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Morningstar | Bulks Defying Longer-Term Risks but Sell-Off in Base Metals and Gold Sees Pockets of Value

We still see significant risks for the miners and think the stocks overall are overvalued. Buoyant commodity and share prices do not reflect the inevitable shift in China’s economic growth towards less commodity consuming activities, and the market has taken too much comfort from the stimulus-fuelled recovery. The underlying sources of instability--poor quality lending in China and growing leverage are yet to be addressed. We see the greatest overvaluation among the bulk miners--those exposed to iron ore, coking coal, and thermal coal. Prices for those commodities remain elevated.

We still see the sector as overvalued with the Australian listed miners overall trading at a 24% premium to our fair value estimates. This is despite a 5.1% decline on average in the share prices of those firms since June 30, 2018 with the sell-off concentrated among the base metals and gold miners, which declined on average by about 15%. It’s here where we see much less overvaluation, and some small pockets of value emerging. Newcrest is the cheapest of our coverage and is trading at a 15% discount to our fair value estimate, just in 4-star territory. We think this reflects the recent sell-off in gold, as well as concerns around the ability of the Cadia Valley mine to deliver consistent production. However, we see meaningful upside from continued expansion and cost saving initiatives at both Cadia Valley and Lihir and longer term from the company’s recent investments.

All these mining firms are rated no-moat. We have increased our fair value estimates for Rio Tinto Limited by 8% to AUD 52 per share, reflecting higher near-term iron ore prices. Our fair value estimates for BHP, Fortescue, Whitehaven Coal, New Hope, Regis Resources, South 32, and Sandfire Resources increase by 2% to 5% to AUD 25, AUD 3.80, AUD 3.50, AUD 3.30, AUD 3.00, AUD 2.80, and AUD 6.10 per share respectively on near-term commodity price increases and a lower AUD/USD exchange rate.

The bulk miners have withstood the market volatility so far, posting share price gains on average since the end of June thanks to strong underlying prices for iron ore and coal. New Hope has been a stand out this year, nearly doubling since March. Fortescue has been the laggard, falling 17% since the end of June and its shares are now slightly undervalued. This reflects concerns around the near-term discounts for lower-grade ores, but we think a normalisation of steel making margins will see the value in use of Fortescue’s ore restored and the discount for their iron ore shrink. In addition, the company is working to improve the grade of its products by introducing a 60% iron grade product. Of the larger miners, it represents the best value, and we think today’s AUD 500 million on-market share buy-back supports this view. However, the risk profile is higher due to the company’s higher position on the cost curve and lack of diversification.

We still think Rio Tinto is the most expensive of the large miners, reflecting the high exposure to iron ore where we are most bearish. The Australian listed shares of BHP and Rio Tinto continue to trade at substantial premiums of more than 15% to the ASX listed shares.

The changes to our fair value estimates for miners under our coverage have been relatively small, averaging 2.1%. The increases are noticeably higher for the Australian listed shares with the lower AUD/USD exchange rate of 0.71 a benefit for these share classes on translation of U.S. dollar earnings and commodity prices. The largest change was for Rio Tinto. Our fair value estimate is now AUD 52 per share, 8% higher than previous, reflecting higher near-term iron ore, alumina and aluminium prices forecasts.

For BHP, the 2.0% increase to AUD 25 per share is tempered by a lower exposure to iron ore. For Fortescue, we have extended the period of elevated discounts for its lower grade iron ore product, which partially offsets the benefit of higher forecasts for the benchmark 62% grade. Our fair value estimate for South32 rises 4% to AUD 2.80 per share with higher alumina, aluminium and manganese price forecasts, with the lower zinc price a partial offset. Independence Group is the only firm where we have lowered our fair value estimate, in this case by 3% to AUD 3.80 per share, with the lower spot nickel price the key driver.

The main changes to our commodity price forecasts have been to incorporate higher near-term prices for coal and iron ore, due to strong seasonal demand from China and disruptions to their domestic coal supply, and the reduction in spot prices for some base metals such as nickel and zinc.

The key changes to our base metals’ forecasts are increased near-term aluminium and alumina price forecasts and lower lead, zinc and nickel spot prices. The latter have declined 15%, 3% and 10% respectively. The last few months have been volatile for base metals with copper selling off more than 20% from early July highs, only to recover some of the losses more recently. Overall though we’ve not made any changes to our near-term or longer-term copper forecasts. Aluminium has yo-yoed on news around potential supply disruptions, tariffs and a broader economic slowdown in China and global trade. Nickel and zinc have sold off on concerns around supply, with China investing heavily in Indonesia to boost output and zinc supply responding to recent decade-high prices.

We’ve increased our near-term bulk commodity price forecasts reflecting strong steel output this year and coal production interruptions in China. We’ve increased our metallurgical coal forecasts by 6% on average to 2020, for iron ore by 10% on average to 2020 and for thermal coal by just 3% in 2019. However, longer-term we see the bulks as having the greatest downside as steel production in China slowly contracts and a greater proportion of steel is produced from scrap, at the expense of demand for iron ore and coking coal. We also expect China’s coal supply to normalise as environmental and safety disruptions work through and new mines are added.

Thermal coal prices have been very favourable, thanks to buoyant import demand from China. The hot summer created seasonally strong demand while a tightening in its own domestic supply on environmental and safety grounds necessitated demand from the seaborne market. Coupled with the weaker Australian dollar, thermal coal prices in Australian dollars are above the previous China-boom high. Steel production has also been strong in the lead up to winter curtailments in China. This has supported iron ore prices. Metallurgical coal prices have also benefited from a reduction in domestic output from China as well as disruptions to supply such as the fire at North Goonyella.