First Samuel has taken a strategic investment in a small ASX listed Indian iron ore producer.
Deutsche Bank released a fantastic graph, as provided below, showing the inverse relationship between capital investment and share price. Investors chase the free cash flow generated by miners.
And we have certainly seen this over the recent year or so. South32 is a case in point, with its share price increasing from around $2.00 at the May-15 demerger from BHP to $3.27 today, with considerable cash generation in this time and minimal meaningful capital investment.
But taking a step back, the question really needs to be asked how sustainable this is. After all, resources are finite. And even if there is more in the ground, once current mines come to the end of their lives, new money needs to be spent to find a more mineable resource, and to construct new mines and processing facilities to get these resources out of the ground and into a usable format. Referring again to South32 – it is getting harder for it to keep production levels up because it has assets in decline and has been maximising cash flow generation.
This graph shows currently there is generally a very low level of capex investment (as a proportion of EBITDA, or earnings). It also appears that this may have turned up, which is consistent with what we have heard and read elsewhere.
And this is where we see the opportunity in the resources sector in the coming years – in those companies that are now prepared to invest for future growth. We are unlikely to be rewarded in the immediate term for such investments, but over our 3 year + investment horizon, as these investments generate returns and cash flow, the likelihood of being rewarded increased markedly (which we view as consistent with the Deutsche Bank graph).
Source: Deutsche Bank
In line with this thinking, First Samuel has taken a strategic investment in NSL Consolidated (ASX Code: NSL). It will be an investment in your equity allocation, with a ~1.8% portfolio weight.
What is NSL?
NSL is an Indian iron ore producer. It is listed in Australia and governed by Australian directors.
NSL has a beneficiation operation in Kurnool, Andhra Pradesh. It is essentially a manufacturing operation – it buys local low grade iron ore. This is mined by local miners at 30-32% Fe, and is it in plentiful supply. Through beneficiation (a process which involved techniques such as magnetic and gravity separation and flotation) NSL turns it into 60-63% Fe. It is then delivered to the many local steel mills, which are located typically in the middle of India.
60-63% Fe is the global standard for iron ore used in the manufacture of steel. Pilbara ore (including that produced be Rio Tinto and BHP mines this grade of ore, known as DSO or direct shipping ore) is this grade.
Location of NSL’s operations (Source: NSL)
We are excited about the investment in NSL - it has a number of unique features, which are expected to deliver strong future returns:
1/ It is in production, and self-sustaining at its current level of production (200ktpa).
2/ It has a unique cost advantage to imported ore (e.g. Pilbara), because of the high shipping costs of bulk commodities such as iron ore, along with import taxes
3/ It has a unique cost advantage to local (government owned) iron ore producers
4/ It has the strong support of the local government to expand significantly, and also move into related value added products over time.
The company has no debt. Additionally, because the Indian ore price received is not the same as the global benchmark price, we are comfortable that NSL is protected in a downside scenario, particularly a benchmark decline associated with a Chinese and / or global slow down.
India (and more to the point Andhra Pradesh) is an iron ore import market now.
Given all these factors, as a minimum, the current profit margin is expected to be sustained. There is also scope for the price (and therefore margin) to increase over the long term.
We expect to be long term holders of NSL, and will continue to work closely with the company as it looks to expand. Initial planned expansion is to 400ktpa. There is scope to expand to 8mtpa (under a MOU with the Andhra Pradesh government).