By Chris Berry (@cberry1)
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Investors in the small cap mining sector are well aware of the “end game” for the junior mining plays - either a take out by a larger company or the mythical “get into production” (which few achieve successfully). Significant structural barriers including strong deflationary headwinds and traditional cyclical issues have altered this line of thinking. I think this mandates that we evaluate the natural resource sector differently.
This is why I continue to believe that those companies with a competitive and disruptive advantage are better placed to survive the current commodity collapse and emerge when global supply and demand forces eventually equilibrate in the future.
That said, if every crisis provides opportunities, the current metals landscape demonstrates significant pockets of value. If that is the case, there are two questions to consider:
Where is the value? And….
What are the catalysts to unlock it? The answer to the first question is subjective; the second is more objective.
Since the end of the current iteration of the commodity super cycle in late-2011, one of the ways I have addressed these questions is through more detailed focus on larger market capitalization companies mainly through dissecting their quarterly earnings calls. Everyone has their due diligence “list” when reviewing companies (management experience, balance sheet strength, sustainability, etc), but listening to what publicly traded commodity producers and users have to say is not as prevalent.
Despite the massaging that occurs with financial results and prepared statements made by executives on the calls, I’ve found it to be a worthwhile exercise in that it offers insight into a company’s forward looking plans and their appetite (or distaste) for growth through acquisition.
There are dozens of companies whose calls you could listen to, but here is a short and not complete list of a few I’ll be focusing on. The companies listed are major producers or users of respective metals and minerals including: copper, cobalt, lithium, rare earths, and graphite:
Source: Bloomberg, Company Websites; Data as of Jan 26, 2015
Here are 9 questions I’ll be looking for insights into:
How has the strength in the USD affected your operations? The converse of USD strength is, of course, weakness in other currencies which makes it cheaper to produce a given commodity abroad. Given the gluts of various metals available globally, this could serve to squeeze producer margins.
Source: Bloomberg
What is the trend in production costs? Are input costs falling? In most cases I’m assuming they’re falling mainly based on the collapse in oil prices. This may or may not be a positive depending on the metal (see my point above about overproduction).
What are the plans for Cap Ex growth or will share buybacks continue to be the method to drive shareholder returns? Of the many reasons to get nervous about share price performance, I think this risk has been seriously overlooked. If companies are generating cash in record amounts and not investing in organic growth, what does a share buyback indicate about a company’s future growth prospects? To be clear, there is re-investment and cap ex growth (albeit more slowly today), but the size and scale of share buybacks in lieu of other methods to grow is a concern.
What is management seeing in China? Are Chinese imports accelerating or stalling based on the current prices of metals? What are Management’s thoughts on stockpiling of commodities versus actual usage? A reliable read on Chinese consumption of commodities has always been famously difficult to ascertain and as the country alters its growth model, this question has only increased in importance as China’s growth continues to slow.
How are politics affecting investment decisions? The government-led ore ban in Indonesia mainly affecting Freeport McMoRan (FCX:NYSE) and Newmont (NEM:NYSE) is only one example. The recent Presidential election in Zambia, Africa’s second largest copper producer, was won by a party which backs the scrapping of a corporate tax on mining and instead raising mining royalties on open pit operations from 6% to 20%. Barrick Gold (ABX:NYSE) has initiated plans to mothball its Lumwana copper mine there and cut the 4,000 jobs which support the mine which produced 260 million pounds of copper in 2013.
Are there any plans to cut dividends? For those companies that pay dividends, this is likely the most important question to answer as a dividend cut speaks to the sustainability not just of the dividend, but of the overall business plan in an era of depressed metals prices and excessive debt. The dividend yield on the S&P 500 is currently 1.96%. For comparative purposes, the US 10 year Treasury currently yields 1.82%. Any dramatic dividend cuts in the corporate sector will no doubt lower the yield and possibly make Treasuries more attractive in a search for yield. With equity markets (the TSXV notwithstanding) at all time highs and rumblings of interest rate increases being discussed, this issue promises to become more prevalent. Just look at the oil and gas small cap sector with $200 billion in high yield debt to see where the metals may be headed. How will FCX cope with $19 billion of consolidated debt on its balance sheet? Cliffs Natural Resources (CLF:NYSE) recently halted its dividend, instead favoring to pay down debt.
What is the trajectory of Free Cash Flow (FCF)? This metric, to me, is enormously more important than earnings per share – an often meaningless and easily manipulated number. FCF is roughly calculated by starting with cash from operations and subtracting capital expenditures. It’s designed to give a clear picture of how much cash a company can generate after outlays or maintaining or expanding the business. In short, this is the number that really matters (but it’s not infallible, either).
To be sure, there are many more questions one could ask and the answers for each company (and metal) will be different. I have said it before, and I still believe this: 2015 is going to be a challenging year which should be used to learn as much as possible about the metals and value chains we continue to write about with an eye on 2017 as a more fertile environment.
After three challenging years in the small cap mining space, getting satisfactory answers to some of the questions above can provide a road map to an environment with better returns.
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