1Q18 commodity review: mining cycle recovery to continue in 2018

Deutsche Bank Markets Research Australasia Australia M&M - Diversified Resources Industry Australian Mining Sector Date 15 January 2018 Recommendation Change 1Q18 commodity review: mining cycle recovery to continue in 2018 Sector outlook positive in 2018 on record FCF, capital returns and macro ________________________________________________________________________________________________________________ Deutsche Bank AG/Sydney Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 083/04/2017. Paul Young Research Analyst (+61) 2 8258-2587 paul-d.young@db.com Matthew Frydman Research Analyst (+61) 2 8258-2607 matthew.frydman@db.com Tim Hoff Research Analyst (+61) 2 8258-1424 tim.hoff@db.com Key Changes Company Target Price Rating BHP.AX 29.50 to 34.50(AUD) - RIO.AX 79.00 to 83.50(AUD) - S32.AX 2.80 to 3.10(AUD) - AWC.AX 2.10 to 2.20(AUD) - WHC.AX 3.50 to 4.40(AUD) - ILU.AX 7.20 to 7.50(AUD) - FMG.AX 4.70 to 5.00(AUD) - MIN.AX 15.00 to 20.00(AUD) - AQG.AX 4.00 to 4.30(AUD) - NCM.AX 19.00 to 20.00(AUD) - NST.AX 4.40 to 4.70(AUD) - OGC.AX - Hold to Buy RRL.AX 3.20 to 3.50(AUD) - EVN.AX 2.20 to 2.40(AUD) - SBM.AX 3.20 to 3.40(AUD) Buy to Hold DCN.AX 2.80 to 3.20(AUD) - IGO.AX 3.70 to 3.90(AUD) Hold to Sell SFR.AX 7.80 to 8.20(AUD) - WSA.AX 2.40 to 2.80(AUD) - OZL.AX 7.70 to 8.60(AUD) - SYR.AX 4.50 to 4.90(AUD) - ORE.AX 5.70 to 6.80(AUD) - Source: Deutsche Bank Top picks BHP (BHP.AX),AUD31.53 Buy Rio Tinto (RIO.AX),AUD80.62 Buy Sandfire Resources (SFR.AX),AUD7.23 Buy OceanaGold Corporation (OGC.AX),AUD3.20 Buy Source: Deutsche Bank After a 2yr recovery in commodity prices and sector re-rate we see the sector as fairly valued on a P/NPV basis (at 1x). However, commodities are trading well above historical real averages and marginal cost but global demand should continue to improve even with our view of a softening Chinese property market. Base metals look more attractive than the bulks. The mining cycle is still in a recovery phase, and sector FCF and capital returns should continue to improve despite rising operating costs and sustaining capex. We see 2018 as the year M&A accelerates. The sector is trading on c.10% FCF yield, with gearing dropping to just 7% in 2018. Our top picks are RIO, BHP, SFR & OGC. Commodity outlook; trading above historical real averages but macro positive All but two commodities (aluminium and nickel) are trading above historical real averages (back to 1980), however with ongoing supply side discipline and a positive demand outlook (DBe global GDP growth forecast 3.8%), with a modest slowdown in China (mostly from credit tightening and lower property sales), we think commodity prices could remain supported in 2018. There appears to be upside risk to demand from China, SE Asia and other emerging markets mostly on infrastructure and machinery. An ongoing weaker USD will also be positive for commodities due to upward pressure on marginal costs. Base metals S/D fundamentals continue to look more attractive than the bulks which we expect to weaken post Chinese heating season on increased supply. We prefer aluminium, nickel, zinc and copper. Sector themes; capital management, growth capex, M&A, cost inflation. Management teams should remain disciplined in 2018. Capital returns should increase further with ongoing buybacks from RIO, S32 (BHP should announce buyback in Aug) possibly supplemented with special dividends, possibly from AWC, S32 and WHC. With sector gearing at record low levels (sub-10%) we think companies will increase growth capex, but it will remain below mid-cycle and we think the sector is short high quality projects. M&A should increase also (likely gold, coal, lithium, mid and large cap base metals). The other things to watch are rising operating costs (labour, oil, stripping and contractor rates) and sustaining capex (holiday hangover). Sector outlook and top picks; BUY; RIO, BHP, SFR, OGC; SELL; ILU, IGO The Australian mining sector is fairly valued on a P/NPV basis at 1xNPV on our price deck but remains attractive on an EV/EBITDA (6x) and FCF yield basis (c. 10% average for 2018) vs. historical averages. We remain positive on both RIO and BHP with improving shareholder and group returns (ROCE), production growth and record FCF yields. In base and precious metals, we rate SFR, OGC, AQG and DCN a BUY and NCM, NST, RRL, IGO & WSA a SELL. We upgrade OGC to BUY (0.85xNPV), and downgrade SBM to HOLD (1.1xNPV) and