Description

I am officially a Chinabear. I can also not resist value (or is that value traps) when I see it. I think I can kill these two birds with one stone by recommending an investment into an Anglo American stub described below.

Profit Streams

Anglo American (AAL.LN) is a global diversified miner listed in London with revenues of over $36.5bil. (Trading volume is also ok on the pink sheets AAUKY.PK)

The EBITDA streams are shown in the table below. I want to apologize for the length of the table, but, in this report I will be creating two stubs and I thought it would be useful to have this table handy as you read through these calculations.

To motivate members to work through these calculations I think that the second stub can be created for $2.7bil. The assets remaining in the stub (marked with an asterisk) generated an EBITDA of $5.1bil in 2011 which dwarfs the lousy $2.7bil investment.

Basic Valuation

How am I ever going to value these profit streams? Luckily the platinum assets and a large portion of the iron ore assets are separately listed. Further, in Q4 2011 Anglo American made two large transactions in their copper and diamond divisions which will help to pin a value on these operations. But, let’s start at the beginning with a basic valuation.

The London price is GBP20.19, or $31.90 using the current GBPUSD exchange rate. (As Anglo’s report in USD it is a lot easier to use the USD price.)

Anglo's looks cheap on both ratings, but, so what all resource companies look cheap. Besides there is a market myth which states that one should buy resource companies on high PE’s and sell on low PE’s.

A simple scatter plot with historic PE’s on the x-axis and the 12 month subsequent return on the y-axis suggests that this myth does not seem to apply to Anglos. I have 350 months of data going back to 1982. There have only been 29 months where the PE was below 6.7. Of these 29 months only 9 had a negative 12 month return and they all occurred before 1984 when Anglos had a completely different risk profile.

Post 1984 there were 15 events and all of them generated positive returns. The 12 month returns ranged between 29% and 162% with an average return of 78%. No black swans here, only white.

Valuation-Creating Stub1

Statistics are great, but, what happens if there is a black swan? What happens if the China bears are right and commodities get hit? Some of this risk can be eliminated by shorting out the operations within Anglo’s which are separately listed. (Kumba IronOre, Anglo Ameican Platinum and Exxaro). For convenience, some of the larger brokers make a market in this stub.

1) Kumba

Kumba Iron Ore (KIO SJ) listed inSouth Africa. Anglos owns 65% of Kumba.

Kumba is a formidable company and scary to short. It produced 44mil tons of iron ore in 2011 and due to expansion projects which are ramping up it should produce 49mil tons in 2012 and 53mil tons in 2013. It hopes to be producing 70mil tons by 2019.

In 2011, average iron ore prices were $150 per ton and operating costs were only $50/ton. These unbelievable margins allowed Kumba to generated an EBITDA of $4.5bil.

My favorite trick in trying to find a “good company” is to look at the cash flow statement where I add up all the cash spent on working capital and “investment activities” over a long period of time. Kumba has spent ZAR24bil since listing in 2006. (I have included the assets of the opening balance sheet in this number). This ZAR24bil investment is currently generating operating cash flows before interest and tax of ZAR32bil for a cash-on-cash return of 135%.

These returns are unbelievable and I am sure everybody Tom, Dick and Harry also want an iron ore mine. And guess what, just like that Economics 1 textbook predicts, a wall of new iron ore supply is about to come on line over the next few years to meet the “insatiable demand from China”.

China currently absorbs 68% of sea borne iron ore market and for this party to continue China will have to spend even more on infrastructure. This is a big ask for the China bears, but, I think the new supply may be the real threat to returns.

The second listed entity is Anglo American Platinum (AMS SJ) also listed inSouth Africa. Anglos owns 79.7% of AMS.

AMS is the largest platinum producer in the world accounting for 40% of the world’s production. Pretty impressive, but, this is not as fancy as it sounds.

Back to my favorite trick. AMS have spent ZAR91bil on “investment activities” and ZAR8bil on working capital since 1986. Cash generated by operating activities before interest and tax was ZAR13.3bil for a cash-on-cash return on investment of 14.6%. The return is flattering as the ZAR99bil has not been adjusted for inflation. In today’s money the ZAR99bil is approximately ZAR142bil so the real return is closer to 9.3%.

I admit the current return is depressed given the challenges faced by the platinum miners. Over the last 20 years the average real return has been 14%. The standard deviation of the return is 10% which shows the extreme volatility one can expect (ie with 66% confidence the return ranges between 4% and 24%.)

For a company that produces 40% of the world’s platinum, the returns are disappointing and the volatility of the return is unacceptable. Platinum is supposed to be so scarce and valuable yet iron ore mines make the platinum business model look stupid.

The obvious problem is that costs and capital intensity seem climb relentlessly as these mines get deeper and grades deteriorate. A less obvious problem is that 70% of the output is sold to the jewelry and motor vehicle market. The jewelry market seems a little artificial to me and I don’t think supplying stuff to the big car manufacturers is a great business model.

Bottom line, the poor returns on investment don’t make this a good company and I don’t mind hedging out the platinum exposure. The Anglo’s management also seem to recognise the problem and I would not be surprised if the asset is deemed non-core and unbundled to investors.

3) Exxaro (EXX SJ)

Exxaro is also listed in South Africa. It’s largest asset by far is a 25% stake in the iron ore assets owned by Kumba. Anglos own’s 9.7% of Exxaro currently worth $750mil.

Valuation-Creating Stub2

The market cap of the stub after shorting out 65% Kumba, 79.7% of Anglo Platinum and 9.7% of Exxaro is $18.8 billion.

So what am I getting for $18.8bil? I will go into more detail below, but, for those who are skimming the idea I will cut directly to the chase.

There have been two recent transactions which highlight the value in the stub.

1) De Beers (Diamonds)

2) Anglo American Slur (Copper)

1) De Beers

Anglo’s own 45% of De Beers. De Beers produces 35% of the world’s diamonds by value. (For those who want to know more about the company or diamonds I highly recommend the following Frontline documentary. http://www.youtube.com/watch?v=i8A9JXLyRwc)

In November 2011, Anglo’s agreed to buy an additional 40% stake in De Beers for $5.1bil from the Oppenheimer family, the founding family of De Beers and Anglos.

I have looked at the transaction and think the price at 8.5 times EV/EBITDA was fair. Assuming that I am correct this values Anglo’s 45% interest at $5.7bil.

As the following time series shows EBITDA is very sensitive to economic crises and I suggest the China bears hedge out this exposure with a luxury goods company who also tend to get smashed by these storms.

2006: EBITDA = $1 232mil

2007: EBITDA = $1 216mil

2008: EBITDA = $1 222mil

2009: EBITDA = $   654mil (“ouch”)

2010: EBITDA = $1 428mil

2011: EBITDA = $1 721mil

2) Anglo American Slur

Anglo’s currently owned 75.5% of Anglo American Sur. AA Sur owns two copper mines inChile, (Los Broncos and El Soldado) and the Chagres smelter. The Sur operations produced 269k tons of copper and generated EBITDA of $1 247mil. This profit will be underpinned in 2012 as Los Broncos ramps up its production from 220k tons to 420k tons per annum.

In November 2011, Mitsubishi acquired 24.5% of AA Sur from Anglo’s for $5.39bil. The Mitsubishi transaction implies a value of $16.5bil for the 75% stake owned by Anglo’s. But, there is a problem. Codelco, the state owned miner, has a call option to acquire 49% of Anglo’s share at a strike price determined by a formula.

Although the option strike date was set for January 2012, Codelco wanted to exercise their option in October 2011 to buy 49% of AA Sur for $6.75bil. Apparently Codelco were going to immediately flip this stake to Mitsui. Anglo’s was obviously upset and this prompted them to sell 24.5% to Mitsubishi. The Codelco call option is now only for 49% of the remaining 75%.

Codelco insist that they are still entitled to 49% of the mine and this dispute is headed for the Chilean courts. While I am not a lawyer it seems that Anglo’s were within their rights to sell, but, while Anglo’s are relying on the law I am worried about the politics. “The government mining company in the Chilean court fighting the foreign capitalists.”

As a result of this risk I am going to give the 75% stake a haircut and value it using the $6.75bil for 49%. This means that the 75.5% Anglo share is only worth $10.4bil.

So we originally had $18.8bil for the first stub. Subtracting the $5.7bil for De Beers and the $10.4bil for AA Sur we now have a second stub with a value of $2.7bil.

The remaining assets of stub2 generated an EBITDA of $5.1bil in 2011. These EBITDA streams are marked with an asterisk in the first table of this report. I am more than happy to discuss these further if asked, but, for now I want to focus on the Brazilian iron ore assets.

The major Brazilian iron ore asset is Minas-Rio. This operation was bought for $5.8bil in 2008 just before the start of the financial crisis. The initial project costs were $3.2bil, but, this seems to escalate every time you blink. The current projected cost is $5.8bil. So Anglo’s are all in for a cool $11.6bil.

The project consist of an open pit mine, a 525km slurry pipeline as well the construction of the Acu port. (Anglo’s will only own 50% of the port.)

The latest update is that the construction of the port is on schedule and that 200km of the pipeline has been laid. Anglo’s are now targeting their first shipment in the 2^nd half of 2013.

The first phase of the project is targeted to produce 26.5mil tons of iron ore which they can land in China for $50 per ton. Assuming an iron ore price of $150 per ton implies that the project will make an operating profit of $2.6bil per annum.

Using the stub to get this project on the cheap is a great hedge for the China bears who decide to short Kumba.

The most optimistic catalysts is that BHP, RIO or Xstrata also see the potential for asset stripping/cherry picking. Remember Xstrata made an unsuccessful bid for Anglo’s in 2009. Anglo’s does look vulnerable with a market cap of $46bil versus BHP($166bil), Vale ($96bil) and RIO($85bil).

Smaller catalysts include developments with Codelco, good news from the Minas-Rio project and the closing of the De Beers acquisition. The Anglo’s share had a nice run following the announcement of the De Beers deal. The deal will be funded using cash currently on the balance sheet which should boost earnings as Helicopter Ben has made damn sure that the interest on this cash is less than the stationary bill.

Otherwise the stock is down 40% since early Feb2012. History shows that a 6.5 PE has been a rewarding entry point. Value will out.

Conclusion

I could give many more examples of value which is not recognized in the current share price, but, I think the point has been made. For 2.7bil an investor gets the $11.6bil Minas Rio project plus other assets which generated $5.1bil in EBITDA. Bottom line, Anglo's looks like a cheap entry point for investors who want some exposure to the commodity cycle.

For the China bears, Anglo’s seems like an ideal hedge just in case you are wrong.

Catalyst