Aussie miners overvalued amid false price hopes and fall in China demand, Morningstar says
Australian miners may have outperformed in the last few years but Morningstar says they continue to be overvalued because of false hopes commodity prices will stay high.
Australian miners may have outperformed in the last few years but Morningstar says they continue to be overvalued because of false hopes commodity prices and demand from China will stay high.
Morningstar senior equity analyst Mathew Hodge says Rio Tinto (ASX: RIO) is the most overvalued of the big miners, followed by BHP (ASX: BHP) and Fortescue Metals Group (ASX: FMG).
In his latest research report, Hodge says the market is pricing both BHP and Rio Tinto as if they have an economic moat - an ability to maintain competitive advantages and protect market share.
"We think the average unadjusted returns on invested capital of around 16 per cent are required to justify the current share prices," Hodge says. "Nearly double our estimated cost of capital for those companies."
The price/book value - the market value of a company compared to its balance sheet value - is about 2.5 for both dual-listed BHP and Rio Tinto.
Hodge says this is "generous given their history of capital destruction."
Rio Tinto is the most overvalued of the group, trading at around $82 compared to Morningstar's fair value estimate of $48. Hodge attributes this to the company's reliance on earnings for iron ore and Morningstar's expectation that prices will fall as demand in China drops.
BHP is trading at around $32, compared to an FVE of $23.
"The share prices of the major miners now factor in the recent favourable conditions continuing in the long term, which we view as overly optimistic," Hodge says.
Andrew Forrest's Fortescue Metals Group is the least overvalued of the miners, reflecting recent elevated discounts for its lower-grade iron ore. Fortescue is trading at $4.50, compared to an FVE of $3.70.
China has had rapid consumption in steel and steel-making materials
However, Hodge says it's optimistic to expect Fortescue to nearly earn its cost of capital because of higher operating costs and the fact the company’s assets were "expensively built" during the China boom.
Hodge concedes the miners' performance had until now defied Morningstar expectations. Rapid growth in debt in China had stimulated more demand than expected.
Miners had also shown "admirable capital constraint", Hodge notes, despite higher commodity prices.
As a result, cash flows have ballooned, boosting balance sheets and returns to shareholders. Morningstar estimates the dividend yields for the three major miners top 5 per cent, fully franked.
"The attractive yield, and increased market optimism around the potential for the miners to grow earnings, has helped to underpin strong share price appreciation," Hodge says.
However, Hodge has reasons to be pessimistic. The market is overestimating cash flow forecasts, and expecting the relative high prices to persist while capital expenditure remains low. This view, Hodge says, is "inconsistent with history".
Again, Hodge cites China's "debt binge" as a key consideration for forecasts. The world's second largest economy has grown debt much faster than GDP, which has been used "to juice economic growth", particularly in fixed assets. As a result, there's been rapid consumption in key commodities such as steel and steel-making materials.
Hodge draws three conclusions:
- China's rate of growth in debt is unsustainable and will slow
- The country's rate of urbanisation will slow
- Growth in demand for copper and aluminium is likely to slow significantly, while steel consumption will decline
"At current rates of consumption, China's steel stocks will reach developed world levels within a decade," Hodge says, "but at a much lower level of GDP per capita than predecessors."
Morningstar's assumptions for miners are based on more bearish commodity prices, Hodge says. "Our long-term assumptions for iron ore, metallurgical coal, and copper are more than 30 per cent below consensus and aluminium more than 20 per cent lower."
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Lex Hall is a Morningstar content editor, based in Sydney.
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