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Diversified miners' cash generation to boost M&A activity, RBC says

RBC Capital Markets remains cautious on the metals and mining sector in the near term amid slowing demand from China's property market, emerging trade barriers and sector valuations that are no longer as attractive as in the recent past.

According to the bank, spot-free cash yields dropped 35% due to rerating over the last year, offset by increases in inflation estimates. Meanwhile, the end of long-term supply contracts has increased shorter-term volatility.

"The shift to spot pricing from longer-term contracts, although causing blips in short-term volatility, appears to be reducing volatility for the commodities over longer time scales," the analysts said in a May 10 note.

In the medium term, however, the outlook is more positive.

RBC expects six diversified miners under its European coverage to generate US$57 billion in regular dividends over the next three years, with excess cash flow and asset sales resulting in an additional US$62 billion.

As a percentage of market cap, Vale SA is expected to generate the most cash, followed by BHP Billiton Group, Glencore PLC, Anglo American PLC, Rio Tinto, and Antofagasta PLC.

"The companies appear to be coming out of the two significantly volatile periods of the past 12 years with a much more conservative approach than in the past," the analysts said.

The analysts also expect an increased amount of excess cash to flow toward mergers and acquisitions, with Glencore likely to take a lead. "With our expectations that mining assets will have appreciating value, and what is, in our view, diminishing returns from further balance sheet strength, we see value in Glencore's differentiated strategy."

Taking into account first-quarter production numbers and changes in full-year forecasts, RBC increased the target prices for all six stocks. BHP was revised up to £14.50 from £14.00, with a sector perform recommendation, due to changes in the global oil forecasts for the company.

Antofagasta's target price was lifted to £9.30 from £9.00, also with a sector perform tag, on the back of lower risk exposure, even though poor first-quarter results are expected to negatively impact the company's EPS.

Rio Tinto's target price remained unchanged at £39.00 amid expectations that physical premiums in the company's aluminum division will be offset by its exit from the Grasberg copper mine in Indonesia and recent coal asset sales. The stock was rated sector perform.

After adding the Hail Creek coal assets in Queensland, Australia, to the model, analysts also retained a £4.10 target price and outperform rating for Glencore despite "significantly risked value" for its assets in the Democratic Republic of the Congo.

Anglo American's target price of £19.50 and outperform recommendation remained unchanged amid expectations that a new reporting structure of Anglo American Platinum Ltd. and strong performance of the Mogalakwena platinum mine in South Africa will offset weaker forecasts for De Beers SA and the impact from the suspension of the Minas Rio iron ore mine in Brazil.

The target price for Vale remains unchanged at US$16.00 with a sector perform recommendation.