Income Investors Shouldn't Touch These Mining Stocks

Income investors should avoid the likes of Vale, Rio Tinto, and BHP Billiton.

Jun 16, 2014 at 9:17AM

After the commodity supercycle ended in 2011, miners such as BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), and Vale (NYSE:VALE) reinvented themselves as strong cash flow generating companies focused on creating value for shareholders. Indeed, strong demand and prices for iron ore up until last year gave these companies confidence they could bring down their debt levels and increase shareholder distribution. However, a sharp decline in iron ore prices this year has seriously affected those plans. More importantly, the depressed outlook for iron ore prices means these miners will struggle to boost shareholder returns, at least in the medium term.

From boom to gloom
The previous decade saw a boom in commodities, driven by strong demand from a fast-industrializing China. Not surprisingly, miners had an excellent run during this period and were seen as high growth companies. Between 2000 and 2010, shares of BHP gained more than 620%, while shares of Rio Tinto gained over 1,150%. In the same period, the S&P 500 fell over 13%.

The commodity boom, however, ended in 2011 as China began to shift from investment and export-led growth to consumption-led growth. Still, the fact that the world's second-largest economy was growing at around 8% meant that demand for raw materials remained steady. However, miners were forced to downsize and focus on core businesses as they began adapting to the new environment.

In recent years, BHP Billiton and Rio Tinto have sold a number of non-core assets. Recently, BHP announced it was reviewing options for its Nickel West business. The company wants to focus on iron ore, copper, petroleum, coal, and possibly potash.

Miners' efforts to bring down costs and focus on core business certainly paid off last year. For the six-month period ended December 31, 2013, BHP Billiton saw a sharp increase in profit, which the miner attributed to improvement in productivity and additional volume from its low-risk, largely brownfield investment program. Rio Tinto also reported a sharp increase in underlying earnings for full-year 2013, driven by cost reduction and record production. Vale's underlying earnings for 2013 rose 15.4%, driven again by cost-cutting measures and a focus on core business.

While the focus on core business and cost-reduction measures certainly helped miners post impressive results last year, they were also helped by strong demand and prices for iron ore, their most important business. Indeed, it was strong demand for the commodity that prompted miners to increase their production. However, the increasing supplies are hitting the market at a time when demand from China has eased somewhat.

Weak iron ore prices hurting miners' plans
Following the end of the commodity boom, miners' strategy was to focus on core operations, cut capex, bring down debt, and ultimately boost shareholder returns. Of course, boosting returns depended to a large extent on strong cash flows, which have now been threatened by a steep drop in iron ore prices.

Iron ore prices have fallen around 30% this year already. The outlook isn't good either. Prices are expected to fall further as miners continue to increase supplies despite a slowdown in China. Some analysts expect prices to fall to $80 a ton because of increasing supplies. Recently, even BHP CEO Andrew Mackenzie admitted that the company expanded iron ore production too fast. While the likes of Vale, BHP Billiton, and Rio Tinto will still be able to turn in a profit at a price of $80 per ton, they will struggle to bring down their debt. In fact, they might even have to take on new debt to continue their shareholder distributions.

BHP and Rio currently have dividend yields of 3.48% and 3.64%, respectively. These levels are certainly impressive. Vale has an even more impressive dividend yield of 9.39%. At these levels, mining stocks are certainly an attractive proposition for income investors. However, weaker iron ore prices will hurt all three companies' cash flows, which could mean shareholder distributions could come under pressure in the future. Indeed, income investors should avoid these stocks right now. 

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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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