How Metals Prices Affect Mining Companies (JJG, DBA, RIO, BHP, FMG, SDL)

We’ve been talking about commodities so often in Smart Investing Daily that we’ve overlooked a key investment sector: commodity-based companies.

Smart Investing Daily reader J.D. reminds us there’s more out there than just the hard stuff, and just the yellow stuff:

Thanks for reports, enjoying reading them. Only thing I have noticed on last couple of reports as I am a newbie, when you talk commodities it seems to be coffee, gold and oil, which is good, how about discussing the minerals like companies FMG, SDL, RIO, BHP etc., and give opinions where they are heading, as all have had drops of late.

The companies J.D. mentions, Fortescue Metals Group (ASX:FMG), Rio Tinto Plc (NYSE:RIO), and BHP Billiton (NYSE:BHP), have major operations in Australia, so answering the question becomes a two-fold process.

[Sundance Resources Ltd (ASX:SDL) has operation in West Africa, and we’ll discuss it separately from the rest due to its size, scope and geographic operations.]

First things first; when you’re talking about commodity-based companies in comparison to commodities themselves, you have to account for different risks, besides those based on pure supply and demand, or value associated with the U.S. dollar, as most commodities are traded in dollars.

With companies you have to account for management styles and credibility. You have to distinguish between a development-stage company and a company that already has established production. You have to account for costs — personnel, financing, fuel…

All of these factors mean prices for commodity-based companies don’t move exactly in tandem with commodity prices themselves.

Not to mention if a disaster happens at a mine…

That means price movement of the underlying commodity becomes a factor in choosing whether or not to invest in a particular company — not the sole catalyst.

[As an aside, junior mining companies, or those still in development stages, do tend to become more attractive when metals prices rise if they’re not yet operational. This is because the value of their reserves climbs, and they do not have to contend (yet) with the costs of extraction. This makes some companies candidates for a takeover.]

So let’s take a look at these companies.

Here’s a comparison of all three major producers over the past year.

Fortescue Pro
View larger chart

These three companies all produce major quantities of iron ore, which is why there is a high correlation between share price movements.

It’s also clear that all three have been coming up against stiff resistance over the last quarter of 2010.

None of these companies has come out with earnings reports yet for the most recent quarter, but we do know that abnormally bad weather has led to production problems in Australia. That might have had some effect in late 2010.

At the same time, iron ore prices have skyrocketed, with some analysts suggesting a doubling of prices as Australia is predicted to have a heavier-than-usual cyclone season.

Couple that with increased industrial demand, and you could have a choppy road forward for these three companies… It will depend strongly on production, and the ability to produce in these harsh weather conditions.

As you can see from the chart above, Fortescue has had a huge breakout.

Between Jan. 17 and 18, the company announced that it shipped 9% more iron ore in its last quarter in 2010 that in the previous year. It also reported that it sold its iron ore at $150 per metric ton, up from $125 in the previous quarter.

From a value perspective Rio Tinto appears to be of better value, when taking into account the debt-to-equity ratio and free cash flow, but Fortescue looks better from a price-to-earnings ratio, price-to-book ratio, and PEG ratio.

  Fortescue (FMG:ASX) Rio Tinto (RIO:NYSE) BHP Billiton (BHP:NYSE)
1. Price/Earnings 7.65 15.19 19.88
2. Price/Book 3.03 3.09 5.25
3. Debt/Equity 1.91 1.49 1.93
4. Free Cash Flow -$63.36 Million $936.62 Million $4.95 Billion
5. PEG Ratio 0.50 1.17 0.85

As a simple play on iron ore, I think Fortescue is the way to go. It’s not spread out over other metals or mining operations. It’s also geographically located in one place — Australia — so the fundamentals will be easy to gauge, and news easy to follow.

Rio Tinto, on the other hand, has diamond operations in South Africa, aluminum operations across Europe, and copper operations in South America. Which area will have more of an effect on prices? How much does each operation contribute to the bottom line?

Rio Tinto is a much more complex company… and if you’re looking at Australian companies, or at least ones with Australian operations (and even more specifically, iron ore operations), Fortescue might be the better bet.

As far as Sundance Resources (ASX:SDL) goes, I think it’s more of a risk. It is still in the development stage, as it is still confirming reserves, and expects operations to start some time in 2012.

It has negative operating cash flow and negative free cash flow, which is not uncommon in a company that’s not producing yet. The stock has gone up some 250% in the last year, which I understand is tempting.

Any stake in this company should be made as though you were putting your cash on snake eyes at the craps table. If it pays off, it’ll pay off big, but it’s a big risk, and not for those who can’t afford to lose.

J.D., I hope this analysis helps you, and our other readers, in picking commodity-based companies.

Before I sign off, a brief update on the agricultural funds I’ve been talking about recently — the iPath Dow Jones UBS Grains ETN (NYSE:JJG) and the PowerShares DB Agriculture Fund (NYSE:DBA). Both retraced significantly yesterday, and have still not filled in their gap-ups from last week.

If we get a bounce here, you may want to consider adding one or both of these to your portfolio.

Written By Sara Nunnally For The Taipan Publishing Group

As Senior Research Director, global correspondent and co-editor of Smart Investing Daily, Sara has traveled all over the world in search of the best investment opportunities to recommend to her readers, be they in developed economies like France and Italy, in emerging markets like the Czech Republic and Poland, or in frontier terrain like Vietnam and Morocco. Her unique “holistic” approach of boots-on-the-ground research has given her an edge in today’s financial marketplace as she searches for the next investment opportunities in hot sectors like alternative energy, currency markets and commodities.  Sara Nunnally’s diverse background includes studies in history, computer science, literature and financial research. She has appeared on news media such as Forbes on Fox, Fox News Live, Bloomberg and CNBC’s Squawk Box, as well as numerous radio shows around the country.

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