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Catch 22 – BHP, RIO, FMG

History is a trash bag of random coincidences torn open in a wind to paraphrase Joseph Heller of Catch 22 fame. Assassination of an Austrian Archduke led to two World Wars. Collapse of a tailings dam in South America results in a 40 million tonne global seaborne shortage supply of iron ore.

Global economic ramifications of Vale’s production shortfall emerge short term with commodity iron ore forecasts price upgrades to $USD75 a tonne. At a time when the world’s biggest customer China moderates GDP growth lower to between 6-6.5%. And implements tax reforms to keep its manufacturing sector ticking over. The Chinese steel industry, which accounts for about 51% of world production, is cranking out a record 900 million tonnes a year.  What slowdown?  There is a global infrastructure boom underway which still has some way to run.  China makes more steel in a month that the USA produces in a year. And a favourable outcome of tariff talks between China and USA should jump start economic growth.

Catch 22 for RIO management and other major Australian resource companies like BHP and FMG is what to do with the continuing rivers of gold flowing from higher iron ore prices. Part of that answer has been special dividends paid to shareholders, mopping up excess franking credits. Created by political imperative of Federal Government change. Ad nauseum, we have preached resources over Australian banks for capital and dividend growth. 

Vale’s short supply is not being turned back on any time soon. Dam remediation, and there are many, will take considerable time. And be expensive. Australian resources, meantime, are going to cut and eat Vale’s lunch. Chinese steel mills wanting reliable supply will be looking for increased Australian ore production. Australian producers are carefully examining capex, with an eye to financial prudence. Past behaviour of build and they will come has been banished.

The proposed hostile Barrick Gold takeover for US Newmont Holdings is throwing up alternative opportunities. The combined Australian gold interests are a whale, valued at more than $6 billion producing around 2 million ounces (Moz) of gold per year. And generating close to $750 million in free cash, with importantly average mine reserves life of 12 years.

An asset portfolio of this scale, much larger than any mid-tier Australian producer, and with cash flow greater than Newcrest’s $700 million could be attractive as another pillar or business system and diversify earnings away from growth focused commodities like iron ore. Gold assets offer counter-cyclical cash flow, and this reduces cash flow at risk through the commodity cycle.

So it could make a great deal of sense for BHP, RIO and FMG to look at the local asset sales which could fall out of this takeover.  Barrick needs to raise cash to fund its bid and local gold miners will be in the same equity raising boat, if the assets are sold piece meal. Whereas the holy trinity could largely fund the acquisition using debt and their existing balance sheets, supported by strong cash flow from iron ore.

It makes sense for FMG which trades at a discount to its bulk commodity counterparts, to look at diversification into gold. Adding gold diversification could re-rate the whole company given precious metal miners trade on a premium multiple. The board has said it is looking for diversification to employ material excess cash flows. And there is strong strategic merit for FMG to add an Australian precious metals arm to its operations. Current 18 month iron ore forecasts suggest FMG will spin out so much cash that its forecast dividend yield could rise to a s much as 11% . And price targets for the stock are ratcheting higher into the mid $7.00’s

The issue of price may limit FMG’s appetite. And the company likely would need to issue some equity to take on the entire Barrick/Newmont portfolio.  Given a FY20 operating earnings EBITDA forecast of US$4.8bn and net debt estimate of US$2.2bn, FMG has a very strong balance sheet and a conservative debt/equity ratio of less than 30%. So any capital raise would be modest.

BHP and RIO whilst having the financial firepower for such an acquisition, may find the issue of valuation around the assets price tag, too confronting. RIO is casting around for other tier one resource assets post the divestment of its coal assets. And while the Barrick/Newmont assets could be a good fit RIO’s conservative approach, like BHP’s, to valuation, probably knocks both out of the race.

RIO shareholders are in the envious position of the company still holding $4.7 billion in franking credits on the balance sheet.  Up until now RIO has focused on buybacks as a primary method of returning cash to shareholders. This has meant its major shareholder’s holding, China’s Chinalco, which doesn’t participate in buybacks, has hit its 15% limit. 

Buybacks will be suspended. And shareholders can expect large special dividends like the special just announced of $3.38 a share, in the next 12-18 months.

Chinalco’s maximum shareholding was enforced by the Federal Government when RIO had the begging bowl out post the GFC when it was sinking under a mountain of debt post the disastrous Alcan aluminium assets.

More than 10 years on from the first discussion, pre the global melt down,  between RIO and BHP to merge their operations into one, the relative cash riches the quality of assets and costs savings  must make marriage between the two parties a future distinct possibility.

Milo Minderbender. Catch 22 – certainly.

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