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Gearing Up for a Mining Recovery

After four years of adjusting to a weak commodities market, mining companies are on sounder financial footing, and suppliers to the industry could benefit, amid higher capital expenditure aimed at boosting productivity—not capacity.

A few years ago, when commodity prices were booming, miners couldn’t ramp up capacity and production fast enough to meet China’s seemingly insatiable appetite for steel, copper and other raw materials. Then came a reversal of fortune: China’s growth slowed; commodity prices fell, and miners began to idle their crews and cut capacity.

Suppliers were among the hardest hit. Mining capital expenditures (capex)—the investment to upgrade or replace equipment and other physical assets—have fallen 65% since the peak in 2012. Meanwhile, the depreciating value of those assets has outstripped their pace of replacement.

That could soon change. The sector as a whole is returning to sounder financial footing, according to a recent Morgan Stanley Research report. Many mining companies are now expected to post positive post-dividend cash flows this year, a key barometer of financial health, giving them excess cash to spend, with free cash reaching peak levels of $25 billion to $30 billion by 2020, says Menno Sanderse, Morgan Stanley's European Metals & Mining analyst.

The turnaround hasn't been lost on investors. Stocks for mining equipment suppliers have rallied 30% since the start of 2016. “We think this optimism is justified," says Ben Maslen, who covers European Capital Goods for Morgan Stanley. While the recovery is likely to start slow and gather momentum, he adds, considerable upside remains, especially for those positioned to help miners upgrade their aging fleets and use the latest technology—particularly around integrating connectivity and the Industrial Internet of Things—to boost productivity. 

Mining Majors Should Have Peak Excess Cash Again in 2017-2020e

Note: Free cash flow less dividend, based on spot commodity prices.

Source: Morgan Stanley Research estimates

Old Gears, New Tech

“Technology is changing how miners invest, putting more focus on productivity than capacity," says Maslen, who along with Sanderse and their teams, recently revised forecasts for mining capex and looked at how the trend will play out for investors. On average, suppliers could deliver 8% upside to consensus estimates for 2018, with standouts seeing more than 30% improvements on their base-case assumptions.

While capex growth is key for mining suppliers, the companies that offer the best upside are those that have used the downturn to improve their own operations. “Many suppliers have made, and are still making, significant cost reductions," Maslen says. “We would expect any volume recovery to drive a pick-up in profitability—particularly for names where cost cuts have been most aggressive." (For specific company names, ask your Morgan Stanley representative or Financial Advisor for the full report, “Mining Capex Is Back," Sep 6, 2016.)

Certain areas will take priority when spending returns. Miners will likely focus first on upgrading mobile mining equipment with shorter operational lives, including slurry pumps, underground drill rigs, excavators and trucks. By the end of 2016, the mobile surface-mining fleet will be the oldest it has been in more than 10 years, the analysts estimate. In their base case scenario, they forecast a 2017-2020 compound annual growth rate of more than 19%, which is 3% to 4% ahead of consensus estimates.

Demand for aftermarket products should return in 2017, but investors can't count on a repeat of the double-digit growth seen in 2005 to 2008. Low single-digit growth is more likely, with the biggest gains going to suppliers with products that are integral to mining activity. These include drilling consumables, slurry pump wear parts and tires. Indeed, the mining sector can account for more than 10% of sales for some of the major tire manufacturers.

Companies that focus on stationary equipment and infrastructure will eventually benefit from increased spending, but this uptick likely won't come until later in the recovery.

Software’s Growing Importance

In terms of the technology side of this upswing, it’s more than just hardware. This time around, because miners are less focused on increasing capacity and more on improving productivity, they are investing in areas such as greater automation and agile production, all of which involves software more than ever before. As such, companies that haven’t been categorized as mining suppliers in the past—or have derived a small percentage of sales from the sector—could see a significant boost from increased mining capex.

“Our analysis and recent industry surveys suggest that key technologies will be among the fastest-growing areas over the next decade," Sanderse says. In an industry survey, more than 40% of mining companies surveyed said they would likely implement data mining and predictive analytics in the next 12 months. Other areas of focus included machine control, automation and laser surveying.

While the behemoth earth machines of old will always have their place in the world of mining capex, the rising importance of software technologies may mark an inflection point. In general, software now contributes more to the U.S. economy, for example, than does hardware. More productivity, says Sanderse, could very well mean smaller fleet sizes.

Contribution to U.S. GDP: Software vs. Hardware

Sources: BEA gov, Morgan Stanley Research

For more Morgan Stanley Research on the global mining industry and related sectors, ask your Morgan Stanley representative or Financial Advisor for the full reports, "Mining Capex Is Back" (Sep 6, 2016) and “Digital Manufacturing at the Tipping Point – a Deep Dive” (Sep 5, 2016). Plus, more Ideas.