Mining is not a desirable business. High capital startup costs, commoditized products and continually high capital spending costs depress profitability, return on equity and margins. Meanwhile, commodity prices are unpredictable, making the business very unstable indeed. Volatile prices coupled with high costs make this an industry where only the fittest survive.
Over the past two years, however, the mining sector has completely overhauled itself. After the financial crisis, China’s economic boom inspired miners to invest tens of billions of dollars in new projects to ramp up production. Capital discipline went out the window, and billions were wasted on projects that would never be developed. At the same time, the rush to produce sent commodity prices sliding. At the end of 2015, almost every mining company in existence was, according to Wall Street analysts, on the verge of bankruptcy as years of irrational capital spending and falling commodity prices had taken their toll.
But the industry reacted quickly and, for the most part, the crisis has been averted. Miners cut costs to the bone, canceled expensive vanity projects and increased high-quality production to try and improve margins. At the same time, technological advances have helped improve efficiency while lowering costs and widening margins.
All of these developments have helped the industry quickly regain composure. Managers are now focused on paying down debt and returning cash to investors, rather than chasing new megaprojects. Stable commodity prices have also helped.
Improving outlook
The mining industry’s transformation has turned it from an “avoid at all costs” sector into something more desirable for investors. Indeed, according to analysts at Morgan Stanley, the global mining industry as a whole now trades at a free cash flow yield of 11% and over the next five years, the sector could generate an estimated $344 billion of excess cash, which works out to around 72% of capital employed today. This is the best-cast scenario even though at the baseline, Morgan’s analysts are estimating free cash generation of $269 billion.
Assuming the industry can avoid falling back into old habits, investors should see the bulk of this cash. Global mining giants such as BHP Billiton Ltd. (BHP, Financial) and Rio Tinto PLC (RIO, Financial) have shifted their dividend models over the past two years from progressive dividend policies to payouts based on earnings or cash flows. Consequently, in periods of abundant cash generation, more funds will flow automatically to shareholders rather than risk reinvestment in poorly timed projects or share buybacks.
At spot commodity prices, Morgan estimates the sector’s 2018 dividend yield is an average 7% at an 11% free cash flow yield.
Based on spot commodity prices, the industry’s largest players are set to become cash cows under the new dividend policy guidelines. Morgan's estimates suggest Rio Tinto could yield 10% for 2018 and 2019 as the money continues to flow. Meanwhile, diversified sector leader BHP Billiton could pay out a yield of 7% for 2018 and 2019 based on spot prices.
The better buy
Of the two, Rio Tinto seems to be the better buy. As the world’s largest focused iron ore miner, the company has unrivaled economies of scale and profit margins. For 2016 and the first half of 2017, the company managed to cut $2.1 billion of pre-tax cost improvements, and operating cash flow for the first half of the year was $6.3 billion. Around 50% of this total was returned to investors. The company declared $1 billion in share buybacks and $2 billion in interim dividends while it also reduced net debt by $2 billion to $7.6 billion, pulling gearing down from 17% to 13% year over year.
During the first half of the year, Rio was able to produce a tonne of iron ore for less than $14, generating EBITDA margins of 69% at its best operations. Such low production costs indicate the company will be able to remain profitable even in the most severe market downturns. If debt reduction continues at its current pace, Rio will be debt-free within two years.
Even though mining is not glamorous or the perfect business, the industry’s change of direction over the past several years has completely changed its attractiveness to investors, from basket case to cash cow. For income investors, it might be worth taking a second look.
Disclosure: The author owns no stocks mentioned.
