Mining returns may have peaked: PwC

The outlook for the mining industry is good, but the sector may not be able to duplicate the growth it has experienced over the past year due to soaring operating costs, a new study by PricewaterhouseCoopers concludes.

The study, entitled Mine — As good as it gets, says that the global mining industry has not seen the effects of economic slowdown that hit other regions or sectors of the economy. In fact, the opposite is true — the sector has had explosive growth.

Total shareholder returns for the top 40 mining companies averaged 119% in 2007, compared to 55% in 2006, the study notes. In addition, the study shows that market capitalization of the industry grew by 54%.

But investors should not expect the good times to continue indefinitely. The surge in commodity prices that has led to the mining stock boom is also contributing to unprecedented growth in operating costs for miners, which may significantly squeeze the margin of returns.

For example, while revenue for the top 40 companies grew by 32%, it was outpaced by higher costs in areas such as energy and labour, which grew by 38%. It was the first time since 2002, the first year PwC undertook the study, that cash flows from operations were insufficient to cover the increased levels of investment activities. Significant external financing has been obtained to fund the various growth ambitions.

PwC says most indicators still point to exceptional growth. There are signs that some areas are tapering off and may be close to a peak. Net profit margins, return on equity and return on capital employed indicate that companies’ relative earnings have been maintained or decreased slightly compared to previous years as cost pressures escalate. The study warns that those companies which cannot control these climbing costs will struggle to keep pace with their peers.

“The good times continue for the global mining industry,” says Paul Murphy, PwC Canada mining practice leader. “Record commodity prices and continued growth in emerging economies have let the top mining companies avoid the slowdowns that we have seen hitting other sectors. While most indicators are still showing strong performance and continued growth, we have seen a decrease in margins due to cost increases. And with continuing issues with skills shortages, it is ever harder to bring new supply to the market. For some industry participants, this may be as good as it gets; however, for those companies operating low-cost long-life mines, the future looks very bright.”

The composition of the industry has also been radically transformed by consolidation and the growth of emerging market mining companies. In 2003, the market capitalizations for emerging markets’ companies made up 14% of the total top 40 market capitalizations; in 2007 this relative weight grew to 36%.

Traditional mining powerhouses Canada and Australia have seen their market capitalizations in the mining industry decrease and their cost of doing business skyrocket. For example, PwC says its publication for the junior mining industry in Canada shows recorded production cost increases of 76% from the prior year, although this has also been accompanied by production increases to meet swelling demand.

Canada’s junior mining industry remains one of the most fertile for returns. The Toronto Venture Exchange’s top 100 junior mining companies have experienced a 135% growth in market capitalization since 2005.

“Only time will tell if this next generation of emerging companies will continue their successful growth or whether they will fall prey to the other global top 40 players’ acquisition and diversification strategies,” the study’s authors write about Canada and Australia’s junior mining industries.

There isn’t a direct correlation between the price of mined commodity and the actual revenues being generated by companies. For example, margins of return by gold producers have been tight, despite record-high prices in the past year.

“In contrast to the diversified companies, the gold sector in particular has experienced weaker return on equity and return on common equity. In 2007, a number of gold companies have continued to exit their hedging commitments in an attempt to allow their companies to receive greater exposure to higher prices,” the study says. “Gold continues to be a higher-cost sector, reflected in the returns achieved relative to the rest of the mining industry. Despite its relative weaker performance, gold companies typically have a higher price earnings multiple than other miners. The higher price earnings ratios are partially explained by the role of gold as a store of wealth, which makes it subject to different market forces.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(06/17/08)

Mark Noble