Is there an opportunity in ASX miners after share price declines?

Iron ore prices have dipped below $100 US per tonne and analysts expect the price declines to continue as weakness in the Chinese property market are impacting steel prices.

According to Rio Tinto, China’s huge residential property market accounts for roughly 30% of its steel demand. Central government efforts to limit speculation are reducing activity. After years of inflation, residential house prices are falling.

The National Bureau of Statistics reported that prices of new homes in China’s 70 largest cities fell 3.6% year on year in May 2024, the sharpest decline since January 2019. Prices of existing homes fell even further, down 8.2%.

Falling prices exacerbate pressure on developers trying to finish properties and house purchasers seeking to pay for them.

Property developers are highly leveraged, with many like Evergrande and Country Garden in default. Rising unsold inventory adds to pressure on developers.

With house prices falling, unsold inventory continues to rise as homebuyers tighten their pockets in anticipation of further decreases in prices.

As a result, newly started construction activities continue to slow. In May, the People’s Bank of China unveiled a CNY 300 billion (USD 42 billion) package to help local governments purchase unsold new homes and turn them into affordable social housing. However, the package is likely to have minimal impact, as it accounts for less than 10% of the total value of unsold new apartments.

With China’s population shrinking since 2022, for the first time since 1961, structural pressures on housing construction are building, in our view.
While exports and imports modestly improved over the quarter, China’s trade is soft. Soft consumer demand damps imports, while weaker growth overseas, driven by rising interest rates, weakens exports.

Global trade frictions, including “friendshoring”— manufacturing in and sourcing from countries that are allies—and onshoring, are also contributing. These are likely to remain longer term headwinds.

China’s playbook is to boost commodity-intensive infrastructure spending when economic growth slows. However, a combination of poor returns on new infrastructure investment and a central government commitment to more consumption-led growth means stimulus spending in this downturn is muted.

The stimulus can come if the Chinese economy substantially slows or enters a recession. But growing debt is a headwind to both the amount of stimulus and its effectiveness.
Rising fixed asset investment in manufacturing partially offsets muted demand from the property and infrastructure sectors, which drive more than half of China’s steel demand. JPMorgan estimates building and construction accounts for about 30% of the country’s copper use.

Investment in China’s real estate sector is soft, a headwind for GDP growth. The central government has increased support for the property sector, but we think much more needs to be done for it to stabilize.

China weakness and falling iron ore prices are impacting the share prices of miners. Here is our view on the largest three miners in the ASX 200.

BHP BHP

• Morningstar Rating: 3 stars
• Fair Value Estimate: $40.50
• Moat rating: None
• Uncertainty rating: Medium

BHP is the world’s largest miner by market capitalization. Its main operations span iron ore and copper, with smaller contributions from metallurgical coal, thermal coal, and nickel. The company is also developing its Jansen potash project in Canada. BHP merged its oil and gas assets with Woodside Energy in June 2022, vesting the Woodside shares it received to BHP shareholders, and exiting the sector. It purchased copper miner Oz Minerals in fiscal 2023.

The share price has declined over 20% year to date.

Commodity demand is tied to global economic growth, China’s in particular. BHP benefited greatly from the China boom over the past two decades. China is BHP's largest customer, accounting for roughly 60% of sales in fiscal 2023. With demand for many commodities likely to soften as the China boom ends, particularly iron ore which has disproportionately benefited from the boom in infrastructure and real estate investment, we think the outlook is for earnings to materially decline.

Its generally low-cost, high-quality assets mean BHP is likely to be one of the few miners that remains profitable through the commodity cycle. Much of the company's operations are located close to key Asian markets, particularly the low-cost iron ore business, providing a modest freight cost advantage relative to some producers such as those in Africa and South America.

BHP correctly values a strong balance sheet to provide some stability through the inevitable cycles and derives some modest benefit from commodity and geographic diversification. Much of its revenue comes from assets in the relative safe haven of Australia. The development of Jansen in Canada is BHP’s major expansion project now that the Spence Growth Option copper project is ramping up, with the company also pursuing modest expansion of its Western Australia Iron Ore operations above 290 million metric tons per year.

The good times during the height of the China boom saw significant capital expenditure, notably on iron ore and onshore US shale gas and oil. Overinvestment in the boom diluted returns to the point where we struggle to justify a moat. As a commodity producer, BHP lacks pricing power and is a price taker.

BHP bulls say

• BHP is a beneficiary of continued global economic growth and demand for the commodities it produces.
• BHP’s Jansen potash project gives it additional diversification, with potash being less correlated to the other commodities it produces.
• BHP's iron ore assets are industry-leading. The company remains well placed to continue low-cost production and increase output with minimal expenditure and an efficiency focus.

BHP bears say

• BHP has shown improved capital allocation since its mis-steps during the China boom, but continuing high commodity prices could encourage it to once again aggressively expand output.
• With its earnings dominated by iron ore and copper, structurally lower demand from China could lead to significantly lower earnings.
• Resource companies could face growing sovereign risk as governments under fiscal pressure look to plug budgetary holes by taxing the industry.

Rio Tinto RIO

• Morningstar Rating: 3 stars
• Fair Value Estimate: $112.00
• Moat rating: None
• Uncertainty rating: Medium

Rio Tinto is one of the world’s largest miners with operations in iron ore, aluminum (including bauxite and alumina), copper, and minerals (mineral sands, borates, salt, diamonds). Commodity demand is tied to global economic growth, China’s in particular.

The shares have dropped close to 19% year to date.

Rio Tinto benefited greatly from the China boom over the past two decades. The firm’s largest customer by far is China, with about 60% of sales in 2023. We think the outlook is for earnings to materially decline with demand for many commodities likely to soften with the end of the China boom, particularly iron ore which has disproportionately benefited from the boom in infrastructure and real estate investment.

Rio Tinto has a large portfolio of long-lived assets with low operating costs, meaning it is one of few miners profitable through the commodity cycle. Most revenue comes from operations located in the relatively safe havens of Australia and North America. The invested capital base was inflated by substantial procyclical investment during the height of the China boom, including overpaying for Alcan. The subsequent iron ore expansion was also made when unit capital costs were high. These factors diluted returns to the point where we struggle to justify a moat. As a commodity producer, Rio Tinto is a price-taker, with the lack of pricing power reflecting in cyclical commodity prices.

The recent focus has been to run a strong balance sheet, tightly control investments, and return cash to shareholders. Rio Tinto is also focused on winning back the trust of investors and other stakeholders such as regulators and the indigenous peoples on whose lands many of Rio’s mines are located after the destruction of the caves at Juukan Gorge in 2020. The company's major expansion projects are the Oyu Tolgoi underground mine and the expansion of the Pilbara iron ore system's capacity from 330 million metric tons to between 345 and 360 million metric tons. Those projects are expected to complete in the next few years. Otherwise, the focus is on incremental expansions through productivity and debottlenecking initiatives. These will be small but capital-efficient and should modestly improve unit costs and returns.

Rio bulls say

• Rio Tinto is one of the direct beneficiaries of China's continuing strong appetite for natural resources.
• The company's operations are generally well run, large-scale, low-operating-cost assets. Mine life is generally long, and some assets, such as iron ore, have incremental expansion options.
• Capital allocation has improved following the missteps of the China boom with management generally preferring to return cash to shareholders than to make material expansions or acquisitions

Rio bears say

• With miners including Rio benefiting from high commodity prices, governments may use it as a source of tax revenue to plug shaky budgets.
• Rio Tinto is leveraged to demand for iron ore. If iron ore prices fall materially, the company’s earnings will decline significantly.
• While Rio has shown much improved investment discipline since its mis-steps during the China boom, if commodity prices remain high, then the temptation to once again expand aggressively will increase.

Fortescue FMG

• Morningstar Rating: 3 stars
• Fair Value Estimate: $16.20
• Moat rating: None
• Uncertainty rating: High

Fortescue is the world's fourth-largest iron ore exporter. Margins are well below industry leaders BHP and Rio Tinto, and some way behind Vale, meaning Fortescue sits in the highest half of the cost curve. This is a primary driver of our no-moat rating. Lower margins primarily result from price discounts from selling a lower-grade (57% to 58% iron) product compared with the 62% iron ore benchmark. The lower grade is effectively a cost for customers through a greater proportion of waste to transport and process, additional energy/coal per unit of steel and lower blast furnace productivity. This results in a lower realized price versus the benchmark. In the 10 years ended June 2024, the company realized an approximate 23% discount versus the 62% benchmark.

Fortescue shares have fallen over 40% year to date.

Fortescue increased rapidly thanks to favorable iron ore prices, aggressive expansion, and historically low interest rates. Expansion from 55 million metric tons of capacity in fiscal 2012 to around 190 million metric tons by 2023 was unprecedented. Fortescue built much of its capacity around the China boom peak and baked in a higher capital base than peers. This means returns are likely to lag the industry leaders who benefited from building significant capacity when the capital cost per unit of output was lower.

Fortescue has done an admirable job of reducing cash costs materially versus peers. However, product discounts remain a competitive disadvantage. The addition of about 22 million metric tons a year of iron ore production from the 69%-owned Iron Bridge joint venture allows Fortescue blending options. Iron Bridge grades are much higher, around 67%, meaning Fortescue could blend most of its iron ore to increase its average grade to between 58% and 59%.

Fortescue is a China fixed-asset investment play, with practically all of the company's iron ore sold there. In the long term, we see demand for steel in China declining as the country's stock of infrastructure matures and with the rate of urbanization past its peak.

The company’s strategy is to transform into a diversified iron ore and clean energy company. Its green energy initiatives are at an early stage, but the company has big ambitions in the space.

Fortescue bulls say

• Fortescue provides strong leverage to the Chinese economy. If growth in steel consumption remains strong, it's also likely iron ore prices and volumes will, too.
• Fortescue is the largest pure-play iron ore company in the world and offers strong leverage to emerging world growth.
• When steel industry margins contract, it's likely that product discounts narrow significantly relative to historical averages, reducing Fortescue’s competitive disadvantage relative to the majors.

Fortescue bears say

• We think that ultimately Chinese fixed-asset investment will slow, and future iron ore volume growth and prices are likely to be much less favorable.
• Margins are significantly lower than those of diversified peers BHP, Rio Tinto, and Vale, and this could see Fortescue’s margins fall much more than peers if iron ore prices fall.
• Fortescue produces an inferior, lower-iron-grade product, which attracts a discount to the benchmark 62% iron ore fines price. Lower-grade reserves mean this discount is likely to persist.

Conclusion

In all three cases the price falls are justified in our view and a rational reaction to demand headwinds from China. All three miners were overvalued. They are now fairly valued. None of the miners have moats as all are price takers. There is little for an investor to do but hope for a turnaround in China. We think that is unlikely.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.