Miners under fire

By Martin Li, 25 May 2010

Sector Focus

After flourishing for much of 2009, miners could be forgiven for once again feeling under fire. First, base and bulk commodity prices started to dive on fears of a slowdown in Chinese demand and unresolved concerns over European government debt levels. Then, in early May, the Australian government proposed a 40 per cent "super tax" on resources sector profits following the Henry Review. This was followed in short order by the Chilean president proposing to raise mining and other corporate taxes to help the country recover from the devastation of the earthquake earlier in the year. This has prompted fears that other major mining countries, such as Brazil, Mongolia, Zambia, the Democratic Republic of Congo, and even South Africa, could decide to follow suit in what is being termed "super-tax contagion".

Beleaguered sector

"This is yet more bad news hitting the beleaguered mining sector," said Christian Georges, metals and mining strategist at Olivetree Securities, of the Chilean proposal to raise an additional $1.2bn (£830m) in revenue over the next two years. "One has to wonder whether mining's near-term future is to be characterised by ongoing earnings downgrades," he added.

Mr Georges points to the potential impact of the proposals on Anglo American and Xstrata, which both own 44 per cent stakes in the giant Collahuasi copper mine in Chile and have plans to expand its production to satisfy demand from China. "The profitability levels anticipated may suffer should the government decide to maintain this increased tax level over a longer period," he concludes.

If the Henry Review proposals become law, they could raise significant uncertainties for the Australian resources sector, in particular in regard to investment in resources projects, and potentially, dividend payments. According to Australian government estimates, the 40 per cent super tax is expected to cost miners an additional A$3bn (£1.7bn) in 2012-13 and A$9bn in 2013-14. Resources companies could face tax rates of up to 57 per cent, which would substantially alter cash flow, feasibility models and investment decisions for the sector.

Threat to investment

James Ferguson, UK mining tax sector lead at accountants Deloitte, believes the Australian super tax could have several negative reprocussions. There could be a fall in inbound investment to Australia from overseas, particularly from China, which has been a major investor into Australian natural resources projects over the last two years. A direct impact on valuations is feared, as post-tax cash flows is a common measure for valuations and would be reduced by any tax increase.

Meanwhile, a number of major Australian resource projects are structured as joint ventures between majors. The changes in the tax rules could trigger "material adverse change" clauses in the agreements which would require renegotiation or termination of joint ventures. The cost and availability of mining project finance may also be adversely affected as projects would have reduced cash flows with which to service debt.

However, Mr Ferguson identifies some limited good news for the sector from the Henry proposals as part of the proceeds of the super tax will be allocated to much-needed infrastructure development in states active in the resources sector. Improvements in road, rail, ports, water and power will indirectly benefit resources companies that are often constrained by infrastructure bottlenecks. In addition, exploration companies will receive a rebate of their exploration expenditure immediately, rather than having to wait to set those costs off against production income.

Lower yields

Nick Mellor, a mining analyst at Ambrian, has estimated the impact of the proposed Australian super tax on miners' earnings in 2013, the year when the proposals would first bite following the stated implementation date on 1 July 2012. He calculates a 25 per cent EPS decline for BHP Billiton and an up to a 40 per cent EPS decline for Rio Tinto from his original forecasts for that year. This could lead to very flat dividend profiles over the next four years, a prospect already alluded to publicly by BHP Billiton chief executive Marius Kloppers.

Mr Kloppers also suggested that investments slated for major projects in Australia could be redirected elsewhere if the proposals go forward. Many of the large groups exposed to the super tax have investment options that could see them refocus on commodity projects outside Australia. While these might currently have longer-term timeframes, they could be accelerated in preference to Australian projects should the super tax scenario become a reality.

However, Mr Mellor advises investors not to get too fixated on the current proposals and to focus instead on the miners' potential for earnings growth over the next two years. According to Ambrian forecasts the highest PEG ratio (a comparison of a share's price earnings ratio with EPS growth, where anything below 1 is generally considered good value) in the sector is only 0.2 on a three-year outlook for the large cap miners."We struggle to see what other sectors in the global economy can compete on this basis," he concludes.

Not all grim

The absence of buying from China has exerted downward pressure on hard-coking-coal and iron-ore prices. Mining shares are likely to remain weak until underlying commodity prices and sentiment improves. However, the outlook isn't totally grim. Although commodity prices have corrected in recent weeks, they remain high relative to historical benchmark levels and mining groups continue to generate significant cash flow.

Looking ahead, Fraser Phillips, senior mining analyst at RBC Capital Markets, believes that the onset of the monsoon season in India and the seasonally strong summer construction period in China should lend some near-term support to bulk commodity (iron ore and coal) prices.

Furthermore, Charles Gibson, head of mining at Edison Investment Research has "great reservations about whether the proposed Australian super tax will actually be imposed", and, if it is, he strongly suspects that it will be in a very watered down form. "There is almost no detail on the proposal and there are elections in Australia at the end of the year. I see this more as an election ploy, rather than a serious fiscal proposal - certainly at this stage," he concludes. Mr Mellor also suspects a political driver behind the proposed tax, believing this has a lot to do with Prime Minister Kevin Rudd's falling poll ratings.

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