Back to the Future

- What happens if we mean revert? — "We have run long-term commodity price assumptions through our models to determine what earnings and cash flow would look like under a mid cycle commodity price environment. On our analysis, the large diversifieds would be trading at an average PE of 12.6x, which is slightly ahead of the long-run PE multiple for the sector of 12.3x."
- Near-term commodity momentum critical — "The copper price has been trading in a $6,000 to $8,000 per tonne trading range since the beginning of 2010 (currently $7,486/t) and we expect it to remain in this range for the rest of the year. A breakdown of this range is likely to occur at some point and with inventory drawdown, lack of new LME inventory, and increase in cancelled warrants, the risk in the short term could be to the upside."
- What is being priced in — "The diversified miners are trading on an average PE of 8.1x spot 2011e earnings, versus 7x on our base case. Moreover, the mining sector is currently trading at a 20% discount to the market on spot commodity prices and on a historical basis it has traded at a 5% discount. In order for the sector to return to market multiples, then the copper price (along with the basket of commodities would have to fall by c15% or copper would have to fall to around $6,800/t ."
- Stress testing balance sheets and cash flow — "The key negative impact of the downturn in 2008 was the impact on cash flows and high debt positions of the mining companies. Under our long-term pricing scenario, free cash flow for the sector would fall by c70%, however the large diversifieds would be in the strongest positions, while the pure commodity companies would be impacted the most. Kazakhmys, for example, would experience difficulty given its $1.4bn capex commitment in 2011 and swing into negative cash flow under long-term prices. Once again the diversified miners look the strongest, with each able to maintain sufficient Free Cash Flow for expected capex under such a scenario."
- What to do — "We recommend investors sticking to the large diversified miners, with key picks of Xstrata and BHP Billiton. We are currently neutral on the sector, after being buyers in May and we would look to move to an underweight position on higher equity prices."


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