Fair Value Estimate: 2,700p ¦ Uncertainty Rating: Very High ¦ Economic Moat: None
Thesis (Last updated 04/01/2011)
No factor will play a more important role in Anglo American's (AAL) future than the economic trajectory of emerging markets. For the past decade, emerging market economic growth--and the demand for industrial commodities that accompanies it--has pushed prices for copper, iron ore, and coal to record highs and the profits of miners like Anglo to previously unheard-of levels. This has also engendered a dramatic shift in the underlying sources of volatility facing miners. Where commodity prices would once shudder at the release of weak industrial production numbers from the United States, Germany, or Japan, Chinese statistical releases now command the market's attention--and rightfully so, given China's pre-eminent share of consumption for most industrial commodities.
Anglo is positioning its portfolio for a future that looks much like the decade just past, defined by continued strong growth from China and the rest of the emerging world. The company has jettisoned multiple noncore businesses ranging from paper to construction materials to gold and redeployed capital to segments better leveraged to emerging market growth. Platinum, copper, iron ore, and coal--each of which accounts for roughly 20% of Anglo's revenue (excluding operations the company plans to sell)--will play a leading role for Anglo.
Anglo is the world's largest producer of platinum group metals, accounting for 40% of annual global output. Despite its size, Anglo's platinum business is far from a reliable profit machine. In 2009, while $4.5 billion in sales made the platinum segment the largest by revenue, it earned a meagre 1% operating margin on those sales, making it a laggard both in Anglo's portfolio and relative to platinum-producing peers like Impala. There's plenty of room for improvement, and given the sheer size of Anglo's platinum business, any gains would have major implications for overall earnings. Thus far, we've seen some signs of success, particularly in labour productivity, a metric of critical importance because of labour's 50% share of the unit's cash costs (not unusual for platinum mining). We ultimately expect to see a relatively modest improvement in Anglo's overall position on the industry cost curve as the efficiency gains Anglo may achieve in the coming years will be muted by a progression into less economical geology. (Read more on Anglo's platinum business here.)
Anglo is the world's sixth-largest copper producer, with annual output around 1.5 billion pounds. The most important assets in Anglo's copper portfolio, in terms of annual output and mine life, are Los Bronces and Collahuasi, both in Chile. While these operations are middling from a cost perspective (Anglo's consolidated cash costs are middle of the pack too), we could see some improvement as Anglo undertakes expansion projects that deliver economies of scale. A large expansion project is already under way at Los Bronces, which is expected to nearly double the mine's annual output from 500 million pounds to 1 billion by late 2012. At Collahuasi, Anglo and joint venture partner Xstrata (XTA) are in the midst of conceptual studies that would see annual production levels hiked from 1.2 billion pounds to 2.2 billion, potentially challenging Escondida for the title of world's largest copper mine. (Read more on Anglo's copper business here.)
Anglo's iron ore business produces about 45 million tons per year, principally in South Africa. Although far from the largest player in the seaborne iron ore game, Anglo is a relatively low-cost producer; we estimate unit cash costs rank in the lower half of the seaborne iron ore cost curve. While it's unlikely Anglo will challenge Vale (VALE), Rio Tinto (RIO), or BHP Billiton (BLT) for iron ore supremacy anytime soon, management has big plans for growth via greenfield projects in South Africa (plus 9 million tons) and Brazil (plus 26.5 million tons). Big greenfield projects are not without risk, however, as the company's efforts at the Minas Rio project in Brazil demonstrate. Originally slated to come on line in 2010 at a cost of $2.7 billion, costs are now expected to total $4.6 billion with mining to commence in 2013 at the earliest. (Read more on Anglo's iron ore business here.)
Anglo's coal operations are divided into two comparably sized segments: thermal and metallurgical coal. The bulk of Anglo's thermal coal assets are in South Africa, where the company ranks as the largest coal producer, accounting for about one quarter of the country's roughly 260 million tonnes of annual output. Anglo's South African thermal coal assets primarily serve the domestic market (60% of volume goes to Eskom, priced on a cost-plus basis), but the real gravy is in the export market, where Anglo is geographically situated to capitalise on growing Indian coal demand. Anglo's metallurgical coal operations in Australia, while far from the largest down under, are relatively low-cost operations with potential for expansion. (Read more on Anglo's coal business here.)
Valuation
Our fair value estimate for Anglo American's London-listed common stock is 2,700 pence per share. Our model incorporates the following midcycle commodity price assumptions: copper at $2.50 per pound, platinum at $1,750 per ounce, seaborne thermal coal at $100 per ton, seaborne iron ore at $100 per ton CFR China, and seaborne coking coal at $200 per ton. We use a 12% cost of equity, a higher-than-average discount rate, but in our mind reasonable because of the commodity price volatility and country-specific risk associated with owning Anglo American shares. This discount rate results in a terminal EV/EBITDA multiple of 6.8 times (we've capitalised the minority interest when calculating enterprise value to facilitate cross-company comparisons). Were we to employ a 10% cost of equity, which is closer to the average across Morningstar's entire coverage (but, in our opinion, not indicative of Anglo's risk profile), our fair value estimate would leap to 3,500 pence per share and an associated terminal EV/EBITDA multiple of 8.4 times.
Anglo's production growth in the next few years will come in the form of three major projects: Los Bronces in copper (about a 40% increase to consolidated copper volume, with a anticipated late 2011 startup), Minas Rio in iron ore (about a 60% volume increase, late 2013 startup), and Barro Alto in nickel (about a 200% volume increase, early 2013 startup). We expect profits to expand in 2011 largely on the back of stronger commodity prices, followed by a gradual decline in the following years as new supply comes on line to push prices closer to their long-run marginal cost of production.
Risk
A severe and lengthy downturn in commodity prices represents the greatest risk to Anglo. Exposure to the volatile rand/U.S. dollar exchange rate is also a concern. Management estimates a 10% change in this rate has a $358 million annual earnings impact (aftertax). Anglo's South African heritage is at once a blessing and a curse for the firm. Anglo controls many of the crown jewels of the country's mineral endowment, with valuable assets ranging from iron ore to thermal coal to platinum to diamonds. But owing to the spectre of creeping (or outright) expropriation, doubts linger as to whether the full economic value of those assets will accrue wholly to Anglo. The government's management of the mining rights regime remains fraught with accusations of corruption and nepotism, as mining rights too often appear to be awarded and revoked based on familial and collegial proximity to the powers that be rather than substantive legal grounds. Even large multinationals can find themselves stripped of rights that they once thought ironclad, as ArcelorMittal (MT) would attest after discovering its rights to the Sishen iron ore mine had been stripped for procedural reasons. More ominously, influential voices inside the ruling African National Congress party continue to call for nationalisation of mining companies. Despite all the press it gets, we doubt South Africa will end up looking like Venezuela. Private-sector mining activities are demonstrably beneficial to the South African economy, tax base, and employment situation and neighbouring countries that have kicked out multinational miners have done so to disastrous effect. Nonetheless, as long as groups like the ANC Youth League push for nationalisation (dismissed as a ludicrous idea by the mining unions), tail risk is likely to weigh on Anglo shares for the foreseeable future as investors slap a South Africa discount on future cash flows.
Management & Stewardship
Management, led by CEO Cynthia Carroll, has undertaken several big initiatives that we expect will create value for shareholders in the long run. Foremost has been the divestiture programme that has seen Anglo shed large operations that were, at best, ancillary to the core mining business (for example, paper and construction materials) as well as mining operations that had historically created little value for the firm (for example, zinc). Carroll should also be credited with a big shakeup of Anglo's organisational structure that shifted segment management duties for many businesses away from their traditional London home to the countries where Anglo's mining operations actually reside, cutting corporate head count 25% in the process. Finally, management has embarked on a companywide asset optimisation and international procurement initiative, which it believes can yield $2 billion in annual efficiencies. While undoubtedly an impressive sum, we tend to discount such claims even after supposed completion, since they are impossible to verify independently.
Overview
Financial Health: As long as commodity prices remain high and the firm eschews the debt-financed megadeals that have tripped up peers, Anglo's financial health is likely to remain robust. With $2.9 billion in cash and $9 billion in undrawn committed credit facilities at mid-2010, liquidity is ample. EBITDA/interest coverage, which dropped to 5.8 times in 2009 (from 11.1 in 2008), should be dramatically better in 2010, as strong commodity prices bolster cash flows. In the first half of 2010, coverage was 12.1 times, and prices for Anglo's key commodities--platinum, copper, and coal--have all improved since midyear. Looking beyond 2010, a couple of items (other than the obvious sensitivity to commodity prices) are worth noting. On the plus side, in contrast with peers like Vale, which expect to spend record-breaking sums on new megaprojects, Anglo's expansion plans--at least those with board approval--are less ambitious. Consequently, the risk of a major cash outflow being followed by a precipitous drop in commodity prices is less of a concern. On the negative side, Anglo's maturity profile has a very low duration: The vast majority of its debt comes due in the next five years and the firm has no maturities beyond 2019. While this emphasis on short- and medium-term financing may reduce Anglo's annual interest expense, in the long run it also increases the firm's liquidity risk.
Profile: Global mining giant Anglo American's portfolio spans many commodities and many continents. Like fellow diversified mining giants, Anglo has significant exposure to copper, coal, and iron ore, but it is unique in its significant platinum output, which accounts for roughly 40% of the annual global supply. Anglo also owns 45% of De Beers, in most years the world's largest supplier and marketer of rough gem diamonds.
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