Kumba Iron Ore paid R5 billion in dividends to shareholders at the end of H12014, which translated to R15.61 per share.
In stating its investment case after its interim results announcement in July, the group committed itself to continue returning value to shareholders at a level of around 10% dividend yield; “one of the highest in the industry”.
Nevertheless the share price has dropped by more than 28% in the last year, currently standing at R297.00.
Karl Gevers, head of research at Benguela Global Fund Managers, warns that statistical value indicators like price/earnings (PE) ratio and dividend yield, which are “useful valuation shortcuts”, should be used with caution and not be seen as a replacement for intrinsic valuation.
“Kumba has been a favourite stock for many South African investors for some time. This is mainly due to its high historic dividend yield, currently at 13.5%”, he says.
Gevers believes this may come under threat due to weakening demand from China, increased supply in the international market as well as the deteriorating quality of the Sishen mine, Kumba’s largest asset.
Kumba’s main asset is its 74% stake in the Sishen Iron Ore Company. The operations of this company comprises of Sishen, Kolomela and Thabazimbi mines. Sishen accounts for more than 62% of production and 67% of the group revenue.
Sishen’s stripping ratio – the ratio of waste produced in relation to ore – has deteriorated from below 1.5x in 2008 to above 4x currently, increasing cost from R101.86 in 2008 to R266.50 this year, Gevers says.
He expects the stripping ratio to increase further over the 19 year life of mine as deeper mining is required to access the ore body.
Gevers says while Kumba would remain one of the lower cost producers in the world, the sustainability of such low cost is under threat.
The other risk factor for Kumba is the 38% deterioration of the spot iron ore price since the beginning of the year. Weaker demand from China and increased supply from Australia and Brazil, among others, are the underlying factors impacting the price.
Gevers says large producers like BHP Billiton, Rio Tinto and Fortescue are increasing supply at a very low cash cost, while Australian producers further benefit from proximity to China.
Taking into account the benefit Kumba may gain from the weaker rand, Gevers says his interinsic valuation of the Kumba share is marginally below R265, “indicating potential further downside risk”.
He says at the current price of R296 per share “our forward dividend yield for 2015 and 2016 would come to around 7.5% (2015) and 5.7% (2016), while our forward PE estimate is 10x and 15x respectively.
Mohamed Shiraaz Abdullah, analyst at Sanlam Private Wealth, says more than 60% of Kumba’s production is exported to China. He says as China clamps down on pollution, the demand for Kumba’s higher quality lump ore increases in comparison with more readily available, but lower quality fine iron ore. Steel mills need more lump iron ore to comply with new environmental legislation, which gives Kumba a potential competitive advantage.
Nevertheless he expects the oversupply to continue as China’s spending on infrastructure and property slows down. “Our expectation is that this macroeconomic trend will continue, coupled with the bottom-up work on the company, where we expect margins to be squeezed and capex and debt to increase. This does not bode well for Kumba and its dividend. At iron prices between $80-$90 we forecast downside from current levels,” he says.