Mining – a refuge from the mad?

Most value investors share two things; a reverence for Buffett and a disdain for miners. I hear it all time, even among my colleagues (One of my career goals is to get James Greenhalgh into a mining stock. Not yet).

Miners are lousy; they are cyclical, capital intensive and price takers. All that is true. But is it different from other industries? 

Every business has variables outside of its control. Software and telcos depend on rapidly changing technology, retailers are reliant on fickle fashion, infrastructure and real estate businesses bend to interest rates and regulators are crucial in healthcare.

Key Points

·       Value investors too quick to dismiss mining

·       Be selective. Act counter-cyclically

·       Five of the best mining opportunities today

It's true that miners have no control over the price of their output. Yet volume and cost are well understood and competition isn't likely to emerge from the garage of a teenager, or anywhere else, overnight. 

There is a playbook for investing in the sector: be selective and deploy cash amid gloom. That might mean ignoring the industry 80% of the time, but one should be open to miners and treat them as any other cyclical business.

Buying in the downturn

We are already in a global recession. Economic activity all over the world has collapsed in a matter of weeks and commodities that began modestly priced have sunk further. 

Prices are falling but producers are responding by lowering output and shutting mines. Investment plans have been abandoned and supply is falling.

The demand shock will one day end and it's likely the resources industry is unprepared to meet new demand. Higher prices in the future are likely and now is the time to prepare for that possible outcome. 

Below we outline the best miners (or, at least, the ones we know the best) to consider for those prepared to stomach resources stocks.

The diversified miners

BHP and Rio Tinto are the best miners in the world. Both businesses are anchored by iron ore assets which, in a bad year, still generate a return on assets of about 15%. In a good year, ROA typically exceeds 50%.  

The Pilbara generates such riches because iron ore isn't really a mining business - it's a logistics business.

Most of the cost and complexity of iron ore mining is in transporting ore from the mine to the coast where it is loaded onto giant ships. Doing that economically means building integrated networks of conveyer belts, rail and ports. 

The rail system in the Pilbara is among the world's longest at almost 3,000km; ports support the world's largest ships and Rio's conveyor system is among the world's longest.

The sunk cost of that infrastructure means the cost of new supply for BHP and Rio is a few dollars a tonne while a new entrant must spend billions of dollars. More than 80% of the world's seaborne iron ore originates from just two colossal mining basins - the Carajas in Brazil and the Pilbara. That is unlikely to change. The giants continue to generate sensational returns from iron ore.

Rio's aluminium exposure and BHP's oil exposure are two big differentiators between the two giants. Whereas Rio has written off tens of billions of asset value from its aluminium business and generates ROAs in the low single digits, BHP's ROA from oil tend to be closer to 20%.

BHP remains the better business but both boast low debt, low costs and sensible management. The big miners have never been in better shape.

Neither are Buys today, however, largely because high iron ore prices have protected valuations. We don't think they are dear, although, bruised from collapsing oil prices, BHP is mildly cheap.

Miners, even of this quality, need a big margin of safety.

Another chance at South32

South32's asset quality isn't a patch on Rio or BHP but it is well diversified with operations spanning alumina mining and refining, manganese, aluminium and base metals. The miner carries net cash of almost US$500m and shouldn't need to raise equity even if commodity prices lurch lower.

As you can see from Table 1, most of its earnings and assets are involved in three commodity groups - alumina, manganese and metallurgical coal, used in making steel. 

Those three commodities last year accounted for about 90% of EBIT and 60% of the asset base. All three commodities are highly cyclical - met coal and manganese are linked to the steel cycle while alumina is an input into making aluminium. Each has suffered margin declines between 25 and 44% over the past year so these earnings aren't at cyclical highs.

South32 has the asset quality and capital allocation record to generate average, or perhaps slightly above average, returns on capital over the cycle. Its biggest assets are its best; South32 is the world's largest and lowest-cost producer of manganese, while the Worsley alumina refinery remains among the best anywhere.

Some older assets are shrinking - the glorious Cannington mine, which has made billions for South32, is in terminal decline - but management has sensibly acquired new mines at reasonable prices. Hermosa in Arizona appears to be a clone of Cannington and could, in time, be worth billions.

We don't need to pay for such optionality today with the stock trading at just over half net tangible asset value. 

Decent quality assets, sensible capital allocation and a knockdown price.

Special situations: Mineral Resources

Buying decent assets during a cyclical trough is the bread and butter of sensible investors. Occasionally, however, a more interesting proposition emerges: Businesses that, for different reasons, are comprehensively misunderstood and mispriced. We believe we've found two such situations and we've written about each in the past.

Mineral Resources was taken to our internal review, the Dragons Den, at similar prices to today. This is an unusual business which we described in detail in an Ideas Lab.

At the risk of repeating ourselves, we don't think the market understands a business that is completely unique to all its peers. 

Mineral Resources operates the world's largest independent crushing business and is contracted by the world's biggest miners to crush their iron ore to exacting standards.

Crushing is a vital and challenging task. It demands large rock of random size be crushed into neat, uniform particles of specific size. Crushers need to be reliable and economic to build and service in remote locations. 

With decades of experience, Mineral Resources has built a specialty niche and carries the largest inventory of spare parts in WA. It can boast better uptime than competitors.

Crushing volumes have grown, on average, 15% per year for years. This is now a fantastically profitable division that generates stable, predictable profits at high rates of return. 

As crushing involves high upfront construction costs followed by long periods of contracted revenues, we think this is more akin to an infrastructure business rather than a mining services one. In our view, the crushing business alone is worth well over $2bn against an enterprise value of $2.8bn for the entire business.

The rest of Mineral Resources is an owner of mining assets where asset quality is low and profits variable, but the business holds life-of-mine contracts for crushing and services. The margins it earns on its assets remain attractive and it retains explosive upside potential as a high-quality lithium miner. 

At the right price, investors get a quality crushing business and plenty of mining optionality, guided by an owner-manager with a terrific record of capital allocation. Those comfortable with risk - low iron ore prices will hurt mining profits - can start to build a position now although we'd formally commence coverage, with an upgrade below $12, a level which offers the mining segment for just about nothing.

Iluka and the MAC

You might think that utterly dominating the global supply for a key commodity would guarantee high returns. Mineral sands are used to describe a group of commodities - zircon, rutile and ilmenite - that are used to whiten paper and produce ceramics and paint. Iluka is the world's largest producer and controls about a quarter of global production. Yet it has never made satisfactory profits.

Mineral sands is a lousy industry. We aren't interested in Iluka for its mining business. Rather, as we described in an Ideas Lab, we are interested in Iluka's royalty business.

Among its grand mining assets sits a decade's old royalty that grants Iluka a 1.232% cut of any revenues BHP generates from an iron ore tenement known as Mining Area C (MAC). 

BHP currently produces 65mtpa from MAC but is halfway through a US$3.5bn expansion that will grow output to 145mtpa. This expansion is crucial, as it replaces ore from a depleted iron ore mine. 

Output from MAC will be high grade, low cost and comes with a 30-year mine life. It will be operated by the world's largest miner with a fortress balance sheet. Iluka's royalty is the closest thing you will see to a license to print money.

Iluka currently earns about US$85m a year from its MAC royalty. BHP's expansion will gift a one-off payment of US$80m payment and, assuming iron ore prices at US$55 a tonne and a normalised exchange rate, Iluka can expect about $140m a year in low risk, cost-free cash. At current iron ore and currency, that ought to be closer to $270m. 

In a zero-interest rate environment, a low risk, zero-cost stream of cash with a top miner as a counterparty should be coveted.  Many analysts have compared the MAC royalty to other listed mining royalties and announced valuations between $1.4bn-1.9bn. We think that grossly underestimated the quality of the asset which, in our view is worth between $2-2.5bn against an enterprise value of $3bn for Iluka.

With the board now committed to splitting the royalty business, that implies a low price for the mining operation which counts tangible book value of $700m and net cash on the balance sheet. Not to mention a quarter of the world's output of an important commodity.

The greatest risk from here is how the immense royalty cash flow is used. Management has said some scary things - that they wish to build a global royalty business - so we must show caution. We also don't want to be stuck holding minerals sand assets. That said, the MAC royalty is among the best assets in the sector. If we take a conservative valuation of $2bn for the MAC royalty and tangible book for the mining business, we come, roughly, to the current share price. From here, we can probably expect high single-digit returns which, for some, may be enough.

We prefer to see the structure of the MAC royalty and how it is capitalised. The board and strategy will determine whether the royalty becomes a true cash machine or a platform for vanity and ambition. We expect the royalty business to be listed next year. Put it on your watchlist.

Disclosure: The author owns shares in Mineral Resources.

Gaurav Sodhi is the Deputy Head of Research at Intelligent Investor. To access more share research from Intelligent Investor, start a 15-day free trial today.