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April 3, 2017

Is a turnaround ahead for Asia/Pacific mining stocks?

by Tim Gaumer.

Suppliers of iron ore and their investors might be encouraged by the recent upward trend in ore prices. Exhibit 1 shows a longer term trend. In it, you can see that iron ore prices are still well off their highs of 2012. The better news is in Exhibit 2, which shows that those prices may have hit a low during 2015. The recent surge in prices came quickly and now stands about double where they were at the low point.

Exhibit 1. Iron ore prices – long term trend

Source: Eikon/Datastream/Fathom Consulting

Exhibit 2. Iron ore prices – short term trend

Source: Eikon/Datastream/Fathom Consulting

Share price gains

We may be seeing more normalized commodity prices driving the appreciation in the share prices of mining companies. Exhibit 3 shows that over that last 52 week period, mining shares have been the third largest gainer of all Thomson Reuters Business Classifications (TRBC) Industry Groups – appreciating 45% over this period.

Exhibit 3. Mining Sector Gains

Source: Eikon/Aggregates App

Fundamentals are key

Indeed, underlying company fundamentals seem to be improving and providing some justification for sharply rising stock prices. The Australian economy is especially exposed to natural resources and commodity prices. Exhibit 4 is the output of a screen that ranks all Australian companies with a market cap greater than US$1 billion by our predictive Combined Alpha Model score. This model incorporates a number of factors, from Earnings Quality, Analyst Revisions, institutional investors buying patterns, valuations and more (see Exhibit 6). Metals and mining companies make up a disproportionate number of these in the top ranks.

Exhibit 4. Australian companies ranked by Alpha model

Source: Eikon

Large cap search

Expanding our search to all large cap Asia/Pac companies in the TRBC Metals & Mining Industry Group (market caps greater than US$5 billion), we find that many companies across the entire region fall into to the top 10% of the model’s rankings. The improving prospects for companies in this industry appear to be something we’re seeing not just in Australia, but across the region.

Exhibit 5. Large cap miners ranked by Alpha model

Source: Eikon

Spotlight on Fortescue

Fortescue Metals Group Ltd. (FMG.AX) is at or near the top of both sets of screening results, receiving a 100 on a 1-100 scale where 100 is the highest and most bullish score. Fortescue, one of the world’s largest iron ore miners, proclaims itself as the global low cost producer and has a 17% market share of iron ore imported to China.

Exhibit 6 shows the components of this model for Fortescue. The size of each slice in the pie chart represents the weight it receives in the overall model and the numbers, its component score; again, on a 1-100 scale with 100 being best and representing positive characteristics. Going around the chart, ARM stands for the StarMine Analyst Revisions Model (StarMine being the brand for our predictive stock ranking algorithms).

Price Mo is a Price Momentum signal – stocks that have been trending higher tend to continue in that direction for about the next year. Next, Fortescue appears to be inexpensive based on both the Intrinsic Valuation (IV) model, based on a dividend discount model framework and on a relative basis. The Relative Valuation (RV) approach combines six different valuation ratios, such as P/E, price to book, price to cash flow, etc. The company also ranks well when examining whether or not its earnings are coming from sustainable sources, which is what the Earnings Quality (EQ) score represents. It expands on the Accruals Anomaly, pioneered by Professor Richard Sloan and others, then at the University of Michigan, during the mid 1990’s. Smart Holdings (SH) is a model of our own creation. It examines the recent buying behavior of institutional investors and compares the characteristics of companies they collectively seem to favor to those of, in this case, Fortescue. This high score shows the company shares many of the same characteristics that investors have been seeking when looking for stocks to add to their portfolios.

Exhibit 6. Fortescue’s Alpha model rankings

Source: Eikon/StarMine Combined Alpha Model

Price drop/inventory gains

A sharp decline in global iron ore prices was accompanied by a large inventory buildup at Fortescue. That combination strained both cash flows and the balance sheet. It is encouraging to see inventory levels decline in each of the last two years. At the end of its most recent fiscal year, it had declined to just over 60 days.

Exhibit 7. Fortescue inventory days

Source: Eikon/StarMine EQ model

Watch cash flows

Higher ore prices, lower costs, and an inventory reduction have contributed to a turnaround in free cash flows. During the six months ended June 2016, free cash flow was nearly US$1.7 billion, compared to less than $700 million in reported net income. That difference is shown below in green. The red periods showed the amount by which free cash flow lagged net income. The company has put that cash to work paying down debt, which has been reduced by about half since it peaked in 2014 at over $12 billion.

Exhibit 8. Fortescue free cash flow

Source: Eikon/StarMine EQ model

Given its June fiscal year-end, the most recent earnings don’t even reflect the sharp ore price appreciation shown back in Exhibit 2. Analysts, however, take both the recent past and their future outlooks into consideration when publishing their financial forecasts. We can see those recent estimate changes in the details of the Analyst Revisions Model (ARM) below in Exhibit 9. Analysts have been strongly revising upward their estimates for EPS, EBITDA and revenue for both this year and next. And they have, on average, raised their recommendations. This puts Fortescue in the top 1% of all companies in the Developed Asia Pacific region, as can be seen in Exhibit 10.

Exhibit 9. Fortescue analyst revisions

Source: Eikon/StarMine ARM

Exhibit 10. Fortescue Analyst Revisions Model score

Source: Eikon/StarMine ARM

Stock price gains

OK, that’s a lot of positive news we’ve just outlined. How much of that has already been priced into the stock? Certainly some of it – the stock was trading at about AU$1.50 at the beginning of 2016, today it’s a bit above AU$6.00. Contrarians have been well rewarded. But, by at least one measure, it still doesn’t appear expensive. From the details of our Relative Valuation model, on a forward 12-month basis, the stock trades at just 1.3 times book value, has a P/E ratio of only 7.6 and has a dividend yield above 6%.

Exhibit 11. Fortescue relative valuation

Source: Eikon/StarMine RV model

A value proposition?

In fact, that seems downright cheap. That’s why, if you return to Exhibit 6, you’ll see why this model ranks FMG at a high 96, where high numbers suggest an undervalued stock and low numbers raise an overvalued flag. Not only does FMG appear cheap compared to others across Asia/Pac, but, from Exhibit 12, it appears cheap relative to its own history. The upward trend in the gold line shows the historical Relative Valuation scores, while the stock price is shown in blue. By this model, the stock was very overvalued in 2007-2008 (remember the “commodities supercycle” theme?). The stock rapidly retreated from above $12 to under $2, validating our model during that period in history. With that phrase fallen by the wayside, the model showed Fortescue growing ever cheaper and never more so than today.

Exhibit 12. Fortescue relative valuation

Source: Eikon/StarMine RV model

Quantitative models

That’s not a recommendation, just a series of observations using a systematic collection of quantitative models, using Fortescue as a representative example of the Asia/Pac metals and mining industry. But, given the trends in pricing and costs, professional investors may be able to dig around and unearth a few interesting opportunities in this recently out of favor industry that has shown signs of revival over the last year.

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