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Morningstar | Strong Cost Performance from Anglo American, Raising our FVE to GBX 1,400. See Updated Analyst Note from 28 Feb 2019

Anglo American’s adjusted net profit after tax, or NPAT, of USD 3.2 billion was flat compared with 2017 but beat our USD 3.0 billion forecast. The stronger than expected profit was underpinned by an impressive performance on costs and better profitability in the copper and diamond divisions. Adjusted EBITDA rose 5% to USD 9.2 billion primarily with higher prices which added USD 0.9 billion to EBITDA. Favourable currency moves added a further USD 0.2 billion and volumes USD 0.8 billion. Inflation and the loss of earnings from the Minas-Rio iron ore mine in Brazil reduced EBITDA by USD 0.6 billion each. Unadjusted NPAT of USD 3.5 billion was inflated by impairment reversals in coal.

We raise our fair value estimate for Anglo American to GBX 1,400 per share from GBX 1,200 per share previously. The increase reflects several improvements, the most impactful being higher forecast iron ore earnings. We’ve lowered our cost forecasts for Anglo’s iron ore operations in Brazil and South Africa with the company making solid progress on the productivity front. In addition, we’ve also assumed higher near-term and long-term iron ore premiums for the company’s Minas Rio mine in Brazil. Similarly, our operating cost forecasts for the copper and nickel operations have also reduced and assume Anglo’s realises slightly better coal prices in future.

Despite the improvement in the firm’s cost base and the increased fair value estimate, we retain our no-moat rating. On an unadjusted basis and excluding goodwill, we forecast Anglo’s return on invested capital, or ROIC, to be 13% in 2019, above our estimated cost of capital of 9.4%. But by midcycle, we forecast ROIC to decline to around 7%. Lower expected prices for coal, iron ore and, to a lesser extent, copper is the primary driver. If adjusting for the considerable cumulative asset impairments of about USD 20 billion since 2008, forecast midcycle ROIC excluding goodwill is around 4%.

Changes to production guidance were relatively minor with the result. In the near term, Anglo has raised its guidance for iron ore production for 2019 from Minas Rio by about 9% or 1.5 million tonnes to 18 to 20 million tonnes. The mine restarted in December and is ramping up faster than Anglo expected with some help on the government approvals side. On the cost side, Anglo performed better than their guidance and our expectations in 2018. Inflation of costs from the lower 2018 base will benefit 2019 operating cost for the company. Longer term, Anglo aims to increase production overall by about 23% by 2023 from 2018 levels. The planned Quellaveco copper mine is the largest chunk of production growth, adding 180,000 tonnes of copper and starting in 2022.

Cost efficiencies and productivity are a focus enabled by better operating performance and new technologies. Those drive to improve mining, hauling and processing efficiencies. However, we see several similar productivity initiatives being undertaken by Anglo’s key competitors. Overall, these initiatives as part of the ongoing technological gains which should help to boost production and lower costs for the industry. Competition will likely see much of the benefits passed on to customers via lower commodity prices with a lower cost curve.

The balance sheet is in good shape with net debt declining nearly 40% to USD 2.8 billion. This included USD 0.5 billion of cash from Mitsubishi which will contribute to Quellaveco’s development. The cash will be spent in 2019, so adjusted net debt is about USD 3.4 billion. Anglo aims to maintain the conservative balance sheet and avoid the past industry mistakes of overleveraging. We think this approach is appropriate given the cyclicality of commodity prices and the relatively high industry capital expenditure requirements. Based on our forecasts, Anglo American could have net cash by 2020. It’s likely the dividend payout ratio will increase over time given the relatively strong balance sheet and forecast capital expenditure restraint.