Value Now In BHP And Rio?

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

By Greg Peel

Here we are four days on from the government's announcement that it would look to implement the resources super-profits tax (RSPT) recommended in the Henry Tax Review, and still the market is battling to understand the detail. Of most concern is just exactly what impact on discounted valuation the tax will have on Australia's listed resource companies, and in particular on the two biggest players, BHP Billiton ((BHP)) and Rio Tinto ((RIO)). Said Citi in a report this morning:

“The extent of the impact seems to vary quite markedly across the market, reflecting commodity price assumptions and ambiguity over exactly how the RSPT works”.

The first variance factor is not related to the tax – differing assumptions on longer term commodity prices among analysts have always extrapolated into wildly varying discount valuations and hence target prices and recommendations. However, given profits are based on prices, and the RSPT taxes profits (unlike the existing royalty system which is imposed on production), in fact the new tax adds a new dimension of variance into analysts' valuation models depending on their initial price forecasts.

Throw in the second point of variance – ongoing ambiguity over the RSPT itself – and we have a recipe for simple uncertainty. It is uncertainty more than anything which drives investors to exit stock positions. If the tax is bad but if we know just how bad then prices can adjust accordingly and be done with it. But we just don't quite know yet how bad, or not so bad, the implications of the tax really are.

And, of course, we don't know whether or not the RSPT will be watered down (my assumption is Rudd started from the worst point to leave the door open for concessions) before it becomes legislation, or whether it will ever become legislation, or whether the Rudd government will be around in 2011 anyway. More uncertainty.

Macquarie has been a particularly heavy critic, not so much of the tax's intent but of its detail.

The analysts interpret that miners' future deductions associated with upfront capital investment will be diluted in early years, thereby reducing their value in net present value (NPV) terms. And then any “capital account” balance will be inflated at what the analysts call the “paltry” rate of 6%. In the context of a miner's weighted average cost of capital, and the inflation factor associated with the similar and pre-existing Petroleum Resources Rent Tax, Macquarie finds 6% “quite hard to stomach”.

Macquarie is coincidentally holding its Australian Equities Conference this week, and no prizes for guessing the hot topic around the coffee urn. Senior mining executives are most upset they weren't consulted before the tax announcement (blow me down) and are frustrated over the “cloud” that has descended on the industry. The factors the Macquarie analysts would like to see addressed in the upcoming consultation process are the apparent total net tax exceeding 50% (including royalties and corporate tax and allowable offsets) and the rate any “remnant capital shield” is carried forward (currently being that 6%) and the rate at which that shield can be amortised over time.

Got it? Well one can begin to understand just how complex the RSPT is and why it is not simply a 40% tax.

Citi notes that as of yesterday's closing prices, BHP and Rio have fallen 15-20% from their recent peaks (and they're both down another 2% today as I write). Those falls have been kicked along by this tax uncertainty, but in the context of base metals prices being around 15% lower and oil about 10% in the same time frame, given Chinese tightening and European fears, the actual uncertainty impact is difficult to gauge. However, Citi suggests the valuations of both are beginning to look attractive.

Inherent in Citi's conclusion is the analysts' own interpretation of NPV impact on the two miners of the Henry tax alone. They say 11% for BHP and 12% for Rio, but other broking houses have differing views which again comes back to commodity price assumptions. The actual impact on earnings, says Citi, is 5-9% given the impact is lower in the short term and higher in the longer term (2015 and beyond) based on accelerated capex depreciation.

Citi did have a $55 target price for BHP and $100 for Rio pre-Henry but applying Henry means Net Present Values (NPV) fall to $38 and $80. That puts BHP at fair value right now and Rio at a 15% discount. “Historically,” says Citi, “these [valuation levels] have been good buy signals for both on a 6-12 month view”. But the analysts nevertheless recognise the aforementioned “uncertainty” that will weigh on momentum in the short term.

BHP and Rio both have approved expansion plans both in Australia and across the globe. Obviously Pilbara iron ore was in each case a priority for expansion prior to Henry, and although Citi suggests existing Pilbara projects will not be overly impacted, expanded operations will be. This will likely mean both companies will shift priority to offshore projects.

Macquarie concurs, noting “our analysis indicates that the net present value of the 'next generation' of iron ore developments in the Pilbara will be reduced by more than 30% should such an RSPT be attached”.

The implication here is one for the Rudd government to consider. If it chases BHP and Rio priority investment offshore then RSPTs will not be there to collect, nor jobs created locally etc etc.

But coming back to Citi's “attractive” valuation claim, the analysts readdress the issue of variance of long term commodity price assumptions. Citi is using notably conservative long term prices in its NPV models, the analysts admit, particularly for copper and coal. Were these adjusted back to current prices or consensus estimates, then most of the RSPT impact would actually be offset.

Thus the two miners are in theory even more attractive.

Who among you might be so bold? I think one can very safely say the market has assumed the worst from Henry, and that's how Rudd saw things playing out anyway. I am reminded once again of an experience many moons ago.

When I was once a proprietary trader looking for approval to trade new markets, the very wise deputy CEO (no names, we'll just call him Alan Moss) advised me to always insert a clanger in my proposal to the CEO that clearly was not acceptable. The CEO would then spot the clanger and be pleased that he had done so, and I would humbly withdraw with approval on the basis the clanger was removed – leaving my actual proposal intact.

Had Rudd consulted the mining industry before announcing an RSPT, as Howard would have done, he would have ended up with something very favourable to the industry. Now that consultation is open after the announcement, the industry will likely be happy with any concessions it can get. Feigning defeat, Rudd would concede to a watered-down tax which might just be what he had had in mind in the first place.

Or am I just giving him too much credit? It is a point which supports Citi's valuation case, all things being equal on the China/Europe front of course.

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