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Metals Miners Positioned for Strong 2017


TOM BUTCHER: When we spoke about the mining industry last October, one of the most important topics was capital restructuring. How have things progressed since then?


CHARL MALAN: At that time, we were talking about how the industry was extremely overleveraged. The companies had borrowed too much money, and their net debt-to-equity ratios were north of 50%. But since then, companies have changed their balance-sheet structures quite aggressively. Net debt or debt-to-equity is now around 20%, which is a huge improvement. They primarily did that in two ways. The first was through asset sales and the second was by cutting capital spending.


The drop in capex across the mining industry over the last few years is dramatic: It peaked at about $160 billion in 2012 and has fallen by nearly two-thirds to around $60 billion. That obviously has made a big difference in company balance sheets.


The other thing that happens when capital spending is cut so much is that future growth is limited. Back in the heyday of 2012, nearly 70% of all capital being spent was allocated to growing either assets or the production base. That number is now closer to 20%. Clearly, we have a few years ahead where not only will capital spending be significantly lower, but also supply, or growth of supply, will be substantially subdued because of the lack of spending and growth.


BUTCHER: Earlier this year, you spoke at Mining Indaba, the world’s largest mining conference. What was your most important takeaway from the conference?


MALAN: Yes, I spoke at the conference, and expressed my views on the sector. I shared that we are currently at an inflection point where I see demand changing. Secondly, I see that growth of supply is at risk, over the next five years. The last thing I spoke about was valuations and where I think equities are now valued.


My biggest takeaway was about free cash flow yield, which is a company’s free cash flow per share divided by its share price. Having upgraded its balance sheets and improved free cash flow, the industry’s trading at about a 15% free cash flow yield; this compares to the 2000s, when the yield was about 7% and companies were using it to pay dividends and buy back shares.


Today, this much higher level of free cash flow will go to debt reduction, which is very positive for the industry’s financial condition. We would then expect companies to reinstate dividends, which represents the type of financial stability the industry needs. Then, only after dividends have been restored, companies will start looking at special dividends, share buybacks, and growth spending or supply spending.


BUTCHER: Let's move from supply to demand. What does demand look like?


MALAN: The demand picture has improved, largely due to a much more favorable economic environment. In October we spoke about slower GDP growth, and now we are talking generally about stronger GDP. The U.S. Small Business Optimism Index is at a post-recession high. China's producer price index is substantially stronger. We were talking about deflation back in October, but now we are talking about inflation and the fact that there is a clear inflationary trend taking shape. Overall, U.S. inflation is picking up, with some labor inflation coming through the system.


The other big contributor to demand is that the environment has shifted from an emphasis on monetary policy to an emphasis on fiscal policy. This is happening globally, most notably in the United States, Japan, Brazil, and Australia, which all are looking at spending more money — which really means infrastructure spending. For the commodity and metals worlds, you typically see a trickle-down effect in which spending on infrastructure translates into rising demand. This should happen much faster than what we've seen in the monetary policy environment over the last couple of years.


BUTCHER: What’s the bottom line for mining equities?


MALAN: We see prices going higher as a result of two key factors:
First, because the industry has improved its balance sheet so dramatically and the stocks are trading at a 15% free cash flow yield, a significant portion of that money is going to come back to the industry. To put this in historical context, the industry was trading at an EBIT-to-EBITDA multiple of about eight times in the 2000 period, but the free cash flow yield was only about7%. Now we have a 15% free cash flow yield, but the EBIT-to-EBITDA multiple is only around four-and-a-half, five times.


There’s a good rerating argument to be made here that, because the commodity price environment looks better and balance sheets are stronger, the current four-five times EBIT-to-EBITDA multiple could very easily go back to the seven-eight level that we saw in the 2000s.


Second, demand is looking stronger, which will be an underlying trend. The lack of capital spending means that supply should be lackluster for five years or so. That means we’re going to have a stable commodity price environment, which is fantastic for equities: Mining company executives can plan budgets and look forward, and investors will gain confidence from greater stability in revenues and earnings.


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