Introduction to the Group
I compiled a key group of financial variables for the top diversified mining majors. This group includes the following companies shown here, ranked by their earnings before interest taxes depreciation and amortization (EBITDA) for their most recent fiscal years:
- BHP (BHP) (NYSE:BBL) - $23.2 billion
- Rio Tinto (RIO) - $19.3 billion
- Vale (VALE) - $16.6 billion
- Glencore (OTCPK:GLNCY) - $15.8 billion
- Anglo American (OTCQX:NGLOY) - $9.2 billion
- Nornickel (OTCPK:NILSY) - $6.2 billion
- Teck (TECK) - $4.6 billion
- Vedanta Ltd. (VEDL) - $3.6 billion
- South32 (OTCPK:SOUHY) - $2.5 billion
This group only includes diversified majors so some other large miners like Freeport-McMoRan (FCX), which focuses exclusively on copper, are not included.
My analysis focused primarily on these miners' free cash flow margins and free cash flow returns on invested capital. Where these numbers are relatively strong, you can be sure that that the stock price of the company will follow.
Free cash flow is the actual cash that a company has left each year to pay dividends, repurchase shares, make acquisitions, and pay down debt. The free cash flow margin is the free cash flow divided by total revenue or, in other words, the percentage of revenues that result in free cash flow (for shareholders).
Free cash flow return on invested capital is the percentage of free cash flow generated by a company's invested capital. You probably have all seen those junior mining presentations that show these high internal rates of return on mining projects. The actual, real-life results for major miners have been much lower. The average for these 9 majors over the last 5 years has been only 7.9%.
Let me take a moment to explain invested capital using a hypothetical example. I think you will find this helpful.
Consider a mining company getting ready to produce from its first mining project with the following simplified balance sheet:
|Property Plant & Equipment||$400,000,000|
|Total Shareholders' Equity||$300,000,000|
In the double-entry accounting equation, assets = liabilities + shareholders' equity and assets - liabilities = shareholders' equity.
This mining company raised $500 million, comprised of $200 million in debt and $300 million in equity. It has $500 million of invested capital (debt + shareholders' equity). If it generates $100 million of average annual free cash flow over the first 5 years of its project, then its average annual free cash flow return on invested capital would be 20% ($100 million/$500 million).
There is a cost to capital. For starters, the miner will have to pay interest on the debt. There is also a cost associated with the common stock, but that is a complex topic beyond the scope of this post. Aswath Damodaran from the Stern School of Business at New York University estimates that the average cost of capital for 94 miners is currently 9.31%, with the average cost of debt that goes into this estimate being 8.43%. Given that many of these 94 miners are not the large majors, this 9.31% number is too high for these top diversified majors. Something closer to 7-8% is probably more realistic.
What we want are miners that are generating free cash flow returns on their invested capital that exceed their cost of capital - preferably those that far exceed their cost of capital. Those that are not exceeding their cost of capital are destroying shareholder value. As I mentioned above, the average for these 9 majors over the last 5 years has been only 7.9%. As a collective group, they are barely adding value for shareholders. This is where stock selection becomes important.
Another thing I like about looking at free cash flow returns on invested capital is that it reveals the quality of a company's past investment decisions. If they put projects into production with too high metals price assumptions, or if they ended up having to invest far more capital than anticipated, then such failures will show up here.
Free Cash Flow Returns on Invested Capital
Here is how these 9 majors rank when it comes to free cash flow returns on invested capital for their most recent 5 fiscal years:
- Nornickel - 21.6%
- BHP* - 9.3%
- South32* - 8.7%
- Vedanta Ltd. - 8.2%
- Rio Tinto - 7.5%
- Anglo American - 5.1%
- Vale - 4%
- Glencore - 3.6%
- Teck - 3.1%
* Only for the most recent 4 fiscal years.
These results reveal a few things.
First, the low-cost and long-life nature of Nornickel's nickel and palladium production shows up here. The assets continue to deliver high free cash margins while requiring relatively less sustaining capital investment. Remember, these figures were 5-year averages. Nornickel's 2018 free cash flow return on invested capital was 38.2%. Not surprisingly, Nornickel also had the highest average 5-year free cash flow margin at 26.2%.
Second, BHP and South32 are ranked 2 and 3, respectively. South32 was spun off of BHP in 2014. In the past, BHP's leadership did a relatively better job than its peers in choosing how and where to invest its capital.
Third, at least over the past 5 years, Glencore and Teck have been destroying shareholder value.
EBITDA and Free Cash Margins
Here is how these majors rank when it comes to average annual EBITDA margins and average annual free cash flow margins over the last 5 years:
- BHP - 50.3%
- Nornickel - 48.5%
- Vale - 39.8%
- Rio Tinto - 39.1%
- South32 - 30%
- Teck - 27.9%
- Vedanta Ltd. - 27.3%
- Anglo American - 20.6%
- Glencore - 6.5%
The average annual EBITDA margin for the group over the last 5 years was 32.2%.
The leadership of BHP, Vale, and Rio Tinto here is primarily due to their iron ore businesses. Iron ore is a high margin business nowadays that is tough for new players to break into at a meaningful scale.
Free Cash Flow Margin
- Nornickel - 26.2%
- BHP - 23.8%
- South32 - 16.6%
- Rio Tinto - 15.6%
- Vedanta Ltd. - 14.7%
- Teck - 9.3%
- Vale - 8.9%
- Anglo American - 8.2%
- Glencore - 2%
The average annual free cash flow margin for the group over the last 5 years was 13.9%.
Consistent with their strength in free cash flow returns on invested capital, Nornickel, BHP, South32, Rio Tinto, and Vedanta Ltd. also had the highest free cash flow margins. Generating higher levels of free cash flow, we should expect these miners to generally also pay higher dividend yields and potentially trade for higher valuations. Let us take a look and see.
Dividends & Valuation
Here is what I estimate the dividend yields will be in 2019 for each of these miners and also their current price to prior fiscal year free cash multiples:
- Vedanta Ltd. - 9%
- Rio Tinto - 5.7%
- Nornickel - 5.6%
- South32 - 5.6%
- BHP - 5.3%
- Anglo American - 4.7%
- Vale - 3%*
- Glencore - 2.5%
- Teck - 1.5%
*I assume Vale reduces their dividend this year due to the uncertainties surrounding the tailings dam disaster. If they pay out the same amount as in 2018, the current dividend yield would be 5%.
The average estimated dividend yield for the group is 5%.
Keep in mind that a company's dividend yield will also be higher if its share price is undervalued. This is the case with Vedanta Ltd. As you can see in the following list, it is trading for the lowest valuation, excluding Vale which has been beaten up a bit over the tailings dam disaster.
As I have stated time and time again, higher free cash flow puts more value in the hands of shareholders. I am not the least bit surprised that Rio Tinto, Nornickel, South32, and BHP are the highest dividend payers while Glencore and Teck are bringing up the rear. Quite frankly, Teck's dividend yield at this point in the mining cycle is pathetic.
Price to Previous Fiscal Year Free Cash Flow (as of April 30, 2019)
- Nornickel - 20.4
- Rio Tinto - 16.1
- BHP - 12.5
- Teck - 9.8
- Anglo American - 9.2
- Glencore - 8.4
- South32 - 8.0
- Vedanta Ltd. - 7.8
- Vale - 7.3
The average price to previous fiscal year free cash flow multiple for the group is 11.0.
Trading at only 8 times free cash flow and sporting a dividend yield of 5.6%, South32 is relatively undervalued, especially considering the fact that it ranks in the upper tier in the group in free cash flow returns on invested capital (higher than Rio Tinto) and free cash flow margins. A look at the Aluminum market would be warranted though, because 48% of South32's EBITDA from its 2018 fiscal year came from its aluminum businesses. South32 is also repurchasing shares, has an extremely low level of debt (debt to EBITDA of .2), and has an ample amount of cash on its balance sheet.
I hope you found this financially-focused analysis of the diversified majors helpful. I thought focusing on the last 5 years would be a good cross section because it includes 2 years of the bottom of the mining cycle (2014-15) and 3 years of the upswing (2016-18). I think it demonstrates that Nornickel, BHP, South32, and Rio Tinto should be considerations for investors looking for the generally more conservative level of exposure to mining that these majors provide. Glencore and Teck should be avoided.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Vedanta Ltd. is a holding in some client and family portfolios that I manage. I have an economic interest in the stock. I may also initiate new positions in South32 over the next 72 hours.
I'm an investment advisor and owner of True Vine Investments, a Registered Investment Advisor in the State of Pennsylvania (U.S.A.). I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Any investment advice or recommendations involving securities referenced in this article is general in nature and geared towards a readership of sophisticated investors. This article does not involve an attempt to effect transactions in a specific security nor constitute specific investment advice to any particular individual. It does not take into account the specific financial situation, investment objectives, or particular needs of any specific person who may read this article. Individual investors are encouraged to independently evaluate specific investments and consult a licensed professional before making any investment decisions. All data presented by the author is regarded as factual; however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive analysis. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment advisor.