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Back to Part XIII - Cable TV Industry

By Mark Bern, CPA CFA

The diversified metals and mining industry (not to be confused with the precious metals industry) will continue to benefit from the growing demand of the growing global consumer class. As emerging economies evolve, hundreds of millions of people who once lived at survival living standards are now moving upwardly economically and becoming consumers. A great visualization of this is captured by Hans Rosling in his video from TED "Ideas Worth Spreading." He talks about population and how the billions of people are and will continue to move upward in the consumption chain. If you have not seen this video it is a real eye opener and well worth your time.

If you are a new reader to this series you may find it worthwhile to read the original article of the series as it describes the process I use to select the companies that I consider to deserve to be called quality dividend-paying companies. I have also put together a Dividend Investors' Guide to Successful Investing concentrator blog listing all of the articles in this series by industry and date of publishing. I will keep that site current with weekly updates. So, let's get back to my assessment of the industry at hand: diversified metals and mining.

My belief is that commodities remain in a long-term bull trend, but that we are experiencing a correction of intermediate duration due to the sluggishness of the world economy. Demand is slow primarily because the developed economies of the world, most notably Europe and the U.S., are struggling. The struggle seems to be related to massive debt levels and trade imbalances and I don't really see any realistic attempts to address the root of the problem. However, some band-aides are being applied and we'll be sent out to play some more soon enough. The worst of the crisis may not have been averted, but it may be accurate to say that the worst of the crisis has been postponed. For this reason, I remain cautious in the short and intermediate terms for most equities and most definitely for commodity-related issues such as these.

But my longer term view is that we will eventually get past our problems, one way or another, and that growth will recovery along with surging demand from all the new consumers. This is a wave that cannot be stopped. The people of the world see that others are attaining new, more elevated living standards and want to experience it for themselves. The poorest of the poor will not see it on television, hear it over the radio, or read about it over the Internet. But they will hear about it through word of mouth. It will take time for word to spread, but when it is something of this magnitude it will reach nearly everyone regardless of where they live eventually. A few in extremely remote areas may opt for the status quo, but the vast majority will want to join the economic revolution and enjoy the benefits for themselves. This means that we'll need more infrastructure, more cars, more washing machines, and more of just about everything that many of us already take for granted but that many more may have only heard other talk about. So, when the current correction appears to be at its worst in commodities, we should be ready to add to our positions or create new ones if necessary.

My other concern for this industry is the new law passed in Australia imposing additional taxes on natural resources companies. I believe that this could have a significant impact over the next two or three years. Canadian leaders seem also to be watching this development to determine if it is a viable option to raise more federal funding for the government. I suspect it will backfire on Australia very quickly and that the law will be repealed eventually. It shouldn't hamper the long-term outlook but could make for some trouble in the shorter term.

Leading the pack, by my estimates, will be BHP Billiton (BBL), with operations in several countries but with concentrated operation in mineral-rich Australia. As stated above, I believe BBL could be in for a rough couple of years, but I also believe that management is up to the task of finding a way to minimize the impact as much as possible. The company is well diversified in terms of the variety of ores it mines and also has a sizable operation in oil exploration and production. The oil production should be a positive as I believe that oil prices will rebound before most metals. Let's look at the report card.

Metric

BBL

Industry Average

Grade

Dividend Yield

3.9%

2.0%

Pass

Debt-to-Capital Ratio

19.0%

18.3%

Neutral

Payout Ratio

21.0%

30.0%

Pass

5-Yr Average Annual Dividend Increase

23.0%

N/A

Pass

Free Cash Flow

$3.33

N/A

Pass

Net Profit Margin

33.0%

22.6%

Pass

5-Yr Average Annual Growth in EPS

19.8%

19.6%

Pass

Return on Total Capital

34.6%

19.5%

Pass

5-Yr Average Annual Growth in Revenue

20.0%

1.6%

Pass

S&P Credit Rating

A+

N/A

Pass

BBL rates only one neutral ranking against nine Passes. I hope you can see why this is my favorite company in the group. I wouldn't buy shares today, but I think we'll see a good opportunity to get in at a great price coming soon enough. You can call me crazy. I really don't mind. But I project a target price for this stock (U.S. traded ADR) of $125 in five years. If we get in at an even better level, the total return potential gets really interesting. This may be a great candidate for selling long duration put options that are deep out of the money to collect some nice premiums and potentially pick up shares really cheap.

My next entry is a company that readers will recognize from several of my previous articles. Freeport McMoRan Copper and Gold (FCX) produces primarily copper, gold and molybdenum from its mines. At current production levels, the company has copper reserves that would last another 32 years, gold reserves for more than 25 years, and molybdenum reserve that could last for more than 39 years. The company experienced a labor-related production interruption at its Grasberg operations that pummeled the stock in the first half of 2012 and the shares have not recovered since. The company refinanced $3 billion of its debt to lower interest expenses. That should help somewhat in future periods. The company saw EPS drop in 2008 and cut its dividend in 2009. But both have recovered to new highs. I don't like dividend cuts and will often eliminate companies that do so unless the metrics are highly favorable and only if dividends have been restored and risen above pre-cut levels. Thus, FCX made the list on that basis. Putting that offense aside, though, once the global economy begins to recover, I believe that FCX will have excellent upside potential. Let's look at the metrics.

Metric

FCX

Industry Average

Grade

Dividend Yield

3.9%

2.0%

Pass

Debt-to-Capital Ratio

18.0%

18.3%

Pass

Payout Ratio

21.0%

30.0%

Pass

5-Yr Average Annual Dividend Increase

9.7%

N/A

Pass

Free Cash Flow

$1.74

N/A

Pass

Net Profit Margin

21.8%

22.6%

Neutral

5-Yr Average Annual Growth in EPS

7.0%

19.6%

Fail

Return on Total Capital

24.6%

19.5%

Pass

5-Yr Average Annual Growth in Revenue

8.4%

1.6%

Pass

S&P Credit Rating

BBB

N/A

Pass

FCX rated one fail, one neutral and eight passes. The fail is primarily due to the problems experience in the Grasberg operations mentioned earlier. That problem appears to be history, at least for now. Everything else on the report card looks very good. I really like the prospects for FCX for the long term and have a five-year target price of $55 on the stock. That combines with the excellent dividend that appears will increase at an above-average rate to provide a potential average annual compounded total return of over 15 percent. That falls short of my expectations for BBL but it is still well worth consideration.

Now we'll take a look at my final entry from this industry: Rio Tinto PLC (RIO). RIO, like FCX and almost every other company in the industry, saw its EPS fall during the last recession and also cut its dividend. The exception to this industry-wide phenomenon was BBL, in case you were wondering, which increased its dividend every year straight through the recession. But even BBL experienced a temporary drop in EPS. Like any other quality company RIO has bounced back with EPS for 2011 increasing by 43 percent over the previous high in 2007. Indicated dividends have also recovered to higher than pre-cut levels. Of the three companies I present here, RIO is probably the most geographically diverse. It rivals BBL for product diversity as well. Also, I believe that RIO is the most likely of these companies to take advantage of the lower valuations to make some strategic acquisitions of smaller competitors with good properties. Let's look at the metrics.

Metric

RIO

Industry Average

Grade

Dividend Yield

3.9%

2.0%

Pass

Debt-to-Capital Ratio

28.0%

18.3%

Fail

Payout Ratio

14.0%

30.0%

Pass

5-Yr Average Annual Dividend Increase

7.4%

N/A

Neutral

Free Cash Flow

-$0.14

N/A

Neutral

Net Profit Margin

25.7%

22.6%

Pass

5-Yr Average Annual Growth in EPS

7.8%

19.6%

Fail

Return on Total Capital

21.7%

19.5%

Pass

5-Yr Average Annual Growth in Revenue

12.5%

1.6%

Pass

S&P Credit Rating

A-

N/A

Pass

Of the two fails, I am more concerned about the growth in EPS than the debt ratio. Even though the debt-to-capital ratio is high for the industry it is very manageable for RIO. The company tends to make acquisitions using debt and then pay the debt down over subsequent years. Debt has decreased from $38.6 billion to the 2011 year-end level of $21 billion since 2007, during a period that saw a lot of volatility in commodity prices, not all of it beneficial to the company. That seems like pretty good management of capital resources to me. Revenue dropped by about half from 2008 to 2009 and has yet to fully recover. But EPS has fully recovered from pre-recession highs, so I have to admit that management is squeezing more profit out of less revenue and I have trouble complaining about that. The neutral rating for slightly negative free cash flow relates to management's ability to manage its capital resources as explained above so I'm not frightened by this either. Overall, I believe the company ranks third in the industry and I have a five-year price target of $80 per share. That works out to an average annual compounded total return of over 15 percent. That is not bad for a third place finish.

Of the remaining companies in the industry that I have looked at, Alcoa (AA), Titanium Metals (TIE), Allegheny Technologies (ATI), and Materion (MTRN) have displayed more volatility in EPS than I can accept. Southern Copper (SCCO) has a tantalizing dividend yield, but the payout ratio around 90 percent is too high for the list. That, combined with a debt-to-capital ratio of 40 percent and EPS growth of only 3.9 percent, kept the company from further consideration. TIE's EPS has actually fallen by an average annual rate of 17.1 percent over the past five years. Cameco (CCO.TO) has negative cash flow, a less-than-stellar dividend history, and its return on capital ratio is less than half of the industry average. Materion and Teck Resources (TCKB.TO) have return on capital ratios of about 10 percent and 11.9 percent, respectively; well below the industry average. Both companies also have cut dividends. Teck's dividend has yet to recover to pre-recession levels and MTRN has a net profit margin of only 2.6 percent in an industry that averages 22.6 percent. Amcol (ACO) has a flat dividend, debt-to-capital more than double the industry average, and a net profit margin of only 6.4 percent.

This concludes my assessment of the diversified metals and mining industry. As always, I encourage questions and comments and will do my best to answer any and all questions pertaining to the article.

Source: The Dividend Investors' Guide: Part XIV - The Promising Future Of Metals And Mining