Basic Material Ideas - Where do you get the best returns? Macquarie Research,

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Basic Material Ideas
Where do you get the best returns?
Event
 Given the escalation in capital costs over the past few years, the return on
investment in the bulk commodities end of the market has become more of a
focus. The increase in operating costs has also impacted returns and in most
markets, it appears that both operating cost and capital costs will continue to
increase.
 Stock focus – Stocks with higher ROEs and are well valued are in focus.
 Thermal Coal – Straits Asia, Harum Energy, Bukit Asam and Shenhua.
 Iron ore – Atlas Iron, Fortescue, Mount Gibson and Mitsui
 Coking Coal – Fushan, Mitsubishi (8058 JP, ¥2,039, OP, TP: ¥3,000)
 When looking at the sectors, it is much harder to find value in the Coking Coal
segment under this sort of analysis. Despite the higher GP margins, the
returns are lower at this stage given mine ramps ups and equity dilutionary
impacts. Fushan looks interesting but there are still a number of hurdles that
need to be overcome before we can push it fully.
Impact
 We have reviewed average capital costs and average cash costs in
major iron ore and coal producing regions. The real aim of the analysis is
to assess where dollars are best spent when it comes to expansion projects.
We take average capital costs and compare them to average cash returns to
see what sort of investment returns can be expected in the industry.
 Iron ore – Cash returns at current spot prices are very high in most regions.
This also means that returns on capital invested are also high. China stands
out as a high returning market at current spot prices but if we revert to our
longer term pricing forecasts, the higher cash cost nature of the market
means returns collapse. We believe the Australian and Brazilian miners stack
up the best given their lower cash cost of production.
 Thermal coal – Cash returns are very high in China and Indonesia while the
higher cost nature of the Australian market means returns are lower. Capital
costs in Indonesia are the lowest so overall returns on capital invested are
very high and supportive for further investment and hence the volumes
forecast to come online over the next few years.
 Coking Coal – Gross margins in Coking Coal are very high in both China and
Australia. The very high returns in China helps to explain why supply seems
to come into the market when demand and prices are high. In our view, the
real issue in the Coking Coal segment of the market is finding decent reserves
to exploit.
Outlook
 In a market where capital costs are increasing and cash production costs are
also increasing, this analysis is necessary. We continue to like Iron ore and
Coking coal from a commodities perspective while we are more neutral on the
Thermal coal market.