Mining for profit

"The commodity super-cycle is officially over." That's what many analysts reckon. It's a view certainly supported by the CRB Continuous Commodity Index - made up of 17 different commodity futures - which recently crashed through key technical support. And the index is still under immense pressure, especially from a slowdown in Chinese demand.

One of the main reasons is the collapse in iron ore price. The story has been well told; as the Chinese economy picked up in 2003, so did internal demand for iron ore to satisfy rapid urban development. Iron ore became the commodity of choice. Now, there is a glut of iron ore, and to add to the bad news, Chinese development growth is starting to slow. Yet the scale of the slump in iron ore prices has surprised many.

"Arguably, this is precisely what the major importers of iron ore wanted and actively encouraged," says Investec Securities.

Iron ore fell from $112 per tonne in the first half of 2014, and is widely tipped to hit $85 in the second half. Investec downgraded its iron ore guidance for 2015 by around a quarter to $80, and anticipates an increase to just $90 the year after.

Source: S&P Capital IQ (Click to enlarge)

And those depressing forecasts are justified by a wave of supply from the majors - between 80-120 million tonnes each year is expected. Include projects not owned by the majors, but that are fully financed, and total additional supply will hit 530 million tonnes by 2018. Investec says that to consume this, demand needs to grow by 7.5% a year, "an outcome that is increasingly unlikely as Chinese steel demand growth falters". Barclays sees Chinese GDP growth of 7.2% this year, falling to 6.9% next year, with steel demand unlikely to grow at all.

The industry big guns can afford operating their iron ore mines at low costs and count on pricing high-cost producers out of the market to increase their share. But this has not yet happened, most likely because some high-cost producers are given a helping hand to keep them in business and protect jobs. The number of high cost producer is, however, expected to fall.

"The low-cost producers, Rio Tinto and BHP Billiton, have the margins to prevail but it appears that this will be trench war fare rather than a decisive battle. As such, we now expect an extended period of depressed prices, with prices only picking up modestly once high cost producers are eventually driven out," says Investec.

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Strike while the iron ain't hot

However, contrarian investors may fancy striking while the proverbial iron is hot. Barclays reckons diversified companies are the best option, in order to hedge your investment, with their earnings suffering from downgrades of 14% on average, although these will be slightly reversed by 1% the year after.

Anglo American's platinum and diamond operations - it owns 85% of De Beers - certainly offset risks on the iron ore side, while Glencore is more about copper than iron ore. That said, the latter is said to be keen on iron ore giant Rio Tinto and could make an offer. It will, however, want to wait until the commodity's price has reached what it thinks is the bottom. A bid would surely signal a rally in mining stocks, but we could be in for a wait here.

And, of course, mining companies need free cash flow (FCF) to embark on new projects, make acquisitions and write down debt. The diversified players, according to Barclays, are expected to have an FCF yield of 0.7% this year, growing to 5% in 2015 and 12.5% the year after. Iron ore pure plays, like Ferrexpo, African Minerals and London Mining are suffering from an average FCF yield of -72.4%, falling to 37.8% in 2015 and 35.3% the year after.

Source: S&P Capital IQ (Click to enlarge)

But while majors are generally quite cheap compared to the FTSE 100 index, trading at much lower price/earnings (P/E) multiples, Investec calls the traditional valuation methodology "misleading", as it does not take into account the weak pricing environment.

Barclays warns: "We should point out that there is an average 40% downgrade to our forecasts if we use spot [current] pricing. In turn, that means that on today's prices the shares are not trading on such cheap multiples. There is some FCF yield amongst the diversifieds, but this is pre-dividend, so if prices do not improve from here, the likelihood of returns of capital is much diminished."

After recently researching whether readers should invest in the diversified majors, Interactive Investor takes a look at the juniors jostling for greater market share, and survival.

London Mining

Having once captured the dizzying heights of around 400p, London Mining has lost 99% of its value over the last three years and is now worth just over 5p. So what went wrong?

It is all down to the company's inability to handle its money, with debts swelling despite completing what Investec calls an "admirable job" on its high-quality operation. But bankruptcy is on the cards unless an investor who believes in the company stumps up some serious cash.

It's no surprise that analysts have slashed their guidance; recommendations of 'sell' and Investec downgraded its target price to 10p from over 50p. It has net debt to earnings before interest, tax, depreciation and amortisation of more-than 10 times.

At the beginning of this week, London said: "The company does not have sufficient liquidity to enable it to continue to trade through this period without raising further finance."

And while many can't deny the company has potential, investors should wait for evidence that a sustained turnaround has taken place and that management is back in control of its capital.

Ferrexpo

The City is more upbeat about Ferrexpo, which is based in Ukraine and supplies iron ore pellets to the steel industry. Despite its exposure to obvious geopolitical risk, the company has managed to maintain its strong operational performance. And Westhouse Securities sees pre-tax profit coming in at $322.7 million on sales of $1.5 billion.

Profit is set to fall by around $100 million in the two following years, with its P/E multiple rising to over 7 times from 5 this year, but Westhouse is sure that when the situation in Ukraine improves, the company will enjoy a re-rating. Targeting production of 12 million tonnes (mt) this year and between 20-22mt next year, the analysts have a 'buy' recommendation on Ferrexpo with an 180p target price, reduced from 220p.

Over the last 12 months, Ferrexpo shares have lost around half their value. Predicting when the rout will end is impossible. High risk.

African Minerals

Another company suffering from the downturn in iron ore price is African Minerals, and analysts rate this on a 'sell'. For the first six months of its fiscal year, it made a cash profit of just $2.7 million, down from the $100 million last year, and operating losses swelled to $85 million from $18.3 million. But its chief executive reckons the company can be cash positive at the end of this year. Brokers, however, is unsure.

After reiterating its 16-18mt export guidance for 2014 with costs of $34-36/t, exports for next year are pencilled in at between 21-23mt at costs of $30/t. A run rate of 25 million tonnes per year at $25/t is expected by management at the close of 2014, but with this being on a cost equivalent to Rio Tinto. Investec calls it "dream territory".

"Operations are improving," says Investec, "but not at near the pace required to offset the dramatic fall in the iron ore price. The company has outlined a strategy to improve operating margins and return the operations to positive cash flow, a strategy that will need to be supported by "appropriate" funding requirements. To this end, it has mandated advisors to evaluate such measures."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.