Morningstar On CommoditiesOur Take on the Commodities Industry
Are firms making the most of soaring prices?
by Parvathy Krishnan, CFA | 06-07-06 | 06:00 AM
For the last few years the world has watched in awe as commodity prices scaled long-forgotten heights. While there is no doubt that a bull market in commodities is currently under way, the jury is still out on how long the bull market will last. In the meantime, the impact of commodity prices is being felt all over the globe.
Consumers face higher gas and electricity bills as well as higher prices at the pump. Industrial and commercial users have watched their raw-material, fuel, and power bills go through the roof. Rising commodity prices have hurt companies that use commodities but aren't able to pass the price increases through to their customers.
Conversely, the producers of commodities are laughing all the way to the bank. With their products fetching much higher prices, revenues and profits have soared, and stock prices have kept pace. Companies have three main ways to put this cash to work--pay down debt, expand operations, or return wealth to shareholders. Interestingly, not many miners have been paying down debt. In fact, CVRD RIO and BHP Billiton BHP, two of biggest miners in the world, have increased their debt loads recently to increase the funds at their disposal.
The windfall, and then some, is primarily being used to return wealth to shareholders and fund expansion. BHP Billiton, Rio Tinto RTP, and Phelps Dodge PD, to name a few, have announced and implemented substantial share-buyback programs and special dividends. Returning wealth to shareholders in the absence of attractive expansion opportunities is a wise decision, in our opinion.
All across the industry, companies are also using the extra cash to fund expansions, either internally or through acquisitions. CVRD, for example, has an impressive lineup of projects slated to be commissioned in the next few years. The same is true for Barrick ABX and Inco N, producers of gold and nickel, respectively. BHP Billiton, on the other hand, has spent more on acquiring growth--the company paid about $8 billion in 2005 to acquire Australian miner WMC Resources, owner of the famous Olympic Dam uranium deposit. Swiss miner Xstrata acquired almost 20% of Canadian nickel and copper producer Falconbridge in 2005 and recently made an $18 billion cash bid for the rest.
Among the next tier of miners, Wheaton River made five acquisitions in two years before merging with Goldcorp GG in early 2005. The new Goldcorp partnered with Barrick to acquire Placer Dome in early 2006, in what is the gold industry's largest acquisition to date. Goldcorp now carries some debt after being debt-free for a long time.
All in all, it is safe to say that more wealth is being used to acquire growth than to fund projects internally, and companies are using cash and stock to fund these acquisitions. The common theme is that commodities producers are cashing in on elevated market sentiment and trying to grow as much as they can when the going is good. While one cannot fault them for having growth aspirations, in a rising price environment it is usually the case that the acquirer overpays for the target. This is typically the case in commodity industries, where sentiment can get way ahead of the fundamentals.
In times like these, the really disciplined companies stand out. Freeport McMoRan Copper & Gold FCX, owner of the prolific Grasberg copper and gold mine in Indonesia, has used its increasing cash reserves to pay down debt, raise dividends, and declare special dividends. Profitability growth, as opposed to revenue growth, is a key consideration, and management has been skeptical about the existence of attractive acquisition targets in an overheated commodities market.
Similarly, Rio Tinto has committed to return about $4 billion in dividends and share buybacks. The company also divested its holdings in Freeport and Lihir Gold LIHRY and booked solid profits on the sale. Rather than compete with BHP Billiton for Olympic Dam, Rio Tinto took a small step and acquired the Hope Downs iron-ore project in Australia.
At Morningstar, just as we like to buy good companies at cheap prices to maximize the returns on our investment, we like companies that are focused on profitable growth. It is no wonder then, that we prefer companies like Rio Tinto over companies like BHP Billiton.
That being said, currently, most mining companies in our coverage universe earn a 1-star Morningstar Rating for stocks. The reason for this rating is that in our discounted cash-flow valuation of a mining company, we assume that commodity prices will revert to trend over the next two years. But we do make a point of differentiating them based on capital allocation and size and quality of portfolio.