TAKING leave of long-suffering shareholders, former Anglo American CEO Cynthia Carroll chose to admonish rather than commiserate with them.
As the Financial Times reported: in a parting shot at shareholder demands for greater cash returns, Cynthia Carroll told the newspaper that there was a "disconnect" between mining companies and investors, adding that the latter need to understand better "what it really takes to deliver projects".
"Some (shareholders are) under severe pressure and want a return tomorrow. They’re going to be hard-pressed to get them because it’s not going to happen that way. We have to be ruthless in terms of what (costs) we’ve got to cut but we have to be mindful we’re in a long-term industry."
Anglo shareholders are demonstrating remarkable patience in the face of disastrous performance in which the company’s earnings and profitability have collapsed. Blaming the global slowdown and bust of the commodity supercycle ring hollow when judged by Anglo’s poor performance relative to that of its large diversified mining house peers. BHP Billiton, Rio Tinto and Anglo American are all listed on the FTSE in London. Since 2007, when Carroll became CEO, BHP Billiton has beaten the FTSE by a factor of 1.95; Rio Tinto has beaten it by 1.31 and Anglo has returned only 0.61 relative to every £1 invested in the FTSE. This is a sad case of sterling underperformance.
Anglo American was once worth more than BHP Billiton, but now its market value is considerably lower. From a peak market value of more than R700bn in 2007 before the global financial crisis struck, the company was worth less than half — R336bn — last month. BHP has held up much better over this period and is now worth significantly more than Anglo (about R230bn more at the end of last month). Compared to early 2003, before the commodity supercycle, shareholders would have done about three times better holding BHP than Anglo shares.
Such relative performance is seen in earnings and dividends a share. Anglo’s aftertax earnings per share, having collapsed in the past financial year to December, is now below the level of early 2003. BHP Billiton’s earnings per share, while also under strong downward pressure, grew much faster over the 10-year period and are a multiple of 2003 levels. The upshot of all this is that, at the end of last month, Anglo was selling for a highly generous and forgiving multiple of more than 30 times its reported earnings, while BHP commands a much more sober multiple of 12.8 times, although this was before second-half earnings have been reported. The average price to reported earnings multiples for both companies over the past decade has been about 13.5 times. Based on this measure, Anglo appears to be priced for a recovery and normalisation of its earnings.
While price:earnings multiples give an impression of the long-term expectations that inform market values, one can use a discounted cash-flow approach to judge more accurately what the market expects of mining houses by way of operating profitability and value creation.
Unlike Carroll and many other pundits unsympathetic to market forces, investors have long-term expectations about growth, return on capital and risk when they value the future cash flow from companies. Smart investors and executives back into and analyse market expectations to understand current valuations before they buy or sell shares. If expectations appear too optimistic then the investment should not be made. Too much pessimism about future expectations provides a potential buying opportunity.
Using CFROI2, a measure of the real cash-flow return on operating assets, we investigated the return on capital implied in the present aggregate value of South African mining companies (we did not include BHP Billiton in our sample).
The average real return on capital (CFROI) for global industrial and service companies is 6%. Firms that can generate operating returns that beat this can generally be said to be creating shareholder value. Firms that generate real operating returns less than 6% are destroying shareholder value. South Africa (defined as firms listed on the JSE) has one of the highest median CFROI values in the world at 10%.
This is something to be very proud of. In general, South African companies are very well managed and create shareholder value. If they can continue to generate returns that beat their cost of capital, they should reinvest their earnings and grow. It is not a lack of cash that stops firms from investing more in South Africa, but rather uncertainty about the risk and economics of future earnings from investments. The government should do all it can to welcome investment and reduce uncertainty if it truly wishes to unleash growth.
Unfortunately, the South African mining sector has not generated a particularly attractive return on capital. The median CFROI for the aggregate South African mining industry is 6.2% over the past 20 years. It has exceeded 9% in only two years, 2001 and 2006. Many miners did very well during the commodities supercycle from 2006 to 2008 but have generated value-destructive operating returns since. Platinum mining has provided a particularly disappointing return on capital since the supercycle collapsed, as has much of the acquisition activity undertaken by the diversified miners.
What are the expectations implied by market values? The aggregate CFROI for South African mining implicit in today’s market value is expected to remain at less than 6%, which is below the real cost of capital or the returns usually demanded of risky mining operations. Spiralling costs and low commodity prices are squeezing profitability, which is baked into today’s lower share prices.
If we compare expectations over the next five years for BHP, Rio Tinto and Anglo American, BHP is priced for its CFROI to go from 10% to 7%; Rio from 7% to 5%; and Anglo from 5% to an alarming and value-destructive 2%. Such low expectations indicate that Anglo is either cheap or the market has decided it is a value trap. The onus is on management to prove the market wrong by improving operational control, not to blame the market for losing faith in the industry.
Based on market expectations, investors don’t want growth from mining houses. Rather, they demand that mining houses pay much closer attention to cost control and operational excellence. These low market expectations should be a warning to managers, workers and the government responsible for mining policy. The lower profits and reduced growth expected is not in synch with demands for higher wages, electricity prices and state interference with mining rights and the taxation of mining profits. If these low expectations can be countered by sober management and relations, then these companies and their returns stand a stronger chance of recovery. If not, expect significant job losses and further evaporation of investment.
In the long run, it will be the real return on the cash invested by the mining companies that will be decisive in determining their value to shareholders. In the long run, economic fundamentals will trump what may be volatile expectations. The mining companies can manage for the long run with complete confidence in the willingness of the share market to give them time, but must bear in mind that actions speak louder than words. This is the "disconnect" that needs to be addressed.
• David Holland is an independent consultant and senior advisor to Credit Suisse. Kantor is chief strategist and economist at Investec Wealth & Investment.