NTO and copper. Very bullish report from Credit Suisse. Snips from a 44 page report:
Equity Research
1 November 2006
Global
Diversified Metals & Mining
Metals & Mining
OVERWEIGHT
Brave New World II
Set for a re-rating?
In our sequel to Brave New World (dated 11 January 2006), we examine why the shares in our mining universe have de-rated despite strong metal prices and record profits. Investors seem
unwilling to say ‘it is different this time’ and are according single-digit peak of cycle multiples that we last witnessed in the late 1980s commodity bull market.
Investors appear worried that we may be coming to the end of the four-year bull market in commodities. We think the recent pullback is a correction in a major uptrend that could last at least another three to four years. In Brave New World II (BNW II) we discuss why we believe the copper price could spike to US$12,000/t next year—owing to low inventories and continued forecast supply disruptions.
The 'centre of gravity' is rapidly shifting from the US consumer to the metal-hungry emerging economies. We illustrate that even if US housing starts were to fall by 1 million homes in 2007, the global copper market could still be in deficit next year. In China, restocking of copper inventories seems imminent after the recent credit tightening measures. We predict that India will add 1% to global metals demand every year for the next five years, driven by infrastructure
spending.
This is creating a ‘snowball effect’. These regions are becoming such a big part of overall global demand today that even small % increases in consumption mean significantly more tonnes consumed. The reality is that industry may not actually be able to keep up and feed the ever-increasing demand. Capital spending on new projects has only just exceeded the previous peak in 1997. In perspective, Rio Tinto’s 60m tonne iron ore expansion announced four years ago is only enough to feed one year of China’s annual demand growth.
In a Brave New World, we believe mining companies need to embrace the cycle, leverage up their balance sheets and focus on buybacks, M&A and growth. If the companies are not prepared to leverage up, they may find somebody will do it for them. <<Call 1-800-BUY-NTO>>Our analysis shows that if corporates increase gearing to 50% and use half of any proceeds for M&A and half for buybacks, then our sector’s true estimated 2007 P/E is just 6.0x compared with our current forecast of 7.7x.
In conclusion, we think we are entering the next phase of this bull market, which is likely to propel metal prices to new levels and set the stage for significant P/E expansion. November and December are traditionally the best two months for the miners globally.
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Ten reasons to buy mining shares
1. Mining shares in our universe trade at 18-year valuation lows. Investors’ apparent preoccupation with a US-led global slowdown means there appear to be good buying opportunities in our universe. If supply remains constrained and demand is better than market expectations, we believe it is only a matter of time before investors realise that 2007 is likely to be significantly better than 2006 in terms of metal prices and earnings.
2. Many investors believe commodities are in a bubble. How many times do we hear that the rally in commodities is a bubble that draws parallels with ‘tulip mania’ or the ‘tech bubble’ of 2000? We understand investors’ concerns given that many commodity prices are at all-time highs and their charts look ‘interesting’. This goes a long way to explain why the shares in our universe continue to de-rate—investors appear to expect a major correction soon. The reality is, however, that while speculators have played a part in driving up prices, the lack of supply and strong demand have pushed copper, nickel, zinc and aluminium into substantial deficits for 2006. Going into 2007, the big four metals (aluminium, copper, nickel and zinc) are likely to be in deficit again, even in a benign growth environment.
3. Infrastructure in emerging economies is more important than US housing starts. Investors’ apparent preoccupation with US economic data and their slowing momentum is providing good buying opportunities in the sector. Our analysis illustrates that the infrastructure programme build globally is more important than consumer-driven swings. In China, the country is spending more money on underground and overland rail
networks in the next five years than the rest of the world has spent in the last 20 years. Russia has just announced a major investment spending programme to reinvigorate its electricity industry. Even in Europe the necessary buildout of electricity generation is likely to require an additional 1 million tonnes of copper over the next ten years. Finally, India’s infrastructure is just beginning. We predict it will add 1% to global metals demand every year for the next five years.
4. Supply, supply, supply Copper supply disruptions from strikes and lower-than-expected mine output should remain a key theme in 2007. We believe there is potential for the copper market to experience supply disruptions of up to 642,000 tonnes next year. The growing deficit in copper concentrate means smelters are likely to take downtime in the near term, which could lead to further tightness in an environment of low inventories. New capacity remains constrained and we expect delays in projects reaching full capacity. Added to this, companies have in recent years not been incentivised to build new mines or smelters and instead appear to prefer to use their growing cash piles on special dividends and share buybacks. This all adds up to a supply story for 2007 that will underpin metal prices and profits.
5. Copper could spike to US$12,000/t in 2007. In recent weeks, tin, lead, zinc and nickel have broken out to new highs. Only copper and aluminium remain the laggards. Copper is holding firm and any signs of a breakout to new highs would likely send a message to investors that they may have become too bearish on the 2007 outlook. Copper is key because it represents 32–51% of the Big 3 earnings. Investors do not appear positioned for positive demand shocks and seem to be factoring in a worst-case scenario for demand in 2007 given their pre-occupation with the US economy.
6. China restocking could return and surprise our demand forecasts. The key question is when will China return to the copper markets and restock its inventory? So far this year
the copper statistics from China have been confusing and bolstered the bears’ belief that China is slowing. The Chinese State Reserve Bureau is believed to have released up to 200,000 tonnes of refined copper into the market, leaving it, we believe, with limited strategic stocks. In addition, copper scrap availability has increased by as much as 200,000 tonnes. Both effects have led to a 20% drop in Chinese semi copper
imports, which implies that Chinese copper growth is slowing. With limited stockpiles, the risk is now that China returns to the market and restocks. This could have the effect of increasing Chinese copper demand growth from 4% in 2006 to 8% in 2007.
7. M&A is likely to hot up in 2007. Pressure is likely to build on our corporates to take part in value-creating M&A deals. If metal prices do stay strong, companies will come
under pressure to take part in the consolidation of the industry. So far, 2006 has been a disappointing year for M&A among the big 3 mining companies. In a Brave New World
(11 January 2006), we had predicted 2006 would be a busy year for M&A. While the Canadian sector has enjoyed a brisk year, the big 3 mining stocks haven chosen to sit it out. In our view, there is still significant undiscovered value in many potential targets. Higher long-term commodity assumptions that reflect the higher cost structure of building new mines and smelters are sending a message to companies that the first
option for growth appears to be M&A.
8. Potential emergence of financial buyers and Chinese consortia. If the mining companies in our universe do not leverage up their balance sheets, they may find someone will do it for them. We are surprised that private equity has not been active in base metals and believe that coal would be a likely candidate for their attention. Perhaps their need for ‘safe less cyclical businesses’ has stopped them so far. Nevertheless the ability to sell forward production and the growing realisation that our universe is enjoying what seem to be sustainably high margins could change this lingering perception. As China has adopted an aggressive downstream growth strategy in aluminium, cobalt, zinc, steel and copper, it has increasingly grown dependent on imported feed. The
country’s lack of self sufficiency in these commodities could be rectified by acquiring foreign producers. The recent shortage in cobalt concentrate and the impact it is having
on producers in China who are struggling to feed their furnaces is a good example of China’s growing dependency on imports.
9. The ‘snowball effect’ means the industry may not be able to catch up with the annual leaps in consumption from emerging economies. Four years into the commodity bull market, the industry is simply not responding fast enough to build new capacity. Each year of delaying new projects is a year that the emerging economies continue to grow and increase the gap between new demand and new supply. In short, this cycle could extend for at least another 3–4 years.
10. With limited gearing and strong cash flows, share buybacks and special dividends will continue to increase because mining companies are reluctant to build new mines. We think miners will come under increasing pressure to leverage up. Our analysis in Figure 4 shows that at 50% gearing it would be earnings accretive for the sector by 21%.
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NTO slide presentation is also worth a look. Of special note are slides #5, #7, #16 starts the Aqua Rica presentation. #21 is the feasibility study summary.
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