Mining's Massive Margins

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On Aug. 26, U.K. Fool Stuart Watson from our sister site (fool.co.uk) provided an interesting take on mining stocks. We thought you'd like to read it. The article has been updated and Americanized by Todd Wenning.

Many commodity prices have come off the boil recently. In addition to oil, major metals such as copper, lead, nickel, zinc, and aluminum have all seen significant price decreases. This has hit the shares of the big mining companies and led many people to ask whether the commodity boom has come to an end.

On the evidence of the latest results from Rio Tinto (NYSE: RTP), it would seem there is still some way to go. Although the bottom-line numbers were boosted by profits from disposals, the company still managed to post a 55% increase in underlying earnings and hiked its dividend by 31%.

There was some increase in production levels, but profits were mostly boosted by higher prices compared to the first half of last year. Rio's three major sources of revenue are iron ore, copper, and aluminum, with iron ore accounting for almost half of profits for the last six months.

The FTSE 100 index currently has the pleasure of including four of the five largest miners in the world, namely BHP Billiton (NYSE: BHP), Rio Tinto, Anglo American and Xstrata. Only Brazil's Vale (NYSE: RIO), the second-largest, doesn't have a main London listing. Collectively, the group has generated excellent returns over the last five years, but is there more left in the tank?

A busy sector for bid activity
Along with higher commodity prices, merger activity has driven the growth of all the major mining groups in recent years. Rio Tinto gobbled up Alcan last year, and Vale and Xstrata were in talks a few months ago, but couldn't agree on a price. However, the bid that is attracting most interest is BHP's move for Rio Tinto.

Indeed, the bid is in limbo at the moment as various regulatory processes are carried out. Last week, Australia raised concerns about the dominant position the enlarged group would have in the Pilbara iron ore region of northwest Australia. However, it's the European competition rules that are expected to be the biggest stumbling block, with a full investigation concluding at the end of this year.

Are big miners cheap?
You could argue that there's not a lot to choose from between the big miners. They earn profits from a different mix of commodities, but are all quite well diversified. BHP is the only one of the four to earn substantial revenues from oil, however. Rio is by far the most indebted of the four, due to its recent purchase of Alcan.

On a trailing price earnings basis, BHP, Anglo, and Xstrata are valued between 10 and 13 times. Rio, thanks to BHP's interest, is valued at 17 times, making it the most relatively expensive of the four.

Using the most basic analysis, these low price earnings ratios make all four companies look cheap. However, the clue as to why lies in their margins. Before depreciation is taken into account, the profit margins in many of the commodities they produce are currently well in excess of 50%. Indeed Rio, being one of the lowest-cost producers, can boast 60% for iron ore and an astonishing 70% for copper.

The low valuations being given to these companies suggest that the market doesn't believe current metals prices will be sustainable in the long term. Either prices will fall or costs will rise, or perhaps both.

I suspect margins will fall back, but this could be more than offset by decent production growth for the next few years driven by the ongoing demand from China, India, and other developing nations. While this demand has moderated in recent months it's still very much in evidence.

Both BHP and Rio have been making medium-term forecasts as part of their bid battle. BHP is forecasting annual production growth of 6.9% from 2007 to 2012, while Rio is going for 8.6% annual growth from 2008 to 2015. For companies of this size, these are impressive numbers.

I'd class myself as a commodity bull, but not a huge one. So I think all four of these companies will do well over the next five years, although, with its higher debt and valuation level, Rio is the least attractive at the moment.

Related mining stocks on Motley Fool CAPS:

Company	CAPS Rating (5 max)	Research
Southern Copper (NYSE: PCU)	*****	PCU
Freeport-McMoRan (NYSE: FCX)	*****	FCX
Alcoa (NYSE: AA)	****	AA
Kinross Gold (NYSE: KGC)	****	KGC

Source: Motley Fool CAPS as of Aug. 26, 2008.