NEWS FLASH – NOVEMBER 10, 2014 CITIGROUP CUTS 2015 IRON ORE PRICE EST. TO $65/TON VS $80/TON, SAYS IRON ORE PRICES MAY FALL BELOW $60/TON.
Welcome to the new world of decreasing commodity prices.
The business media still hasn’t got their arms around this story. And it’s a big story.
China added 5.9 billion square meters of commercial buildings between 2008 and 2012 – the equivalent of more than 50 Manhattans – in just five years and that’s a lot of steel/copper!
What do you think is happening in China now?
Are they going to build another 50 Manhattans…probably not is my guess.
Iron ore prices started around $16 per dry metric ton in 2004 and spiked to almost $200 a ton in October 2010 and now it’s on the way down as you can read from this tweet from Twitter.
This shouldn’t be any surprise to the Model Price user. There have been many negative transits of Teck Cominco since peaking in price in early 2011 and finally falling into the “Blue” – going below EBV-3 – some six weeks ago and one of our strongest sell signals. See Model Price chart below.
Teck Cominco with monthly price bars, EBV Lines (colored lines) and model price (dashed line)
Now if Teck Cominco was trading at over $60 per share in early 2011 and is now trading for less than $18 today, one would think that most of the pain would be over for shareholders. And you can probably see the value orientated money managers rubbing their hands in glee. Teck now trades at about 45% of accounting book value and pays a generous 5% dividend yield.
As a matter of fact while enroute to the office kitchen last week, I overheard on the trading room television – which is always tuned into BNN – a portfolio manager recommending Teck Cominco to viewers with the usual comments…. “Great management, great assets and of course, a nice dividend”!
What Model Price Theory [MPT] is saying?
When the stock price of a public company drops below EBV-3 this signifies that balance sheet write-offs of recorded asset values will be coming sometime in the future. And when the company starts to write-off recorded assets, debtholders start to get nervous. And, you guessed it, when debtholders get nervous the dividend payout to the common shareholders will be cut if not eliminated.
In essence Teck Cominco can and probably will be a ‘value trap’ in that, yes, the company looks like it has good value, a high discount to accounting book value, and a high dividend only to potentially disappear before your very eyes.
And, yes I have noticed that our model price is calculated at $26 this year and over $40 in 2015. But this is based on equity analysts’ earnings estimates today. Will these estimates be impacted by Citigroup’s lowered forecast estimates for Iron Ore? Has the declining spot price of Iron Ore fully reflected in the estimates we are currently using? And has the declining price of Iron Ore been so precipitous that equity analysts have been frozen and have not updated Teck’s earnings waiting for some sort of stabilization in the pricing of the commodity so any earnings estimate – guesstimate – can be realistic.
Of the two pieces of information – model price value or EBV Lines – my preference is always tilted towards our EBV Lines especially in down markets. Why? It’s what the market is communicating that has more value to Model Price users than what the analysts are saying.
Most Cyclical Stocks Are Pro-Cyclical
What do I mean by this….pro-cyclical? Cyclical companies balance sheets also seem to explode in the dollar amount of net equity or net worth as a consequence of peak cyclical earnings and intra-industry acquisitions. Have a look at our long-term model price chart of Teck Cominco’s. Notice how the balance sheet of the company has grown since 2004 – upward sloping EBV Lines mirroring the growth of Teck’s balance sheet (below). Hmm…. Can this balance sheet growth be a coincidence with the price of Iron Ore? This is what I mean by pro-cyclical in that, in this case, as the price of the commodity – Iron Ore – escalates so does the balance sheet of the company.
Teck Cominco’s Long-term Model Price chart from 1995 to Present
As commodity prices recede or reset, to much lower prices, the company is forced to write-off excess assets that are non-productive or non-economic relative to the cost of production versus the falling price of the commodity in question.
As the write-offs occur over a period of time or the ‘big bath’ write-off is taken – usually by new management not accountable for past investment decisions – the size of the pro-cyclical company’s balance sheet reverts back to lows seen at the bottom of previous cyclical lows. And cyclical lows for Teck’s balance sheet is a long way down as you can see.
So don’t be fooled. Yes, Teck Cominco seems cheap. Yes, the company is paying out a healthy dividend. And, yes, our model price calculation is above where Teck’s currently trading at what appears to be a 43% upside. But our model price calculation is only as good as the group of analysts with their earnings estimates and nobody I know has a crystal ball or better still knows what is going on in China.
The very important “tell” here is the share price of Teck going below our EBV-3 or as we say in our office ‘Going into the Blue’. This is very important information alerting investors that serious balance sheet realignment (write-offs) will be coming.
Yes, you can see the future in this situation and the counter-cyclical forces will play havoc on investors who think they are purchasing Teck’s recorded assets at 55 cents on the dollar and a dividend stream – yes, getting paid to wait (cough!) – that may not last beyond a few quarters!