Editor’s Note: This article first appeared as the In Focus feature in the May 2012 edition of Australian Edge.

The S&P/ASX 200 Materials Index comprises a wide range of commodity-related manufacturing industries, including companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products as well as metals, minerals and mining companies. It forms the basis of the Basic Materials segment of the Australian Edge How They Rate coverage universe.

Until mid-March this index was widely outperforming the broader S&P/ASX 200 Index and the world’s most-watched index, the S&P 500, year to date. But then new worries about a potential Europe contagion as well as suggestions that China’s rate of growth would no longer support the lofty levels materials stocks had found prior to mid-2008 and then again following the March 2009 bottom for global equities.

We’ve seen strong rallies and serious selloffs in this particular market in what still qualifies as the “aftermath” of the Great Financial Crisis, in mid-2009, in mid-2010 and again in mid-2011. Since maxing out post-March 2009 above 15,000, though, the corrections have come within a longer, more sustained downtrend. In fact the S&P/ASX 200 Materials Index is off about 30 percent since Apr. 11, 2011, a correction by any measure.

The question on many minds now is, is the materials and mining boom over?

The simple answer to this question–“yes,” “no,” “I don’t know”–is not of any particular utility. As a dividend-focused investor I’m not interested in “booms,” or “busts,” for that matter. My only interest is in identifying high-quality companies capable of generating easily identifiable cash flows, managing costs, maintaining a solid balance sheet and generating a solid and growing stream of income.

One of the more interesting aspects of the steep decline for the S&P/ASX 200 Materials Index over the past year is the decoupling of the mining stocks from both the Australian dollar and commodities prices. The aussie is also trading apart from commodities, which suggests that the currency is now looked at as a safe haven that global investors desire because of its favorable underlying fundamentals.

Factors supporting the currency include relative global interest rates and investor risk appetite. The Australian dollar hasn’t traded below parity with the US dollar since December, though a recent and unexpected 50 basis point cut to the Reserve Bank of Australia’s benchmark rate as well as the central bank’s downgrade of its domestic growth forecast have it headed below USD1 as of this writing.

The S&P/ASX 200 Materials Index has now retraced a significant chunk of its post-March 2009 rally, save the earliest rush back into such stocks that took it from a low around 6,700 in November 2008. It reached a closing level Friday, May 11, 2012, in Sydney that it last saw in July 2009. The real question now is one of value, as in, are there opportunities in the resources space in the aftermath of this correction?

Assuming we don’t experience a global-demand-destroying event such as occurred with the September 2008 implosion of Lehman Brother and all that followed, we’re looking at favorable entry point for well-placed, high-quality, dividend-paying Australian materials stocks.

With and Among the Wonders

One of this month’s Sector Spotlights falls on AE Portfolio Aggressive Holding and charter member of the “Eight Income Wonders from Down Under” BHP Billiton Ltd (ASX: BHP, NYSE: BHP). If you’re going to buy one materials/resources stock right now, this is the place to start.

BHP Billiton is one of the biggest companies in the world, with unrivaled diversity of assets that includes iron ore, coal, base metals including copper, lead, zinc, silver and uranium and petroleum resources such as oil, natural gas and natural gas liquids. This diversity allows it to ride out weakness in any one commodity or for the broader market and global economy unlike any other capital-intensive company.

The stock is down 26.1 percent over the trailing year, only slightly better than the Materials Index, which is off 27.4 percent in US dollar terms. But as a business BHP continues to hold up, and it remains extremely well positioned to benefit from China’s transition from an investment-based growth story to one driven by domestic demand. Details are in the Sector Spotlight.

BHP Billiton–The Big Australian, the No. 1 company by market capitalization Down Under–is yielding 3 percent at current levels and is a buy under USD40 on the Australian Securities Exchange (ASX) or USD80 on the New York Stock Exchange.

The second S&P/ASX 200 Materials Index component to also populate our original AE Portfolio Aggressive Holdings, New Hope Corp Ltd (ASX: NHC, OTC: NHPEF), looks better on a chart than BHP over the trailing year, having shed 11.8 percent in US dollar terms. But the stock is down more than 30 percent since mid-October, when it became clear that its effort to stoke a bidding war over itself was for naught.

We included New Hope with the “Eight Income Wonders” back in September 2011 because it produced a commodity, thermal coal, supported by rising demand for electricity in Asia, particularly India, had no debt but AUD75 million in cash on the balance sheet, paid a modest but consistent dividend that hadn’t been cut since it first declared one in March 2004 and was cheap at the time, selling at price-to-book value south of 2.

The stock is cheap again, at a price-to-book of 1.59 as of its May 11 close on the ASX. It still hasn’t cut its dividend; in fact it boosted its interim dividend 14.3 percent over the prior corresponding period to AUD0.06 per share, paid May 2 to shareholders of record as of Apr. 17, 2012. And it remains in a net cash position.

Questions about global growth are weighing on the stock, as is the very public effort by newly elected Queensland Premier Campbell Newman to protect farmland in his province from further coal mining.

New Hope seeks to double thermal coal output at its Acland mine in Queensland to 10 million metric tons per annum; the outgoing state government had granted the plan, New Acland, “significant project” status to fast-track it.  But Premier Newman, voted into office in early March on a platform that included opposition to Acland expansion, which would implicate crop lands in Queensland’s fertile Felton Valley, said on Mar. 28, according to The Australian, that it was “inappropriate” to expand the mine in Queensland’s southern food bowl.

New Hope continues to engage with the Queensland government, though there’s been no public statement on any progress since March.

BHP is entrenched because of its size and ability to execute projects efficiently across a wide range of resources all over the world. New Hope’s is a niche, but it’s an attractive one, still.

The International Energy Agency (IEA), in its Coal Medium-Term Market Report 2011, forecast that consumption of and prices for thermal coal will continue to rise over the next five years, despite efforts to reduce its use as a primary source of energy.

In its first report about the commodity, released in December 2011, the IEA concluded that strong demand in China and India, particularly for electricity generation, will keep coal, if not in the kingly state it occupied in the global energy hierarchy from 2000 through 2010, at least among the world’s primary fuels until 2016.

From 2000 to 2010 global coal use grew by 720,000 metric tons per day. This pace of expansion will slow–to about 600,000 metric tons per day over the next five years, according to the IEA.

The IEA projects that thermal coal prices in Asia will rise from USD127 per metric ton in 2011 to USD138 by 2016. Prices ranged from USD40 to USD80 per metric ton in the early 2000s before hitting a record of USD200 in 2008.

Beijing was until four years ago a net exporter of thermal coal but since has become the world’s second-largest net importer, behind Japan. According to research and consulting firm Wood Mackenzie, seaborne demand from China is set to grow from 175 million tons a year in 2011 to 1 billion tons a year by 2030. And India will grow from 80 million tons of thermal coal used in 2011 to about 400 million tons a year by 2030.

Still blessed with a solid balance sheet that will allow it to invest to grow, New Hope is a buy under USD6.

The New, New Iluka

As detailed in two Flash Alerts the week of May 7, recent addition to the AE Portfolio Aggressive Holdings Iluka Resources Ltd (ASX: ILU, OTC: ILKAF, ADR: ILKAY) has issued a second downward  revision to its fiscal 2012 guidance for production of zircon, the primary engine of growth for the company.

We made our initial case for the company in the March 2012 In Focus, The New Iluka and the New China, after it reported blowout 2011 results and declared a final dividend for the year of AUD0.55 per share. We added it to the Portfolio because of its key position in a solid niche market, poised as it is to serve a centuries-long demand for tile in Asia that will only get stronger with the Middle Kingdom’s shift to a domestic demand driven growth model. It is an Aggressive Holding precisely because management was, paradoxically, quite clear about a murky short-term outlook.

The stock closed at AUD16.70 (USD17.01) on the ASX on Friday, May 4, but fell 16.1 percent to AUD14.01 (USD14.18) as of the May 8 close Down Under. The May 7 slide to AUD15.95 (USD16.29) was driven by general fear aroused by weekend elections in France and Greece. May 8 was all about this latest guidance revision.

The most recent announcement follows a Feb. 23, 2012, revision to guidance Iluka had issued as part of its Key Physical & Financial Parameters, 2012-2014 document.

The substance of the guidance changes is as follows:

• Iluka reduced its zircon production target for 2012 from the previously advised approximation of 500,000 metric tons to about 430,000 metric tons while maintaining its high-grade titanium dioxide production level.
• Lower zircon production is likely to mean an increase in unit cash costs of production from initial guidance of approximately AUD650 per metric ton of zircon/rutile/synthetic rutile (Z/R/SR); the impact of fixed costs and some operating inefficiencies could push this figure to about AUD700 per metric ton of Z/R/SR, an increase of approximately 8 percent.
• Iluka now forecasts zircon sales for the full year to be 400,000 metric ton compared with the previously forecast 450,000 metric tons.
• Management is raising its capital expenditure budget from AUD220 million to approximately AUD260 million, as it “brings forward” expenditure related to the Cataby project in Western Australia and adds new funds for the Balranald project in New South Wales.

There is no change to guidance for titanium dioxide production and sales from that issued at the beginning of the year, with market conditions and sales forecasts in line with expectations. Iluka expects its Z/R/SR sales volumes to be approximately one third/two thirds weighted between the first half and second half of 2012.

Based on the revised zircon sales and assuming current pricing, Iluka’s total revenue mix is expected to be approximately 50 percent to 55 percent titanium dioxide, with the remainder zircon and byproducts.

Iluka cautioned that changes to its unit cash cost estimates should be considered in light of estimated revenue per metric ton of Z/R/SR of approximately USD2,300, based on prevailing prices. Even at the higher forecast cost level of AUD700 per metric ton Iluka is still on track for a “material increase” in margins for 2012 over 2011.

The company also maintained its guidance for operating cash flow, which was AUD706 million in 2011 but will be “higher” in 2012. This is a strong positive as it relates to Iluka’s ability to sustain its new, higher dividend level established during and in the aftermath of what was a transformative 2011 for the company.

Iluka had stated on several occasions that it expected a soft quarter or two of zircon demand based on the impact of murky global economic conditions on customer confidence and business conditions in various markets. Management also cited the potential effects of various government policy measures globally and the need for a destocking period, especially for ceramics manufacturers.

Iluka was quite up front about the fact that it expected it would take some time to develop a “clear view” on 2012 zircon demand and how it would develop through the year.

Management noted in its May 8 update that, after a slow first quarter, zircon sales volumes improved in April. This positive momentum stems from better conditions in its key China market as well as in the US. Optimism for a full global recovery is tempered, however, by the tumult in the eurozone, where political upheaval and instability that’s now creeping into the larger economies up risks to the downside. A shift from austerity to growth should be a positive, but the global economic outlook remains far from clear.

Six analysts have reiterated their ratings on the stock in the aftermath of the reduced guidance and the subsequent selloff.

Macquarie continues to rate the stock “outperform,” which translates to “buy” according to Bloomberg, and held its price target at AUD20. JPMorgan reiterated its “neutral,” or “hold,” rating but reduced its target from AUD18.70 to AUD14.50.

RBC Capital Markets still rates Iluka “outperform,” or “buy,” but cut its price target to AUD20 from AUD22. Deutsche Bank advises investors to “hold,” which means “hold;” the new price target is AUD17.80, down from AUD18.85. RBS still rates the stock a “hold” but trimmed its target from AUD18.04 to AUD16.16.

And the famous “Vampire Squid,” Goldman Sachs, says the stock is a “buy/attractive” at these levels, though with a reduced upside of AUD22.50 from AUD24.50.

The buy-hold-sell line, according to Bloomberg’s standardization of Wall Street-speak, stands at 11 “buys”, five “holds” and one “sell.” Even after the price-target reductions from these five houses the average among analysts is AUD19.01.

My view is this selloff presents an opportunity for aggressive investors to lock in a 5 percent-plus yield on a stock backed by a business that’s tied into a durable growth trend and a management team committed to maintaining a generous dividend. Iluka Resources is a buy up to USD16 for aggressive investors who can tolerate a lot of volatility.

Gold

Gluskin Sheff  + Associates Chief Economist & Strategist David Rosenberg isn’t known for bombast. So when Fortune Magazine’s Economist of the Year and MSNBC’s “most accurate forecaster” for 2011 says gold will go to USD3,000 per ounce, it’s worth taking note.

Mr. Rosenberg issued his forecast via an interview with the Financial Times on May 8. He said it will happen “before this cycle is over,” as investors search for safety out of fear of another downturn along the lines of 2010 and 2011.

Gold is now down about 16.9 percent from its high near USD1,900, established in early September 2011, in the aftermath of the infamous Standard & Poor’s downgrade of US government credit from AAA.

This correction seems to have taken the yellow metal off investors’ radar screens, which means there’s an opportunity to find value before the rush for cover begins in earnest.

A major catalyst for a flight to what’s widely perceived as the best store of value on the planet would be a third round of “quantitative easing” by the US Federal Reserve. QE3 would push the volume of US dollars up and dilute the value of existing ones; this continuing devaluation of the world’s reserve currency would have a salutary effect on US manufacturing exports, for example, but will do nothing to ease worries about the long-term impact of negative interest rates. Central banks around the world continue to suppress benchmark interest rates in an effort to provide stimulus for weak economies where fiscal authorities have rendered themselves impotent. As Mr. Rosenberg notes in the FT interview, one of the key determinants of the gold price are real short-term interest rates.

If this sounds like a bearish argument on the direction of the global economy, it is at the same time a bullish argument for gold and gold-mining stocks. And the longer interest rates stay low, the longer the bull run will be.

Aggressive Holding Newcrest Mining Ltd (ASX: NCM, OTC: NCMGF, ADR: NCMGY), the world’s No. 3 producer, reported fiscal 2012 first-half results that largely met expectations, though the board of directors of Australia’s largest gold-mining outfit did boost the “interim” distribution by 20 percent to AUD0.12 per share.

Newcrest, too, has issued two recent guidance downgrades, the first with its first-half report, the second with its March quarter production update, as heavy rains and setbacks at major mines continue to take their toll.

Newcrest has revised its gold production estimate to between 2.25 million and 2.35 million ounces for the year ending Jun. 30, 2012, from a previous forecast of 2.43 million to 2.55 million ounces. It cut its outlook for copper output to 70,000 to 75,000 metric tons from 75,000 to 80,000 tons.

Newcrest produced 2.7 million ounces of gold in fiscal 2011. Before December the company had forecast production to rise to as much as 2.925 million ounces.

Newcrest produced 532,237 ounces of gold and 18,072 tons of copper in the March quarter, down 12 percent and 10 percent, respectively, versus the prior corresponding period. Compounding reliability issues at the Lihir plant, the mine and the Cadia Valley mine in Australia as well as the Hidden Valley mine in Papua New Guinea were hit by heavy rain. Management remains confident in the long-term potential of Lihir and expects the Cadia East development to hit its medium-term targets.

AE Co-Editor Roger Conrad frames the Newcrest dilemma well in this month’s Portfolio Update: “With that backdrop it’s fair to ask why we’d want to own a gold mining stock at all, let alone one with production problems. The answer is upside. Mainly, we can win from either recovering gold prices, an improvement in the mining stock/gold performance spread and/or improved results at Lihir.” Newcrest Mining is a buy under USD32.

The most recent edition of the Gold Mine Cost Report, a joint venture between ABN AMRO Bank NV and VM Group/Haliburton Mineral Services, found that the gold mining industry’s average cash cost of production during the first quarter of 2011 was USD620 per ounce.

This survey is based on data from 111 gold mining companies around the world.

On a year-on-year basis, the average cash cost advanced by 13 percent, continuing the double-digit year-on-year growth seen in every quarter since the third of 2009, when costs fell by 0.4 percent. Median costs of production rose by almost 4 percent, to USD583 per ounce in the first quarter of 2011.

Lower quartile production costs for the bottom 25 percent of projects surveyed fell for the first time since the first quarter of 2009, to USD435 per ounce, down 5.4 percent from the previous quarter. Upper quartile costs, meanwhile, rose to USD764 per ounce.

A big part of the rise in average production costs over the last several years is the weakening US dollar, the currency for gold pricing. Another is increasing input costs. Energy and raw material costs have all increased.

According to the June 2011 Gold Mine Cost Report’s region by region review, “the pick of the bunch” in the section covering Asia and the Commonwealth of Independent States/Europe was Medusa Mining’s Ltd’s (ASX: MML, OTC: MDSMF) Co-O mine in the Philippines, at just USD191 per ounce..

Australia-based Medusa is focused exclusively on its operations in the Philippines, the key to its strategy to become a mid-tier, 400,000 ounce per year, low-cost gold producer.

On the latter front it still clearly continues to succeed: The company produced 18,258 ounces at a recovered grade of 8.1 grams per metric ton and cash costs of just USD239 per ounce.

This represented an improvement over the December quarter, when Medusa produced 16,270 ounces with an average grade of 8 grams per metric ton and costs of USD242 per ounce. Total gold production for the first nine months of the financial year reached 45,100 ounces.

The intriguing thing about Medusa, on top of its low-cost production profile, is that does not hedge its output. In other words, it’s able to capture the full upward momentum of the spot gold price, evidenced by the USD1,738 average price it received during the March quarter.

One of the best cash-generating gold mining companies on the planet, Medusa Mining is a buy under USD6.50.

Iron in the Fire

Grange Resources Ltd (ASX: GRR, OTC: GRRLF) owns and operates Australia’s largest integrated iron ore mining and pellet production business. Its Savage River magnetite iron ore mine is a long-life mining asset set to continue operation to 2023 with current reserves estimated to extend the mine life to 2028.

Grange ships its pellets to major steel producers in Australia and Asia under long-term supply contracts. The company is developing a world-class magnetite project at Southdown near Albany in Western Australia, which is forecast to supply more than three times the amount of ore iron from Savage River. Plans are to ship this concentrate to a dedicated pelletising facility to be built at a suitable location.

Southdown, is slated to produce about 10 million metric tons of iron ore a year starting 2015. A recently completed study estimated the cost of developing the project at AUD2.88 billion, higher than the AUD2.57 billion forecast from a preliminary feasibility study released in April 2011. The latest estimate comes with a AUD535 million contingency, though the estimated cost of production has been refined from “less than AUD60 a tonne” to AUD58.50 per metric ton.

Grange Managing Director Russell Clark said the new capital cost estimate was in line with expectations and described the operating cost forecast was “very attractive.”

About AUD150m has been spent to date on drilling the Southdown deposit, land acquisition, permits and engineering studies. The potential mine life is more than 30 years, giving a net present value of more than AUD1.8 billion and an internal rate of return, according to company estimates, of more than 20 percent.

Savage River produced 573,625 metric ton of concentrate in the three months to March 31, up 64 percent compared to the first quarter of calendar 2011, when it was recovering from a rock slide that occurred in mid-2010. Full-year concentrate production guidance remains between 2.3 to 2.4 million metric tons. Pellet prices remained strong, averaging USD172.57 per metric ton during the period.

“The Australian dollar has weakened in recent weeks, and unit costs of production are such that the resultant healthy margins are expected to remain for the Savage River production,” Grange noted in a statement.

Grange, the only commercial producer of magnetite pellets in Australia that combines both mining and pellet production expertise, declared its first “final” dividend–AUD0.03 per share, paid Apr. 27, 2012–and its second overall. The stock is trading for just 0.78 times book value, and its net cash position and nonexistent debt leave it ample room to grow the business.

Its assets and their ability to sustain and grow a dividend make Grange Resources a buy under USD0.65 on the Australian Stock Exchange (ASX) or using the symbol GRLLF on the US over-the-counter (OTC) market.

Dr. Copper’s Prognosis

Copper prices continue to slide on fear of Europe’s debt crisis, apprehension about growth in China, which accounts for nearly 40 percent of global demand, and generally mixed economic data from around the world. One bright spot is that consumer confidence in the US–still the world’s largest economy–reached a four-year high in May, according to the Thomson Reuters/University of Michigan preliminary sentiment index.

The red metal’s use as an industrial metal makes it sensitive to shifting perceptions of economic growth prospects. It’s an important–some would say “strategic”–metal, used in electrical, engineering, building and transportation applications. It’s also widely used in everyday goods such as phones, refrigerators and laptops.

But as their economies continue to develop and their China and India will drive demand for many years.

The Great Financial Crisis drove the price of copper plummet to USD1.25 per pound from USD4. But it came back strong, rallying from early 2009 lows to surpass its 2008 highs, reaching USD4.60 in February 2011.

The most actively traded contract, for July delivery, settled 1.2 percent lower at USD3.648 per pound on the Comex division of the New York Mercantile Exchange on May 11, the lowest settlement price since Apr. 23, 2012, and down nearly 2 percent on the week.

Melbourne-based OZ Minerals Ltd (ASX: OZL, OTC: OZMLF, ADR: OZMLY) produces primarily copper but also gold from its Prominent Hill open-cut mine in South Australia. The company also owns development property in Cambodia.

OZ has no debt and a cash pile of AUD886.1 million as of Dec. 31, 2011, which combine to make it a potential acquirer-to-grow as well as a potential target for a bigger resource outfit looking for a bargain. Its May 11 close left it at a price-to-book value of just 0.99.

Prominent Hill produced 27,182 metric tons of copper, up 1.4 percent from 26,802 tons in the December quarter and 5.7 percent higher than the prior corresponding period. The mine also produced 38,887 troy ounces of gold, up 2.8 percent sequentially but down 7.2 percent year over year.

OZ remains on track to meet its 2012 output guidance of between 100,000 and 110,000 tons of copper and 130,000 and 150,000 ounces of gold. It produced 107,744 tons of the red metal and 160,007 ounces of gold in 2011.

The company lost out to a higher bidder in the auction of Romania’s state-owned SC Cupru Min SA Abrud, which owns the Rosia Poieni copper-gold mine. CEO Terry Burgess said OZ won’t overpay for an acquisition.

OZ Minerals is a buy under USD10.50 on the Australian Securities Exchange (ASX) using the symbol OZL or on the US over-the-counter (OTC) market using the symbol OZMLF; both represent an ordinary share.