Sunday, January 27, 2008

World Economy Slow Down

I am looking forward to the next stream of financial and annual reports that will be coming soon. I predict that the press releases will focus on the annual earnings and completely gloss over the 4th quarter earnings, which I expect will not be rosy for any base metal company. However, the 4th quarter earning are probably more representative of the company's next quarter earning potential rather than looking at the full years.

In a recent post I was asking if base metals would fall off a cliff. There were many indicators that economic growth was slowing.

The US is of particular concern. According to Nobel economist Joseph Stiglitz the US has been drawing down home equity at a rate of $700 to $800 billion per year.

That's a lot of unsustainable US economy. Further, the US consumption economy is about $9.5 trillion. The home equity borrowing has been 7-8% of the consumption US economy. Now that lending standards have tightened, and home equities have declined, that borrowing is not likely to continue at anywhere near the same rate. It has to be a strong US slow down in the economy and the trickle down effects can not possibly be pretty.

Emerging markets are not likely to make up the slack. China's consumption economy is a mere $1 trillion, so $700 billion is 70% of their economy. Anyone who thinks China will pick up the slack is smoking something pretty strong.

This can't possibly be good for base metals. There are a lot of base metals that go into consumer goods. Additionally, commercial construction is rapidly declining as well, and municipal budgets that might do big capital projects that require base metals are in trouble because municipal budgets are in trouble due to declining revenue from declining home prices in the US. Cities are demanding all departments cut budgets.

Mining projects in the process of being developed do not just stop in the middle of hundreds of millions of dollars being committed to them, so increases in supply tend to strongly lag changing economic conditions. Data showing slow downs for material usage tends to be lagging rather than leading. In the US housing starting were going full throttle as late as last March, and all of the materials that go into housing would have continued to be used until some time in the fall or winter, yet by then housing starts had plummeted, but the actually declines in demand from that reduction will not be fully showing up in financial reports until the end of Q1, and it should be significant. So far Q4 earnings are down about 20% for companies that have reported Q4 earnings. That's gigantic and it is crazy to not think that that isn't have an effect on commodity demand.

Base metals have had enormous leverage of earnings from record commodity prices and they've been bid up in price, valuing the base metals stocks like a coca-cola stock, only base metals are at far more risk to supply and demand price fluctuations that demand a low P/E when prices are strong. When the market looks good and the company has good growth prospects I'd never give a second look to a base metal stock with a P/E of 12 or higher. It has room built in for down side risk and a opportunity to exit without wiping you out should the market turn, which it appears to have done.

There are numerous examples now of how the downward leverage affects earnings. From Q2 07 to Q3 07 FNX mining's revenues declined 28.3%, but earnings declined 64.3% despite the fact that "the total tons of ore, pounds of nickel, pounds of copper and ounces of precious metals produced and sold was were higher ... than in any previous quarter," according to the Nov 1, 2007 news release. According to google finance the current P/E is 21.7, but that has earning of $12.5 million (the last report), $35 million, $30.2 million and $19.7 million included. Go four quarters forward based on last quarter and you get $50 million per year of earnings compared to the current last four quarters of $97 million. It means the P/E for last quarter reported is about 43. Average nickel price was $11.65/lb and copper price was $3.57/lb. FNX is still richly valued despite being down 37% from its high. The $24.87 shares earned 15c/share last quarter. Even if you believe they can double earnings, the shares seem richly valued.

Teck Cominco's earnings declined from $2.01/share to $1.16/share for the same two quarters, only Teck Cominco did not get so insanely valued. Their revenues were down about 1/3rd yet earnings were down 42%. Their loss of leverage of earnings was not nearly as drastic as FNX. Teck's current P/E is 6.46 and forward P/E is 10.63. It is down 40% off its high. The $32.51 shares earned $1.16/share last quarter.

It is likely any base metal company examined will show a higher decline in earnings than revenue because of the leverage and it is also likely that all established companies will experience a significant decline in earnings due to the declines in commodity prices, which are at risk to decline further due to the economic slow the entire world seems to be experiencing.

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