off and then begin to fall, thanks to overproduction. Sometimes a drop in demand caused by a decline in global economic growth arrives just in time to put the final nail in the industry's coffin.
This time the commodities boom has sure delivered the cash flow. Citigroup projects that the mining companies it covers will generate $253 billion in cash from 2006 through the end of 2008. But it hasn't led to a rush to expand production. Companies are investing in new production, but they're spending just as much or more on increasing dividends and buying back shares.
For example, BHP Billiton (BHP) will see operating cash flow of $10.8 billion in the fiscal 2006 year that ended in June, projects Morgan Stanley. Projected capital spending in 2006, Morgan Stanley estimates, will come to about half of that, or $5.4 billion.
Subtract another $2 billion for dividends and $1.7 billion to buy back stock, and BHP Billiton still shows a substantial increase in cash for the year. And that excess cash flow will just increase, given current trends, to $4 billion in fiscal 2007 and $10.4 billion in fiscal 2008. By the end of fiscal 2010, in June, the company will have accumulated $33.4 billion in cash, calculates Morgan Stanley.
BHP Billiton isn't alone, either. Citigroup projects that the mining companies it covers -- the ones set, by its estimate, to generate $253 billion in cash by 2008 -- will have an extra $108 billion in their coffers after paying for dividends and capital spending.
I don't think this buildup in cash as a result of restraint on capital spending is a sign of a newfound wisdom in the executive suites of mining companies. Mining companies are still as gung-ho as ever about traveling to the farthest reaches of the globe to discover new deposits of metals and then braving truly hostile climates and politics to wrest those metals from the ground.
It's just that there aren't many places to dig these days, especially when you subtract the increasing number of countries that have ruled their mineral deposits off-limits to the big multinational mining companies.
Off-Limit Ore
Rising costs reduce the number of attractive sites for exploration and development even further. Higher costs for wages and energy have pushed up costs by about 30% over the past two years.
So companies are increasingly concentrating their capital spending in sectors where it will pay off with the highest returns. Look at BHP Billiton's production report for the fiscal year that ended in June 2006.
Silver production fell 7% year to year on a decline in ore grades: Less silver in the ore means less silver produced, even if the mine processes the same volume of ore. Zinc production climbed 4% as higher-quality ores in some mines offset declining-quality ores in other mines.
Metallurgical coal and manganese production fell 4% and 3%, respectively. Only copper, up 23%, and nickel, up 90%, showed big production increases. It's no coincidence that supply deficits have pushed up the prices of these metals faster than the rest of the sector.
And with new deposits harder to find and more expensive to develop, individual mining companies have increasingly turned to acquisitions as the most cost-effective way to increase a company's production. In comparison with exploration, acquiring mining assets is very predictable. No dry holes. No ores that fail to grade out commercially. No surprises on the costs of getting ore to smelters or to market.
Buyout Boom
The supply of acquisition candidates isn't especially large, of course. The mining industry has already been through rounds of consolidation that have resulted in giant companies swallowing many of the smaller fish in the sector. That has raised competition for the relatively few remaining middle-sized mining companies to a frenzy. And it has put even some of the bigger names in the sector in play.
You can see both parts of this acquisition wave in the recent battle over Falconbridge (FAL) , the Canadian nickel- and copper-mining company. On July 29, Inco (N) conceded defeat in the battle to acquire Falconbridge to Xstrata.
Inco's offer of stock and cash had valued Falconbridge at $17.35 billion. Xstrata, which already owned 20% of Falconbridge, had made a cash offer that valued the total company at $21.24 billion. Not bad when Falconbridge was valued at just $7.54 billion a year ago.
Inco's bid was complicated by a bid from Phelps Dodge (PD) to acquire the entire Inco/Falconbridge combination should Inco's bid succeed. Phelps Dodge still wants to go ahead with its bid to acquire Inco, even without Falconbridge, but that acquisition is itself complicated by an earlier offer from Teck Cominco (TCK) to acquire fellow Canadian miner Inco.
And if all that's not enough, on July 31, Phelps Dodge became the object of interest of a possible bid from Grupo Mexico, the parent of Southern Copper (PCU) .
Enter the Giants
This may all finally bring about the long-awaited entrance in the bidding war of one of the truly huge global mining giants. On Aug. 1, both Rio Tinto (RTP) and Companhia Vale do Rio Doce (RIO) were rumored to be considering a bid. The entry of one of those two companies -- with market capitalizations of $71 billion and $56 billion, respectively -- would mark a huge escalation in the bidding war.
Truth is, all but the very largest companies in the sector are in play, because there are so few midsized companies left. Wall Street analysts figure that any company smaller than $30 billion could well get a bid before this round of consolidation is over. At that size, there are still no more than a couple of dozen potential targets. Even a company like Alcoa (AA) (with a market capitalization of $26 billion) is thought to be in play.
With demand from the fast growth of the Chinese economy likely to keep commodity metal demand close to or ahead of supply into 2008, I think this round of mining industry consolidation has a good way to run. Here are five names I'd like to own as potential acquisition candidates (in alphabetical order): Anglo American (AAUK) , Lonmin, Newcrest Mining, Vedanta Resources and Zinifex. |
