The Henry Confusion

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Greg Peel

The government dropped a bomb on Sunday by announcing that a resource super profit tax (RSPT) of 40% recommended by the Henry Tax Review will be included in the government's immediate fiscal plans. It was a bomb because while some sort of tax on the sector was expected, the earlier rumours of a straight up 40% were thought far-fetched by many and such tax changes have in the past been applied incrementally, with “grandfathering” included, whereas the RSPT is simply a retrospective step-jump which confirmed the resources and energy sectors' greatest fears.

While clearly the stock market has reacted very negatively, as well it might, the reaction is more about a typical response from shareholders due to uncertainty than it is a specific de-rating of valuations based on accurate RSPT adjustments. Aside from the RSPT not yet being law, and thus not guaranteed as law, no one can yet quite get their heads around the early, unclear detail.

Credit Suisse is one broker bold enough to candidly spell it out: “We don't understand it either!” screamed the headline of a CS report published this morning. The analysts noted the government announcement did nothing more than “throw financial markets into a state of mass confusion” on Monday.

If there is anything the resource analysts among the brokers in the FNArena database agree on this morning is that which ever way you look at it, the tax is “bad” for the sector, but as to degrees of “bad” well…here we find some wide divergence of opinion.

For example, BA-Merrill Lynch suggests the tax will knock 10-19% off average resource sector net present value. GSJB Were says 5-10%. Deutsche Bank says 7%. Then we move on to similar discrepancies with energy sector numbers. As far as the big miners BHP Billiton ((BHP)) and Rio Tinto ((RIO)) are concerned, JP Morgan says 5-8% for BHP and 8-15% for Rio (having previously feared numbers around 30% before the actual announcement), UBS says 17% for BHP and 21% for Rio, and Macquarie says 10-15% for BHP and about 15% for Rio.

While FNArena has highlighted often enough that all the variables that go into mining and energy mean analysts can arrive at a wide range of valuations, and as such recommendations, this time we're simply talking inconsistent responses to the same piece of proposed legislation. Once again, the Credit Suisse analysts have summed the feeling up best:

“Despite having spent several hours mulling over the releases and having two separate consultations with tax specialists, we are unable to quantify the impact of the proposed changes. The equity market seems to be implying valuation downside of 5-10%, but then ask ten different analysts what the impact is and you will probably have ten different answers”.

Correct.

Deutsche Bank, for example, has declared the tax to be “not so detrimental” on an earnings basis but the greatest negative impact will be from deterred investment. Deutsche suggests yesterday's market re-rating and earlier adjustments on speculation mean the negatives are “considerably factored in already, it would appear”. GSJB Were suggests yesterday's announcement is “perhaps a little more benign than the market had feared”, while Macquarie suggests “First and foremost, provisional analysis indicates the government's proposal equates to a 'worst case scenario'”.

What is clear is that the RSPT is not simply another 40% tax on top of existing state royalty and corporate tax payments. State royalties are deductible from the RSPT and the RSPT is deductible from corporate tax which will drop to 28% eventually. Capital expenditure and exploration expenses will be granted a level of deductibility and depreciation will be accelerated, meaning the government will effectively take on some of the miners' development risks. But there will be no “grandfathering”, meaning exemptions for longstanding or existing projects – all projects new and old will be taxed.

The latter actually penalises the big miners with mature projects, which relatively do not need much further capex investment, while supposedly benefiting juniors with young projects that still need relatively large amounts of money spent on them. It only applies to mining projects in Australia irrespective of who owns them, and not to offshore projects owned by Australian companies. Thus the greater proportion of revenues accrued offshore, the less impact and vice versa.

It's also complicated for the energy sector, which already coughs up a Petroleum Resource Rent Tax (PRRT). But companies already paying the PRRT can choose to now pay either the PRRT or the RSPT as it suits, while the North West Shelf project is already under a separate royalty arrangement rather than a PRRT.

What this boils down to is existing projects such as offshore WA gas may actually be better off, or at least no worse off, under the new tax regime. Developing projects, such as the burgeoning Queensland CSM to LNG industry, will be hardest hit. This means, for example, that Woodside ((WPL)) will be little impacted while Santos ((STO)) and Origin ((ORG)) could be heavily impacted. Oil Search ((OSH)), on the other hand, will derive all its CSM LNG revenue in PNG and as such is sitting pretty.

I could go on for hours. The bottom line is this proposed legislation is just that at this stage, and that passage in its current form is very far from a given. The government offered the mining industry no chance for consultation during the Henry review process but has now offered about six months of suggestions. Obviously the mining industry is virulently opposed, but will also need to make concessions. In the meantime, it appears the government is expecting opposition and is possibly ready for concessions after dumping the proposal on the market in one fell swoop.

The government hopes to have a Final Design Paper ready by late 2010 (which again implies this is only a prototype design) before submitting the bill to parliament with the changes to begin at the start of FY12. Irrespective of current Senate positions – the Opposition will oppose and the Greens will support, for example, we have an election coming up by year end. Either the Rudd government could lose the election altogether or lose even more leverage in the Senate, or win and win as the case may be. The latter seems rather less likely at this stage, with there even being talk of revolt in Labor's ranks (not just about the RSPT but about every new government policy).

So an RSPT may, possibly, never actually happen. But what can now be guaranteed is months and months and months of uncertainty, and uncertainty is the shareholder's greatest fear. There will also be uncertainty stemming from offshore companies either planning investment in projects (eg CSM LNG) or planning takeover of companies (eg Peabody for Macarthur ((MCC)), Shell and Petro China for Arrow ((AOE))).

Analysts will no doubt push for greater clarification, and the mining industry will lobby hard. The Opposition will create a ruckus, and the poor old small investor will simply be wondering who is right or wrong, who is winning the battle or losing. It will not be an environment in which to invest in the resources and energy sectors with utmost confidence at particular valuation levels.

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