Australia | Oct 11 2006
By Chris Shaw
Improved sentiment has seen investors return to the resources sector in recent trading sessions, resulting in solid gains in leaders such as BHP Billiton (BHP) and Rio Tinto (RIO). Prices are not yet close to peak levels seen earlier this year, but both Merrill Lynch and Citigroup has given reasons why they expect share price gains will continue.
The Merrill Lynch reasoning is based on earnings upgrades stemming from increases to their forecasts for iron ore prices in coming years. Previously the broker has expected prices in the Japanese FY07 would simply roll over from FY06 levels before falling by around 20% in FY08, but it has revised up its forecasts to a 5% increase this year and a rollover outcome in FY08, which compares to the consensus forecast of a 12% cut in FY08.
The increase reflects the broker’s view there is limited downside for iron ore prices thanks to high average production costs in China. It estimates costs for average producers there are around US$64 per tonne and as much as US$74 per tonne for marginal producers due to higher stripping costs, a decline in new capacity grades and recoveries and the fact much of the production expansion is occurring at underground operations, which are higher cost.
As a result it suggests it would not take much to force a cut in production levels. The broker suggests such a move would be supportive for prices and should see the big three iron ore producers, namely BHP, Rio Tinto and Brazil’s CVRD, maintain pricing power until at least FY09.
The new price forecasts have led the broker to lift its earnings estimates for both companies, with Rio Tinto enjoying the larger increases given the company’s greater leverage to iron ore. It has lifted its forecasts for the stock in FY07 by 2% to US$7.6bn, in FY08 by 14% to US$7.2bn and in FY09 by 20% to US$6.1bn. In contrast, BHP’s forecasts have increased by 0.5% to US$14bn, 4% to US$11.7bn and 9% to US$9.5bn over the same period.
The broker values Rio Tinto at $64.48 and BHP at $22.80, with respective price targets of $95.00 and $35.00. Citigroup suggests the renewed exploration focus by both companies offer significant potential for upside to their respective valuations, especially given about 50% of the estimated US$7bn in exploration expenditure will be on greenfields projects, which offer the potential for major discoveries.
Any such discoveries may prove significant for their respective share prices as the broker suggests there could be us much as $5-9 in upside to its BHP valuation and $18-29 for Rio Tinto if both companies can maintain market shares in all their major commodities through exploration success.
Little surprise then both stocks are highly rated in the FN Arena database, each receiving nine Buy ratings and one Accumulate recommendation. Merrill Lynch offers one word of caution though – while it expects both stocks to rally through to the end of the year, it sees potential for some weakness in 2007 as the US slowdown may result in reduced demand for some commodities and the easy money in the sector has probably been made over the past three years.
BHP shares at 2.45pm today were up 26c at $26.13, while Rio Tinto shares were 39c higher at $71.44, which compares to their respective average share price targets according to the FN Arena database of $35.47 and $97.74.