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Metals Miners Advance in 2016 as Focus Shifts to Profit

TOM BUTCHER: Charl, the diversified metals and mining sub-industry has been one of the best performing this year. What is the primary reason for this outperformance?

CHARL MALAN: Good question, and there are two primary reasons. First, is the stabilization of commodity prices. Since 2011 and 2012, commodity prices have generally rolled over quite aggressively. Second, and more importantly, mining companies have restructured and repositioned significantly over this same period from 2011 to the end of last year. This restructuring process has involved major changes at the executive management level. New management has started to focus on profitability, where as old management had always focused on volumes: how many tons, how many pounds, how many ounces I can produce. With new management, and the fact that commodity prices were eroding, the focus shifted a great deal to cost cutting. We saw cost cutting across the complex on many different levels. New management also had to focus quite aggressively on cash outflow. You will see that since 2011-2012, capital spending for the Bix Six mining companies has collapsed from roughly $80 billion to about $20-$25 billion today.

The two key drivers for this year thus far have been asset sales -- many miners sold non-core assets -- and the closing of assets that were not profitable. The really optimal structure we had at the end of last year became super-optimal in the beginning of 2016. Then with the advent of stable commodity prices, we have seen margin expansion characterize most of 2016. The positive combination of margin expansion, higher cash flow, and significantly better balance sheets typically lead to a multiple re-rating for these companies.

BUTCHER: Is this true of Glencore, which had such a hard time in 2015?

MALAN: Glencore could be named the “poster child” for this whole industry. Glencore had been very vocal prior to 2016 about mining for profit versus mining for volume. Glencore had been very critical about the traditional structure where a lot of these other large-cap mining companies were not mining for profit. If you look back twelve months, many people were questioning Glencore’s balance sheet. In terms of net debt to EBITDA, which is a typical measurement for balance sheet strength, typically the industry wants to be somewhere between two to three times (2x to 3x). Glencore was somewhere around three and a half to five times (3.5x to 5x).

This meant that of the large-cap companies, Glencore was one of the more leveraged companies. But Glencore was also one of the most aggressive companies, given that it took steps in the latter part of 2015 and early 2016 to do asset sales and to close assets that were not profitable. Putting this in dollar terms: A year ago, Glencore reported a debt position of approximately $33 billion. With this figure, I am excluding the trading book, which in itself is not really a debt. Glencore made a statement that by the end of 2016, its debt would be down to $25 billion. The industry was very skeptical about this goal given that we have had lower commodity prices, and it has wondered how Glencore would be able to sell assets at good prices. Well, lo and behold, at the end of this year, Glencore will most probably report a debt position of approximately $17 billion. The company basically cut its debt from $33 to $17 billion. Yes, they did raise capital, approximately $2 billion. But most of the other gains came from asset sales and/or asset closures, which meant cash was not flowing out. This has changed Glencore significantly, and its net debt to EBITDA multiple, which had been about three times (3x), is now probably going to be one and a half to two times (1.5x to 2x). This company has really gone from being the bad kid on the block in terms of balance sheets to the kid that's now one of the best positioned. At the moment , the company’s free cash flow yield is approximately 17%, which is one of the highest yields within the industry.

BUTCHER: Let’s look at two specific commodities, zinc and coal. What are the factors behind their having performed so well so far this year?

MALAN: As I have said, most of the commodity complex has stabilized, but there have been a couple of standouts in 2016. Zinc and metallurgical coal have been the standouts this year. Met coal has been by far one of the top performers, having gained more than 100% this year already. The strong performance is mainly because of supply cuts. As I said before, mining assets were sold and closed, as it was not profitable to run them. Earlier, I also spoke about cap-ex reductions, and so if you do not spend money today for tomorrow's production, you are not going to have supply. This has impacted the supply of both zinc and met coal, in particular.

While both zinc and metallurgical coal supply had collapsed, we have had a very stable demand environment, with demand growing at 1% or 2%. Supply in zinc, specifically, collapsed about 15% to 20% in the first quarter of this year. Met coal supply, specifically out of China, which is one of the bigger met coal producers in the world, collapsed approximately 30% to 35% in the first six months of the year. Some of this drop was caused by environmental issues, and we will work through those issues with time. In Glencore's case, it shut about 5% of its global production, and that is not going to come back online until all those assets are profitable.

BUTCHER: Are there any other areas that are interesting at the moment?

MALAN: One commodity that stands out that not too many people are talking about is diamonds, and the specific company we like is called Petra Diamonds. Petra bought a mine from De Beers, one of the biggest diamond mining companies in the world, in 2007. Petra spent a bucket-load of capital on the asset, and they have managed to revive this asset, by doing a couple of things. First, Petra is mining what we call undiluted ore versus diluted ore. Within undiluted ore, typically your grade is higher. Higher-grade ore means more profitability, and typically means lower cost per ton that you mine, so that is a positive. Undiluted ore typically means that your diamonds are bigger, and that means you get a higher price for your diamond. Undiluted ore also means that the value of the stone that comes out of the ground is not only better quality, but it is worth a higher dollar value. These three things -- better grade, bigger stones, and a higher-valued diamond – for a company that's growing its production from roughly 2-2.5 million carats to about 5 million carats over the next three to four years is going to obviously mean a substantial uplift in its revenue. Considering that Petra’s cap-ex profile is flat over the next couple of years, and considering that its cost structure is flat, we may see a massive blowout on free cash flow.

When you compare Petra to Glencore, for example, Glencore is at 17% free cash flow yield and Petra is at 14% to 15%. I met with Petra’s management last month and asked them what they planned to do with the cash. It was very clear to us: the cash will go to shareholders, debt, and last will be growth cap-ex. This is the type of company we are looking for, and that gets me excited.

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