On The RSPT And Iron Ore Miners

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

By Greg Peel

With the benefit of a bit more time to wade through the documentation and crunch some numbers, resource sector analysts have been gradually coming to terms with the implications of the government's proposed Resource Super Profits Tax (RSPT). While the final make-up of the legislation or even the successful passage of legislation remain unknowns, analysts have begun to at least acknowledge associated risks in their valuations.

Morgan Stanley suggests the RSPT in its current form will generate some $85bn for the government over the next decade from the Australian miners which the broker covers in its research universe. The biggest contributors will be BHP Billiton ((BHP)) and Rio Tinto ((RIO)), at a level of around 85%.

The greatest impact will occur between 2013-20 for the two iron ore miners with the most mature, low-cost base and high margin assets given little capital expenditure requirement to offset the profits tax. Morgan estimates an average 28% earnings decline for the iron ore sector.

By contrast, coal miners will see 21% earnings decline and base metal miners 17%, with the least impacted being the gold miners at 9%.

Reaction from all miners to the RSPT has been “swift and negative”, the analysts note, with reports of delays to growth projects and potential dividend cuts. However, “our analysis does not support this,” says Morgan Stanley.

But the analysts do acknowledge that the tax discourages new mining projects that are higher risk and more capital intensive given the significant losses such start-ups can generate in their early stages. Indexing these losses at the long term bond rate does not adequately compensate for the miners carrying the government's share of such losses.

And therein lies the rub. Ken Henry's plan is to tax super profits but in exchange for the government effectively sharing in the risk capital for mining projects, which is most intense for new projects. While such a scheme has merit, all and sundry agree that the grossing up of losses at mere “risk-free rate”, being the government bond rate, is quite insufficient. Or looked at another way, using the bond rate as the threshold for what are otherwise “super” profits is to ignore the cost of capital of miners – a cost which greatly exceeds “risk free”.

Given the government has already suggested it is willing to look at concessions, my tip is it will be this rate which will be reassessed first, and that a satisfactory increase to a more realistic threshold will go a long way to getting miners onside, if such an outcome is possible.

In the meantime, BA-Merrill Lynch has this morning downgraded Rio Tinto to Neutral from Buy and lowered its target price on the stock from $95 to $70. However, this is not an RSPT response.

Rather it is a response to the sovereign debt issue impacting on Europe and the attempts being made by Beijing to cool the Chinese property market. Merrills suggests previous expectations of a further 35% rise in the iron ore settlement price come the third quarter will now have to be downgraded.

As a result of the ratings downgrade Merrills has also now withdrawn Rio from its Australia Focus One conviction list. The analysts have nevertheless replaced Rio with Oil Search ((OSH)) following that stock's 12% (more today) fall in share price to a point where it is trading “significantly” below base-case valuation.

The current market correction brings the RSPT into focus, given potential impacts have basically been lost in the wash of wholesale selling based on Europe deflation fears in particular. The resources sector has been hit hard on the ramifications of European economic contraction, flowing through to Chinese slowing and lower commodity prices. Realistically, we have now passed through the potential valuation impact of the RSPT in its current form.

Macquarie has had a look into Fortescue Metals' ((FMG)) decision to place its Solomon project on hold as a response to the RSPT.

While Fortescue cites an inability to raise funding for the project due to tax uncertainty, Macquarie notes not much has really changed yet. The Solomon feasibility study is still under way but if there is no resolution on the RSPT before the planned investment decision time of early 2011, this might be pushed further out. The project provides about 50c upside “optionality” to the Fortescue share price, the analysts suggest, but the RSPT as is could impact by 35%.

Macquarie has decided to play it safe and reduce its target price for Fortescue from $5.00 to $4.30, retaining a Neutral rating. However, the broker suggests Fortescue's RSPT risk is now priced in given the big fall in the share price, and given negotiations are under way to potentially water down the tax proposal there is limited further downside to FMG based on tax alone.

Click to view our Glossary of Financial Terms