This is a thematic short on slowing global mining capex. Metso is selected as a way to express this short view due to its individual short merits as oultined below.

Thesis Summary

I am advocating a short position in Metso OYJ (MEO1V FH).  Metso operates in 3 main segments: Mining and Construction (“MC”), Pulp, Paper and Power (“PPP”) and Automation (“AU”). 

As I outline in my top-down thesis, I believe that global mining capex is at an unsustainable level and will have to be scaled back, and in addition, Pulp & Paper is a secularly declining industry, which means that Metso will be facing both structural and cyclical headwinds in 2013 and beyond.

Even though Metso’s order intake is down 23% YTD and shrinking book to build ratio which now stands at 90% on the TTM basis, the Street is still projecting 4-5% earnings growth in 2013 and 2014, betting on a rebound in orders in the H2 of 2012, and the stock trades at ~10x forward earnings. My view is that the order book will continue to be weak and the company will face a revenue gap in 2013, which will result into negative operating leverage and will adversely impact earnings, causing the stock to de-rate.

Top-Down Thesis:  Mining value chain – CAPEX got to give.

Despite most metals and materials pricing never recovering back to their pre-2008 crash levels, mining capex actually re-accelerated following the last global recession. In fact, copper remains 20% below its pre-recession peak, zinc is 57% below its peak,  thermal coal is 31% off of its peak (CAPP), Nickel is 51% below its pre-crash level, moly is going for a half of its pre-recession price, and cobalt is selling below $15/lbs after peaking at $53/lbs around February of 2008. At the same time, top-40 mining companies have increased their capex by 53% between 2008 and 2012, from $74Bn to $114Bn (please refer to page 9):

http://www.xstrata.com/content/assets/pdf/x_speech_201205151.en.pdf

Arguably, this was fueled by soaring iron ore (driven by the China’s infrastructure stimulus) and gold prices (which many miners count as a by-product offset to cost), certain inertia associated with large-scale mining projects and cost overruns.

Now that China’s build-out craze wanes and precious metals are off their peaks, I am arguing that we’re approaching, if not already at, a cyclical peak in mining capex. I believe that mining companies will substantially scale back their expansion capex and this will be the reversal of fortunes of equipment manufacturers.

While it is hardly a secret for industry followers that mining companies’ CEOs have been prioritizing capex over returning cash to shareholders (for top 6 miners capex has been growing at 2x the pace of dividend growth) and that the equipment suppliers and engineering companies were robbing them blind on pricing, I believe that the situation has reached the inflection point and the evidence to that is as follows:

1. DCF doesn’t work at these levels anymore

Consider the case of Esperansa, a copper mine in Chile owned by Antofagasta Plc (not to be singled out as a “bad” project,  it just happens to be a clear cut typical LatAm copper project and I have granular details about that mine from a management meeting).

 Esperansa is designed to produce 190Kt of copper, 1.1moz of silver and 250koz of gold in a steady state. The mine was commissioned in 2007 and the original cost was projected at $2.7Bn. The mine had technical issues due to poor engineering and experienced a $200m cost overrun for the total of $2.9Bn. In a recent conversation, the management revealed that if they commissioned the mine today, the full cost would approach $3.7Bn based on equipment and labor cost inflation. It’s easy to calculate that while $2.7Bn investment on $2.5 long term copper is supportive of 13-15% IRR, the $3.7Bn price tag is not – it results into 8-9% IRR, whilst the company’s debt financing alone is costing them 5.5%-7%.

2. Shareholder pressure intensifying

Mining companies are hearing loud and clear, and this really comes through in shareholder meetings, that people want the perpetual “expansion programs” to come to fruition in the form of dividends and buybacks. As John Tumazos put it on FCX call, “We just don't want to feel subordinate to the capital expenditure vendor suppliers as shareholders”. From my conversations with industry professionals, it appears that we will see a lot more shareholder activism in the mining names, big and small. One can easily gauge the degree to which FCX’s and other mining companies shareholders are unhappy by looking at their broken charts.

 3. Lead times on equipment deliveries peaking

Lead times on heavy equipment deliveries are approaching 2007 levels (please refer to page 17 of the presentation):

http://www.xstrata.com/content/assets/pdf/x_speech_201205151.en.pd

4. Financing is not there

Primarily this is the issue affecting Juniors right now, but one has to keep in mind that Juniors are the ones who are doing the exploration work for their bigger peers to acquire de-risked properties for their next mega-project, which would result into yet another multi-billion dollar mining order.

Right now, Juniors are finding themselves between a rock and a hard place. First, project finance is non-existent. Historically, some Spanish and other European banks were big in mining project finance, but alas they have gone insolvent. Than there’s also Canadian banks who are doing it. In my recent conversation with Inmet Mining, they told me that the current terms and definitions of project finance agreements are designed for a company to fail, and are so extremely unattractive that Inmet decided against pursuing project finance and issued public debt instead. Just two weeks after that, Hudbay Minerals had to pull its proposed $400m public debt offering due to “proposed interest rate exceeding our cost of capital criteria”. And as far as equity goes, junior miner equity financing over 3Q 2011-1Q 2012 was 47% and 40% below, respectively, CY 2010 and 1H 2011 levels.

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So Big Picture, we have mining industry which is facing pricing pressures as metals and materials prices slide, and on the other side it’s facing higher capital requirements as equipment prices soar. It is also forced to invest in highly unstable parts of the world (LatAm, Indonesia, Africa), which requires higher risk premium in the IRRs. In this situation, continuing growth in capital investment is not possible without IRRs of new projects falling below companies’ cost of capital. Such value destructive activities can be carried on for a limited period of time before these projects have to be rationed. Capital will not flow into the industry with unattractive returns. This is simple, and inevitable like gravity.

**

But while this is a nice theoretical argument, are there signs that capex cuts will actually happen? As it turns out, there are:

• Rio Tinto said they may delay or cancel its Mount Pleasant project in NWC due to escalating opex and capex costs. The company wants to “live within its means”. Earlier ,Rio pulled out of Abbot Point coal terminal in Queensland
• BHP Billitonis now planning to stagger its capex to meet cash flows. Jac Nasser ,Chairman:  “we should pause, take a breath and see where the pieces fall around the world… The tailwind of high commodity prices has contributed to record growth in the sector. Now we have a period where those tailwinds are moderating and we expect further easing over time. The environment was different [when BHP planned to spend $800Bn on new developments]”.And the times are different indeed -  If you went to a BHP’s (Rio’s, Vale’s, etc.) investor presentation in 2009, they were projecting 20% iron ore demand growth in China through the end of times, and if you went to one this year, they’re talking about  a “window of profitability till 2020”
• New World Resources scaled back its capex at Debiensko project to 5m Euro vs. expected 50m, due to higher costs and lower coal prices
• Newmont Mining said at its investors day that it is likely to suspend its Minas Conga project. The company cited low returns at existing capex levels
• On the most recent call, Potash Corp announced another $500m cost overrun on its New Brunswick facility due to “unanticipated complexities of completely new ore body” (and that was a brownfield, to boot – the extension of an old ore body on the other side of a highway). The company noted that costs are so high right now that it should deter any unspecified competitors (meaning BHP) from attempting a greenfield
• The latest, and the most spectacular casualty is, of course Barrick Gold. After a fiasco at Pascua-Lama ($3Bn capex swelled to $8Bn), the company decided that several mega projects, such as Cerro-Casale and Dolin Gold “no longer meet the company’s hurdle rate” and took them off the table. A bunch of smaller projects were also sidelined, for the total of over $10Bn in capex spend cut overnight

 So, if companies have to cut, and they are in fact beginning to cut capex, what would be the extent of it?

Citi’s mining team out of London has done a lot of work on it and according to their model, if the Big-4 wanted to stagger capex to match their operating cash flows, they would have to cut 2012 capex in double-digits, with Vale being the worst offender who would have to cut by 63% in 2012 and 98% in 2013. This is of course a theoretical estimate, but it illustrates the magnitude of the cyclical downturn in mining capex.

Metso-Specific Short Merits

• Mining will disappoint: In mining, the sell-side is still modeling revenue growth in 2013 – 2014 by 5-9% in 2012 and 1-3% thereafter. I believe that this trend will not materialize, but on the contrary the earnings will decline starting in 2013. Under my base-case assumption MEO1V will see its EBIT consensus numbers cut by 28% in 2013 and EPS cut by 40%, which should lead to substantial share price decline. YTD, Metso’s backlog is already down 23% and this has been a good predictor of revenues and margins trajectory. With the book to build at 0.9x and current orders scheduled to flow through the P&L in 2013, there’s no way that they are going to grow revenues, or earnings (negative operating leverage will kick in
• Unfavorable exposure to paper:  Put simply, paper and pulp is an industry in secular decline experiencing overcapacity globally, with manufacturers going bankrupt in droves and it is hard to fathom any capacity additions and new orders beyond required maintenance. Most recent wave of capacity additions came from China on the back of its stimulus program which is now over. On the most recent call the company acknowledged that the problem with paper is not financing, but lack of demand.  The earnings in this segment will be declining in 2013 - 2014 and beyond, which I believe is understood by the market and reflected in sell-side models.It appears following the latest earnings call that the company will be restructuring its PPP division further as margins continue to erode
• Chinese competition intensifies: MEO1V produces relatively simple types of equipment, such as conveyor belts, crushers, grinders and screeners. It has no IP, valuable patents or know-hows and is facing competition from emerging China’s equipment manufacturers (Sany, CITIC), which in the words of customers are “simply outstanding”. Chinese competitors grew their market share from zero in early 2000 to 85% domestically today (among top 4) and are now gaining share globally outside of China. This competitive environment will further erode Metso’s position and profitability
• Valuation: On consensus estimates MEO1V trades at 10x 2013 P/E, which itself is a turn higher than historical mid-cycle multiple. However, I believe that the consensus does not at all reflect the imminent downside. On my base-case assumption, MEO1V trades at 16x P/E, a very high valuation for a company facing multiple secular headwinds. I see its fair value at EUR 17, 9.5x my 2013 earnings and 35% below the current value

Risks

• Metso has a small net debt position and may finalize the sale of its recycling and auto business. While it is possible that they could use that cash to pay a special dividend, I believe that they will try to grow out of their revenue gap by making a bad acquisition. Nonetheless, the risk of a special dividend remains
• Rapid unanticipated industrial recovery in China supports mining fundamentals for longer