Why are Diversified Miners so Darn Cheap? Why Should You Care?
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Global diversified mining companies like Vale, (NYSE: VALE), BHP, (NYSE: BHP), Rio Tinto, (NYSE: RIO), Teck Resources, (NYSE: TCK), Anglo American, (NASDAQOTH: AAUKY.PK) and ENRC appear to be trading very cheaply on almost any valuation metric. A metric I like to look at is a company's Enterprise Value to 1-yr forward EBITDA. This is superior to a simple P/E multiple because it explicitly takes into account the use of debt leverage used to obtain net earnings.
Using a Goldman Sachs research note from August 2nd, Vale is trading at an EV/2013 EBITDA multiple of 3.7x, BHP 4.7x, Anglo American 3.5x, Rio Tinto 4.4x and Teck Resources 4.6x. That's an average of about 4.2x. Historically these names have traded at 1-yr forward EV/EBITDA multiples of 5x-7x. And that's not all, these companies also have strong dividend yields, Vale about 6%, BHP 4%, Anglo American 3%, Rio Tinto 3%, ENRC 5% and Teck Resources the laggard at about 2.5%.
I believe these stocks are EVEN CHEAPER than EV/EBITDA valuations reveal. Why? Because each of the majors spends huge amounts of upfront capital that will produce future cash flows that are not captured in next year's earnings. I call these hidden resource assets. For example, Teck Resources has oil sands assets that are conservatively worth $3 per share. Rio Tinto owns a significant portion of a massive copper/gold project that is not yet in production. BHP has a reported $80 BILLION worth of capital projects in the works, none of which will be captured in 2013 earnings, and most of it not in 2014 either.
Why are these Bellwether Names so Foolishly Cheap?
Perhaps it's not such a mystery. These companies produce bulk commodities and metals like iron ore, copper, coal, aluminum and zinc, all of which have suffered substantial price declines this year. Earnings this year will be lower than last, but so what? 2011 was a fabulous year and judging by next year's EV/EBITDA ratios, earnings will be solid next year as well. So why don't investors want to hold these stocks?
Investors holding these and many other natural resource stocks have gotten hammered this year. Anglos is down 36% from its 52-week high, Vale down 38%, Teck 40%, ENRC 49% and Peabody Energy is down a whopping 58%. Even worse, many other small-to-mid sized natural resource stocks are down 60%-90%! (if you don't believe me, I have a list of more than 60 names).
Investors that want to reduce exposure to these sectors or are forced to liquidate positions due to margin calls or hedge fund redemptions, typically sell the stocks that have the most trading liquidity, i.e. the majors. Another reason for the poor performance is the dreaded, "conglomerate discount," a situation where a company that has multiple prominent business segments fails to get full credit for the strength of the combined portfolio of assets. This phenomenon has been observed for decades, so it's probably not going away anytime soon. Still, these stocks are really cheap compared to their own historical valuation metrics.
Ok, Ok, I Believe You, the Stocks are Cheap, What's the Catalyst to Make them go Higher?
The shareholders, Boards and management teams are not stupid. There will have to be a move towards equity friendly activities. First, project cap-ex will be slowed, freeing up cash flow. The excess cash flow will be used to buy back stock and/or increase dividend payouts. In some cases, special dividends may be declared. At the most aggressive end of the spectrum, companies may even issue debt to enhance the equity friendly giveaways. Why would a company use debt? Funding costs are at historic lows, the majors routinely issue 10-yr bonds with fixed coupons of 3%-4%, why NOT use debt?
Something more is needed. Vale already has a 6% dividend yield yet its stock is down 38% from it's recent high. Risk appetite needs to return to the natural resource sector. Is that asking too much? No, these are cyclical sectors, they will come back. Once risk appetite returns, the diversified miners could see significant recoveries in their respective stock prices.
MockingJay2011 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.