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The FTSE 100 mining giant is a wholly different proposition to the junior potash miner it is trying to acquired
Thursday 06 Feb 2020 Author: Mark Gardner

Investors who bought shares in Sirius Minerals (SXX) and who want to retain exposure to the company’s Woodsmith potash project face a very different proposition now that Anglo American (AAL)
looks set to take ownership through its planned £409m takeover of Sirius.

To follow the development of Woodsmith into production, Sirius investors would need to reinvest the takeover cash – assuming the deal goes through – back into Anglo American shares. They would then be invested in the project’s new owner, albeit also having exposure to many other projects involving a range of commodities.

The potash project would initially be small in the context of Anglo’s portfolio of operations, but in time it could become an important source of revenue for the expected new owner.

WHAT’S THE DIFFERENCE BETWEEN SIRIUS AND ANGLO?

Unlike Sirius, a junior start-up trying to find a way to dig deep into the ground in North Yorkshire, Anglo American is a century-old miner worth £28bn with 64,000 employees and 36 mining programmes in 10 countries across the world.

In its 2018 results, the company generated $27.6bn of revenue, with $9.2bn of underlying earnings before interest, tax, depreciation and amortisation (EBITDA). Its 2019 results will be published on 20 February 2020.

Anglo is a diversified miner, producing copper, iron ore, diamonds, nickel, manganese, coal and platinum group metals (PGMs) platinum, palladium and rhodium.

What it doesn’t currently have is potash, with the move for Sirius surprising many Anglo watchers.

BMO metals and mining analyst Edward Sterck called the move a ‘speculative foray’ into a ‘green commodity’ by Anglo, noting the substantial money that needs to be spent developing Sirius’ mine.

He also flags concerns over the market competitiveness of the type of product Anglo is aiming to produce, given that the broader potash market is expected to remain in oversupply until 2027.

‘This would certainly be a counter-cyclical investment (for the fertiliser market), but given the extremely long mine life this may present an interesting opportunity in a “green” commodity over the longer term.’

DIVERSIFICATION BENEFITS

Potash can be an attractive commodity for miners because it offers diversification, due to the fact that fertiliser prices aren’t usually correlated with other commodities like iron ore and copper.

Producing potash would also further differentiate Anglo American from its London-listed peers, Rio Tinto (RIO), BHP (BHP) and Glencore (GLEN), the other major diversified miners on the FTSE 100.

BHP has a potash asset – the massive Jansen project in Canada – but it has been put on hold until 2021 while the company decides what to do with it next. Rio Tinto has potash exploration interests but nothing in production.

COMMODITY RISKS TO CONSIDER

Anglo and Rio are the only London-listed diversified miners with diamond assets. This commodity is arguably more important to Anglo as it owns 85% of De Beers and on a group basis derives 14% of its earnings from diamonds.

Liberum analysts see the outlook for diamonds remaining bleak, due to lacklustre Chinese jewellery demand, and weaker consumer confidence in regions like the Middle East causing a pullback in demand for the higher quality stones De Beers specialises in.

More widely, the worry is that cheaper synthetic diamonds will take market share and lead to a long-term decline in demand for natural stones.

In 2018, in an attempt to address this situation De Beers started selling synthetic diamonds for the first time in its 130-year history and as analysts at Jefferies point out, it did so with barely any mark-up in an attempt to drive prices down across the synthetic diamond market.

Before De Beers entered the market, synthetic diamonds would cost around $4,200 per carat, compared to $6,000 for a natural diamond. But the company shocked the industry in May 2018 when it started making and selling synthetic diamonds for $800 per carat.

This should have the effect, the analysts point out, of limiting investment in new capacity for producing synthetic diamonds and clearly differentiate the two markets.

Jefferies comments: ‘The diamond industry’s marketing efforts – which have historically been extremely effective – will be critical once again to create continued demand for natural stones rather than synthetics.

‘In the meantime, Anglo and other major diamond producers are likely to operate on a value over volumes strategy to limit downside risk to prices for natural diamonds.’


TRANSFORMING ANGLO AMERICAN

There are three legs to Anglo American’s future strategy as it attempts to grow production and boost margins. This includes a well-planned operating model, its P101 approach which aims to go above and beyond best-in-class industry processes and equipment, and finally its trademarked FutureSmart Mining initiative. The latter involves the application of technology and data analysis to increase efficiency and reduce the environmental impact of its operations.


WHAT ABOUT PGMS?

In the case of PGMs, analysts are concerned that increased market share of electric vehicles and the growing trend for recycling metals will reduce demand for the mined PGMs used in the catalytic converters of conventional vehicles.

Jefferies says Anglo makes the case that there are technology-driven demand drivers for PGMs, but that ‘market scepticism about the demand outlook for these metals is unlikely to subside for the foreseeable future’.

Iron ore makes up 13% of Anglo’s underlying earnings and Liberum thinks a global oversupply of steel – iron ore is also a key component in the manufacture of steel – will significantly reduce iron ore demand and therefore prices in both 2020 and 2021.

ESG CONCERNS

Those investing with an ethical lens should know that coal accounted for more than a third (35%) of Anglo’s 2018 earnings.

However, the bulk of these earnings came from metallurgical coal, a vital ingredient for steelmakers, with only modest amount derived from thermal coal, a significant contributor to emissions as it is burned to produce energy.

As far as those in the market see it, the most promising area for Anglo appears to be copper, which accounted for 20% of earnings in 2018.

The global copper market is forecast to be in deficit by 2023. The amount produced from mines currently in operation, or set to come online in the near future, is not expected to keep up with demand due to forecasts for rocketing electric vehicle sales and the need for huge infrastructure upgrades across the world, particularly in emerging markets.

Jefferies notes Anglo’s shares have traded at a ‘significant discounts’ to Rio Tinto and BHP due to inferior free cash flow, as well as lower profit margins for the group, dragged down by its diamond business.

Almost half the company’s projects are in South Africa, but despite its mining history the country has an increasingly high risk profile for the industry. It faces a severe electricity crisis as power cuts become more common across the country.

In addition, rising public anger over miners bubbled over during the 2019 elections, with the far-left Economic Freedom Fighters party, which vowed to nationalise all the country’s mines if it got into power, gaining 11% of the vote. And the uncertainty and economic woes have contributed to a devaluation of the domestic rand currency.

CASH FLOW AND EARNINGS TO IMPROVE

Jefferies thinks Anglo’s free cash flow and capital returns should significantly improve after its Quellaveco copper project in Peru comes online in 2022, shifting the focus from the South African assets as Quellaveco ramps up and the copper price likely outperforms iron ore.

There is ongoing a debate over a potential break-up of Anglo American at some point in the future.

According to Jefferies, the strategy would be for Anglo to demerge its majority ownership stakes in its listed South African subsidiaries – Kumba and Amplats – and then benefit from a re-rating of its international businesses, which focus on copper, metallurgical coal, nickel and include De Beers and its Brazilian Minas Rio iron ore mine.

They believe a break-up would create ‘significant value’ for shareholders, and estimate Anglo to be worth £27.25 a share on a sum-of-the-parts basis, well ahead of its current £20 level.

But they can’t see such a scenario playing out until it gets its debt down. Despite reducing net debt by $10bn over the past three years, it still had net debt of $3.4bn as of 30 June 2019, albeit only representing 0.3 times underlying EBITDA.

The analysts believe an adequate amount of deleveraging is likely to take between 18 and 24 months.


SHARES SAYS: Sirius investors eager to continue having exposure to the Woodsmith project must understand that Anglo still comes with considerable risks despite being a very large company with a diverse source of revenue.

Anglo American has been a very good investment over the past four years and there is a lot to like about the business. Unfortunately there are numerous headwinds including how the coronavirus might impact commodities demand in the near term.

Now doesn’t feel like the time to be investing in the resources space given considerable uncertainty to global growth. We suggest you wait on the sidelines until the coronavirus situation starts to calm down before considering Anglo or indeed any mining stock.

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