$175bn+ of balance sheet headroom by 2011… but can they resist another cycle of overpriced M&A?

- A prolonged period of supernormal free cash flow "By the end of 2011, we forecast balance sheet headroom of over $175bn for the UK-listed mining sector. In the last cycle, over exuberant M&A destroyed value for shareholders. The past few weeks have seen three potential acquisitions in the sector (BHP/Potash Corp, Vedanta/Cairn India and ENRC/Camrose), and we do not like any of them. In the current cycle, we think investors should favour those companies most likely to return excess capital. We highlight Rio Tinto and Antofagasta here."
- Pushing out the commodity price peak "We have pushed out our assumed cyclical peak for commodity prices and mining industry earnings to 2012, in line with Nomura's view for a modest recovery in OECD economic growth. In specific cases, we have increased our medium-term commodity price forecasts to reflect worsening supply lags (mainly copper). We continue to forecast the majority of excess cash to be generated from copper, iron ore and coking coal exposure, and our new commodity price forecasts remain the most bullish versus consensus for these commodities."
- Valuation and top picks "Rio Tinto (Buy, TP £59) remains our top pick, driven by iron ore exposure and a renewed discipline to M&A after overpaying for Alcan. We retain our negative view on BHP (Reduce, TP £23), and we downgrade our recommendation for ENRC (Reduce, TP £9.5) from Buy previously. We reiterate our positive view on the miners with valuations still undemanding. However, we also recognise the additional risks (political, fiscal and M&A) that an environment of high free cash flow brings, and we have widened the spread of discount rates applied to our NPV valuations across the sector."

Nomura EMEA Metals & Mining 20100910

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