Australian Mining Sector:1Q18commodity review,mining cycle recovery to continue in 2018

Sector outlook positive in 2018 on record FCF, capital returns and macro.

    After a 2yr recovery in commodity prices and sector re-rate we see the sectoras fairly valued on a P/NPV basis (at 1x). However, commodities are tradingwell above historical real averages and marginal cost but global demandshould continue to improve even with our view of a softening Chinese propertymarket. Base metals look more attractive than the bulks. The mining cycle isstill in a recovery phase, and sector FCF and capital returns should continue toimprove despite rising operating costs and sustaining capex. We see 2018 asthe year M&A accelerates. The sector is trading on c.10% FCF yield, withgearing dropping to just 7% in 2018. Our top picks are RIO, BHP, SFR & OGC.

    Commodity outlook; trading above historical real averages but macro positive.

    All but two commodities (aluminium and nickel) are trading above historicalreal averages (back to 1980), however with ongoing supply side discipline anda positive demand outlook (DBe global GDP growth forecast 3.8%), with amodest slowdown in China (mostly from credit tightening and lower propertysales), we think commodity prices could remain supported in 2018. Thereappears to be upside risk to demand from China, SE Asia and other emergingmarkets mostly on infrastructure and machinery. An ongoing weaker USD willalso be positive for commodities due to upward pressure on marginal costs.

    Base metals S/D fundamentals continue to look more attractive than the bulkswhich we expect to weaken post Chinese heating season on increased supply.

    We prefer aluminium, nickel, zinc and copper.

    Sector themes; capital management, growth capex, M&A, cost inflation.

    Management teams should remain disciplined in 2018. Capital returns shouldincrease further with ongoing buybacks from RIO, S32 (BHP should announcebuyback in Aug) possibly supplemented with special dividends, possibly fromAWC, S32 and WHC. With sector gearing at record low levels (sub-10%) wethink companies will increase growth capex, but it will remain below mid-cycleand we think the sector is short high quality projects. M&A should increasealso (likely gold, coal, lithium, mid and large cap base metals). The other thingsto watch are rising operating costs (labour, oil, stripping and contractor rates)and sustaining capex (holiday hangover).

    Sector outlook and top picks; BUY; RIO, BHP, SFR, OGC; SELL; ILU, IGO.

    The Australian mining sector is fairly valued on a P/NPV basis at 1xNPV on ourprice deck but remains attractive on an EV/EBITDA (6x) and FCF yield basis (c.

    10% average for 2018) vs. historical averages. We remain positive on both RIOand BHP with improving shareholder and group returns (ROCE), productiongrowth and record FCF yields. In base and precious metals, we rate SFR, OGC,AQG and DCN a BUY and NCM, NST, RRL, IGO & WSA a SELL. We upgradeOGC to BUY (0.85xNPV), and downgrade SBM to HOLD (1.1xNPV) and IGO toSELL on valuation (1.3xNPV).

    Valuation and sector risks.

    PT’s set broadly in-line with DCF derived valuations. Company risks;commodity/currency movements (p14). Ratings, PTs and estimates changedfor several companies under coverage (see Figures 2 and 3).