Steel
A combination of changes in the Chinese steel sector that target emissions, profitability and utilisation have provided a structural impetus for both BlueScope Steel ((BSL)) and Sims Metal Management ((SGM)).
A reduction in Chinese steel production, which is around 50% of global supply, should support regional steel prices and create opportunities for supply. This could proportionately shift global production towards scrap-driven electric arc furnace, JPMorgan suggests.
Based on free cash flow pay-out of 50% and a flat dividend, JPMorgan believes BlueScope could announce a $467m buyback at the first half results. Upside to estimates could come from the company increasing its pay-out, being now net cash.
The broker believes the company’s North Star project expansion is viable at the low end and high end in terms of both capacity and cost variables. Analysis is based on the high-end at 900,000tpa and the economics appears sound. Should the expansion not proceed, the analysts believe the company could have the potential to return around $1.5bn to shareholders over the next two years.
Meanwhile, Chinese labour costs are rising and environmental concerns are becoming more of a consideration, playing into the hands of Sims. The ability to invest in assets such as metal recovery plants suggests the company can extract higher margins through the sale of higher metal/furnace-ready products.
JPMorgan suspects capital-constrained businesses will be unable to adapt and Sims could acquire assets at distressed prices. The broker retains Overweight ratings on the stocks.
Mining & Franking
Citi observes one of the Labor Party’s policies is the scrapping of cash refunds from franking credits. Currently around 1.2m shareholders receive cash refunds from franking credits and, while the move is expected to recoup over $5bn per annum, around 300,000 low income pensioners will still be able to claim the rebate.
Part of the historical justification for the premium of Australian stocks such as BHP ((BHP)) and Rio Tinto ((RIO)) versus their UK listed entities is the value of franking credits to Australian shareholders. so the proposed policy has a potential to influence the spread.
BHP and Rio Tinto represent around 8% of ASX dividends. Yet, Citi questions whether franking credits really drive the spread, as a marginal offshore shareholder gets no benefit from these and is therefore ambivalent about buying either the Australian or UK listed stock from a tax perspective.
The broker suggests sentiment towards global growth has historically been the larger driver of the spread, because of the more transient UK shareholder base, as Australia is largely an index market and one third of the ASX register is sticky retail shareholders.
Another impact, potentially, concerns the ability to be able to stream franking credits to shareholders through off-market buybacks at a discount. This is a more valid risk, in the broker’s view, but not considered material either. Additionally, BHP is likely to have already distributed excess franking credits on the balance sheet from the proceeds of the US shale divestment, ahead of any policy implementation on July 1, 2019.
There is more of a risk for Rio Tinto because of the Australian skew of earnings, which drives a structural issue of how excess franking credits are returned to shareholders. Citi believes shareholders will likely restructure their affairs to offset any impact should the policy be implemented if the Labor Party forms government at the next election.
Diversified Majors
Macquarie suggests the earnings upgrade cycle has resumed for the diversified major miners. There is some downside risk for most base and precious metals but core commodities for BHP, Rio Tinto and South 32 ((S32)) are all trading well above forecasts.
Bulk commodities are driving the momentum and alumina stands out, trading around 60% and 90% above Macquarie’s FY19 and FY20 forecasts respectively. Manganese prices are also well above estimates, as are thermal and coking coal versus FY20 forecasts.
Meanwhile, nickel and silver are both trading -25-30% below the broker’s FY19 and FY23 forecasts. The earnings outlook for South32 is transformed at current prices, the most significant being alumina, manganese and thermal coal.
Macquarie believes BHP’s exposure to hard coking coal and oil prices provide a clear advantage versus Rio Tinto, which is also affected by its LME-linked alumina contract. The broker estimates this generates a -US$500m per annum operating earnings loss using spot alumina prices.
Thermal Coal
Newcastle’s premium thermal coal benchmark has surged. High-energy thermal coal has traded at a stable average premium of 22% versus its medium-energy equivalent over 2016-17, reaching a high of 90% in 2018.
Morgan Stanley believes the spike in the differential is not just about Chinese demand but about the weak supply of premium coal. Japan favours premium thermal coal and is the leading high-quality importer.
Japan’s coal imports are down -3% in the year to July while its coal-fired power generation is running higher, pointing to improved coal burning efficiency. Elsewhere, demand from high-quality importers such as South Korea and Taiwan remains stable.
China has been forced to lift thermal coal imports because domestic supply cannot keep up with demand due to of environmental controls but only an estimated 5% of China’s imports exceeded the 5600cal/kg energy level, so China is not a driver of the differential.
Morgan Stanley suggests the tightness in the premium market is partly offset by increased exports from Russia, which has helped Japan to reduce its dependence on Australian supply. Hence, the broker believes Australia’s energy price differential will narrow. The European price has not kept up with Australia and this is likely to result in high-quality producers such as Colombia and Russia redirecting more exports to the Pacific basin from Europe.
Morgan Stanley notes, despite expenditure discipline, Australia’s supply of premium thermal coal is incentivised to grow at current prices and further washing of high-ash coal becomes attractive at current price differentials. Demand from Japan is expected to gradually decline as it commits to re-starting nuclear operations, although the process has been slower than anticipated.
Nickel Mines
Nickel Mines ((NIC)) could become a significant operator in the global nickel industry. The catalyst, Bell Potter believes, is a collaboration and subscription agreement with Tsingshan, the world’s largest stainless steel producer. Tsingshan operates a fully integrated stainless steel facility in the Indonesian Morowali Industrial Park.
Via this agreement, Nickel Mines has applied US$70m of its IPO funds to lift ownership of two rotary kiln electric furnace lines at the park to 60% from 25%. This paves the way for equity production of 10,000tpa of nickel in nickel pig iron in 2019. These production lines are well advanced with commissioning on track for the June quarter of 2019. Bell Potter believes Nickel Mines represents a compelling opportunity to gain exposure to low-risk, low-cost nickel production.
The broker initiates coverage with a Speculative Buy rating and $0.45 target, suggesting the stock is a rare exposure to strengthening nickel market fundamentals as one of only a handful of listed, pure nickel plays worldwide.
