Mining the Possibilities

Want to invest in China? Consider Australian mining companies.

Commercially speaking, China and Australia are growing closer by the minute. China's ambassador to Australia, Fu Ying, recently told a Sydney audience that the gears of the two economies “are meshing into one another.” That coming together, explains the Australian Trade Commission, springs from China's rapid industrialization, which is “fueling an almost unquenchable thirst for Australian commodity exports.”

Is this another aberration in the land of the Great Wall, another fiber optic-like burst of demand destined to fizzle? That seems unlikely. According to Goldman Sachs, China's consumption of the world's base ores has been doubling for decades. In 1980, China consumed 3 percent of the world's iron, copper aluminum and nickel. By 1990 that figure was 7 percent. In 2000, it was 15 percent and will hit 20 percent in 2010, Goldman predicts.

G'day, Metals

A growing share of China's ore is now mined Down Under, which partly explains why China became Australia's second-largest export destination last year, overtaking the deficit-strapped U.S. Charlie Lenegan, managing director at UK-based Rio Tinto, the world's second-largest miner, sees Chinese demand as boosting Australia's mineral exports for decades to come.

The quarterly report from Australia's Bureau of Agricultural and Resource Economics is calling for “a bumper year in 2004-2005 for mining and energy exporters.” It predicts export growth rates of 14 percent in minerals and 37 percent in energy. The bureau's forecast seems tailor-made for resource giant BHP Billiton, a leading producer of both ores and petroleum, but a second promising Australian name is WMC Resources, which is ore-rich in nickel, copper, uranium and fertilizer phosphates. Both companies offer American investors the advantage of trading through NYSE-listed depositary shares.

BHP, the world's largest mining company, was created in the 2001 merger between Broken Hill Proprietary and Billiton, is organized into a seven-segment commodity portfolio: petroleum, aluminum, base metals (copper, silver, zinc and lead), carbon steel materials (metallurgical coal, iron ore and manganese), diamonds, energy coal and stainless steel materials (primarily nickel). The name is the only thing “broken” about this company, which for fiscal year 2004, ended in June, set a record for yearly profit by an Australian company, netting $3.38 billion.

Management recently told investors to expect fiscal year 2005 profits of $5 billion and copious amounts of free cash flow. Given the excess cash, some investors speculate that BHP might be tempted to acquire a smaller miner, like WMC Resources, which owns the world's third-largest nickel reserves and is capitalized at $6 billion (compared to Broken Hill's $70-plus billion).

Interest in WMC as a takeover target rose sharply in late October, when Swiss miner Xstrata bid $5.5 billion for it, and share prices rose above the bid in anticipation of better offers to come. (WMC rejected the Xstrata offer.) WMC's prize asset is its Olympic Dam property — the world's eighth-largest copper and largest uranium deposit — which is currently undergoing an expansion that will double its copper production. WMC is also the world's third-largest holder of deposits of nickel, the key ingredient in stainless steel. Only Russia's Norilsk Nickel and Canada's INCO are larger. WMC, like BHP, is a company that does a lot of business in China, having recently signed a supply agreement with that country's largest nickel producer.

Not Broke

Like Broken Hill, WMC hit its midyear marks solidly, posting after-tax income that was 160 percent above 2003 levels, owing to rising prices for both nickel and copper. (In contrast, BHP's earnings rose a more modest 78 percent.)

WMC's rejection of the Xstrata bid leaves open the possibility of further suitors and higher bids. The company is technically in play. Though WMC shares have risen to the target level set by Australian Merrill Lynch mining analyst Vicky Binns, she is maintaining her buy rating, in part because commodity demand in China and elsewhere “creates the possibility that prices will trend higher than the levels we and much of the market use for valuation.”

Drilling down into Broken Hill, we find that China revenues relative to total revenues rose to 9.8 percent from 6.9 percent one year earlier, with the lion's share of the increase coming from BHP's carbon steel segment. That makes sense. En route to becoming the world's largest steel maker, China became a huge importer of iron ore, of which Broken Hill is Australia's top producer. BHP's carbon steel unit also provides China with metallurgical coal, the material used in blast furnace steel making.

Binns sees carbon steel providing 27 percent of operating profits during the current fiscal year, up from 21 percent last year, then climbing to 33 percent in fiscal 2006. “We expect coal prices to go up big time,” she wrote.

Management is bullish on steel. Graeme Hunt, president of Broken Hill's iron ore division, pointed out in a recent company report: “China is the fourth-largest car producer in the world, but most people there still don't have a car. There's a long way to go.”

Binns raised earnings estimates, citing higher oil price forecasts and the strong market outlook for steel-making raw materials like coking coal and iron ore. Binns has Broken Hill earning $1.74 per share for fiscal year 2005, which implies a multiple of about 13 times, a level well below her long-term EPS growth estimate of 16 percent. Binns, who rates BHP shares a buy, points out that its operating margins are better than those of competing giant miners, such as Rio Tinto and Anglo American, adding, “We believe BHP Billiton is the best relative exposure in the global [mining] sector.”

Both Broken Hill and WMC Resources benefit from the rapid development of China. And both companies are sufficiently diversified to offer investors a call on the global commodities cycle, now clearly in an upswing. After years of underinvestment, the cycle for industrial commodities has turned positive. That development favors resource companies, especially those Down Under that mesh well with the industrial engine of the new China.

Either Ore

Two mining companies poised to make a killing in China.