A Prediction for ‘Blue Chip’ Australian Iron Ore Miners

A quick note about Australian stocks. If iron ore prices stay below $100, BHP Billiton and Rio Tinto will have less cash to pay down debt and return to shareholders, according to analysts from Macquarie and Credit Suisse. After booming export volumes in the first quarter, BHP announced plans buy back about $10 billion of its own shares while Rio targeted around $8.5 billion. Both companies aimed to reduce net debt as well.

Capital management is the most important job that management has. But normally, you’re managing capital to get the optimum mix of debt and equity so you can grow the business (earnings). If you’re managing the capital structure of the company purely to return cash to shareholders, or to boost earnings per share by reducing the number of shares outstanding, you’re really managing the share price, not the business (although for executives with compensation linked to the share price performance, there is no difference).

Of course, businesses exist to deliver cash to their shareholders. But that cash has to come from operating the business efficiently, keeping costs low, and being generally good at your chosen line of work. BHP and Rio Tinto are both trimming costs. And both have access to world-class iron ore deposits and great infrastructure. But where is the growth going to come from? Haven’t we just had an epic period of demand growth, of price growth (for iron ore), and of share price growth?

Here’s a prediction: The shares of the big miners will be re-rated this year to reflect much lower future growth. They’ll go from ‘safe’ blue-chip materials companies (making up 17.2% of the market capitalisation of the ASX/200) to cyclical mining companies with too much debt and exposure to price volatility in their underlying commodity (iron ore).

To be sure, neither stock is a one-commodity-wonder. But when our ‘rim of fire’ tour hits China tomorrow, I’ll show exactly what’s at stake by looking at China’s fixed asset investment and real estate bubble. The future of Chinese steel demand is the critical issue.

Regards,

Dan Denning
for Markets and Money

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Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.


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