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Metals & Mining

Cheap valuations – real or illusion?

Earnings momentum remains positive and most mining companies still seem cheap to us based on spot valuation multiples. However, we believe margins have reached elevated levels in some cases, which may not be sustained over the long term. We believe production disruptions and supply discipline may support high margins over the medium term, but call for margins declining slightly over the longer term. We still see value in the mining sector and prefer companies that offer attractive FCF yields based on sustainable mid-cycle margins. Our top picks are Rusal, Norilsk Nickel, Alrosa and African Rainbow Minerals (ARM; which we upgrade to BUY).

Underinvestment supports high returns over the medium term

We believe sector capex has been cut to a level that could result in supply deficits over the medium term. Capex/depreciation, which averaged around 2.0x over the past 16 years, is still only at around 1.3x, which is not enough to replace depleting mines, in our view. We therefore forecast mine production to decline over the next 10 years. This could underpin rising commodity prices and sector returns over the medium term. Supply disruptions and increasing regulation and scrutiny with regard to permitting are adding to supply constraints.

Positive earnings momentum; upgrade ARM to BUY

We increase our earnings forecasts and TPs for most companies under our coverage as we incorporate higher commodity prices (for iron ore, copper and nickel in particular). Changes to our TPs are summarised in the table on the right. We upgrade our rating on ARM from Hold to BUY as its medium-term cash flows benefit from an improved iron ore outlook. Earnings momentum for the sector remains positive and we calculate 24% upside to consensus one-year forward earnings if spot commodity prices prevail.

Attractive spot FCF, but margins approaching optimistic levels

Mining companies’ valuation multiples seem cheap to us based on earnings and FCF calculated using spot commodity prices. However, many commodity prices are no longer supported by costs and in some cases incentivise new supply. We therefore forecast declining margins over the longer term. Market expectations about ‘normalised’ margins have increased substantially since the beginning of 2016. Our long-term margin forecasts have increased more than 70% since 2016 and are now approaching the average margin achieved over the past 16 years, which included the commodity super-cycle. Key downside risks to spot margins are: 1) investment in new supply as high prices remove capital barriers; 2) a slowing global economy; 3) increasing demands from other mining stakeholders, which is typical during a high-commodity-price environment (governments, labour, suppliers to the mining industry etc).

Sector update

Equity Research 1 April 2019

Metals & Mining Global

Johann Pretorius +27 (11) 750 1450

JPretorius2@rencap.com

Steven Friedman +27 (11) 750 1481

SFriedman@rencap.com

Kabelo Moshesha +27 (11) 750 1472

KMoshesha@rencap.com

Siphelele Mhlongo +27 (11) 750 1420

SMhlongo@rencap.com

Derick Deale

+27 (11) 750 1458 DDeale@rencap.com

Summary sector ratings and TPs (ranked by total potential 12M return, including estimated dividends)

*Priced at market close on 26 March 2019. **Previously Hold.

Source: Thomson Reuters Datastream, Renaissance Capital estimates

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Contents

Comfortable balance sheets and supportive dividend potential 12

Renaissance Capital

1 April 2019

Metals & Mining