Is There Value In BHP and Rio?

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By Greg Peel

Australia’s Big Two globally diversified “miners”, BHP Billiton ((BHP)) and Rio Tinto ((RIO)) boast resource sector asset portfolios that are similar enough to encourage comparison, but dissimilar enough to encourage differentiation. BHP has a large interest in oil and gas, and Rio does not. Both are big iron ore miners, but Rio is bigger. Both have extensive copper and coal assets. Both have further interests in other base metals, uranium and so forth, but it is not these divisions which are generating the bucks at present.

Both are in the process of undertaking a major portfolio clean-out, which they hope will involve the divestment of a lot of smaller, or more marginal businesses. Leaving aside BHP’s energy assets for now, iron ore, coal and copper are dominating earnings. Coal and copper prices are struggling, leaving iron ore, and both companies’ major iron ore production expansion plans, as critical for both. Iron ore is also critical for market perception, given the great deal of attention now placed on spot iron ore pricing.

As noted in my most recent article with regard to BHP and Rio (Lean, Mean, Mining Machines), under respective new CEOs both companies are focused not just on asset sales, but also on the assiduous reduction of their costs of production and maximisation of the productivity of existing projects. Stock analysts are very encouraged by these strategies and see the strong potential for re-rating of share prices as a result. Capital returns to shareholders, one way or another, would seal the deal, but then both companies need to first reduce debt levels first as part of their cost reduction programs. And current expansion projects are still sucking up capex.

Brokers might be positive, and many have, and for a long time have had, Buy ratings on one or both stocks. The market, on the other hand, is not convinced, as the following charts demonstrate. The first is a chart of the benchmark ASX 200 index, in which BHP and Rio are influential:
 

 

The second is a chart of the ASX 200 Materials Sector, which BHP and Rio dominate:
 

 

For many investors coming back into what appears to be a more positive Australian stock market, or for those long suffering holders of the big miners, this chart exemplifies the disappointment and frustration shareholders are feeling. If the stock market is positive then BHP should be positive, shouldn’t it?

JP Morgan believes there are no less than five reasons why the market is anything but positive on BHP and Rio.

The first and most obvious is iron ore price fear. Not long ago, iron ore export prices to China (and Japan, Korea et al) were negotiated annually. Commodities analysts spent all year publishing and rejigging their forecast price expectations, but the wider investment community really didn’t pay much attention until the annual price reset was announced.

Today, the big producers still negotiate deals on at least a quarterly pricing basis, but more and more iron ore is being shipped at the margin on spot pricing. Suddenly the iron ore spot price has become a hot news topic, even in the popular media, let alone the wider investment community. When Goldman Sachs lowered its longer dated iron ore prices forecasts recently it was just about front page news. FNArena is perhaps guilty, too, of popularising spot iron ore by now publishing price movements each day on the website, from late last year. But we are simply responding to reader demand.

I’m surprised Tom Waterhouse isn’t running a book on iron ore. Or perhaps he is.

The bottom line is that while iron ore spot prices go up or down each day, stock analyst earnings forecasts do not. Stock analysts lay out what they call a “price deck” of average price forecasts for this year, next year, at least one more year, and thereafter “long term”. These numbers then feed into net present value (NPV) calculations for mining stocks and percolate through to share price targets. Right now, spot is around US$137/t while analysts are working off a near term price of around 120 and a long term of around 80 (which is where Goldman Sachs recently downgraded to). In other words, the trend of daily spot price movements will ultimately become important to analysts, but daily price fluctuations are not. The same can be said for miners’ management teams. Spot prices are volatile.

Yet whenever the daily spot price of iron ore drops a couple of percent, iron ore miners are sold down. Three years ago the wider market would have been blissfully unaware of how iron ore prices were trending. One can see why JP Morgan considers iron ore spot price “fear” as the number one reason iron ore mining stocks have underperformed in 2013.

There has also been a lot of talk recently of a near term global surplus in copper. This is not front page stuff, but significant given up until recently just about every commodities analyst was forecasting higher copper prices ahead on constrained supply and a potential deficit. What they didn’t count on was such a big drop in demand, and copper prices have been suffering all year. This is reason number two for JP Morgan.

Beyond that, JPM also cites concerns of a slowdown in the Chinese property market (implying lower demand for steel and copper). Recent news of new tax-based constraints on property development and speculation being imposed by Beijing sent relevant stock prices plunging. Then there’s the simple issue of neither BHP or Rio being able to reward long suffering shareholders with buybacks, special dividends or the like given their ongoing capex programs and aforementioned need to pay down debt. And finally JP Morgan simply points to forecasts for low earnings growth from either this financial/calendar year.

These are all, suggests JP Morgan, “near term headwinds”. Arguably the price of iron ore is not “near term” but perennial, but the point is stock analysts have already valued the shares of iron ore producers based on lower iron price expectations. Specifically, analysts have factored in the impact of increased supply set to hit the oceans over the next couple of years as production expansion from not just BHP and Rio, but also from Fortescue Metals ((FMG)) and various aspirational juniors, along with foreign producers. In other words, the market need not panic every time the iron ore spot price drops from 135 to 133.

On the flipside there are also “incremental medium term positives”, as JPM puts it, being ignored by the market in the case of the Big Two. These include the aforementioned down-sizing, cost-cutting and efficiency strategies the miners are now pursuing, and the potential for capital returns down the track once these programs start paying off and debt is brought under control. Then there’s the apparent general improvement in the global economy, and the simple fact that the share prices of both have already been knocked down some way. JP Morgan also believes investors in general are underweight the sector.

JP Morgan is therefore “comfortable” with its positive outlook on both stocks. Given this broker specifically rates stocks within a sector, and not against the benchmark index, the analysts are positive on BHP, but have only set a Neutral rating given they prefer Rio, which attracts a Buy.

A preference for Rio is not uncommon among brokers, including those who set ratings against the benchmark index. Indeed, five of eight FNArena database brokers have Neutral (Hold) ratings on BHP against two Buys and one Sell. Seven brokers have Buy ratings on Rio, against one Hold.

The one Sell rating on BHP is courtesy of BA-Merrill Lynch, who downgraded from Hold in January. A glance back at the materials sector chart above suggests this was a good move. Merrills has not yet deigned to re-rate the stock, nevertheless, despite a significant stock price retracement in the meantime. What Merrills has been doing, however, is some sensitivity analysis.

Which brings us back to the iron ore price.

The Merrills analysts, along with peers from other brokers, recently trotted out to the Pilbara to see how the iron ore landscape was looking these days. Merrills spoke not just to BHP and Rio, but to Fortescue, Hancock (not listed) and the various junior miners operating in the area. What the analysts found is it is not just the market that is worried about the potential for lower iron ore prices going forward.

“On the WA iron ore field trip,” says Merrills, “a common theme was the impending pressure on iron ore prices going forward. Although there was no clear message as to the degree to which prices may fall from here, it was apparent that management do not see the current levels being sustained under current conditions”.

Merrills current 2013 average iron ore price forecast is US$120/t, which includes a fall to 110 in the second half from current levels above 130. On a base case, the analysts have set an NPV for BHP of $26.41 (last traded price $33.13). It is important to note that while NPV is fundamental in broker target prices, Merrills’ target for BHP is currently $34.00. Net present value is a base value to which a premium is often added.

If Merrills assumes a 130 iron ore price for the next three years, the analysts’ BHP NPV rises to $27.97 (up 5.9%). Assuming a 70 price for three years implies $23.87 (down 9.6%).

For Rio the analysts have a base case $63.76 (last traded $57.75) and a target of $80.00. At 130 the NPV rises 5.7% to $67.40 and at 70 falls 11.8% to $56.21.

For Fortescue the analysts have a base case of $7.34 (last traded $3.97) and a target of $5.50. At 130 the NPV rises 36.7% to $10.04 and at 70 falls 41% to $4.33.

Fortescue’s swings are far more substantial because Fortescue is a pure-play iron ore producer and not a diversified resource company. As for the junior pure-plays, as one might imagine Merrills’ analysis delivers some wild swings.

By holding all other input values equal, Merrills’ analysis is discounting one major underlying factor. If the iron ore price were to trend downwards towards the US$80/t brokers are factoring in in the longer term, it is unlikely the Aussie dollar would remain above parity for too long. Indeed, in each case of up or down in iron ore price, Aussie dollar movement is likely to be in the opposite direction, acting as a dampener on actual Aussie dollar earnings from iron ore sales.

UBS, for example, is forecasting a decline in iron ore price to 72 over four years. But the broker simultaneously expects a decline in the Aussie to US$0.80 from today’s US$1.04. UBS has currently assigned a share price target for BHP of $40.00, for Rio of $89.00, and for Fortescue of $5.35. UBS rates both BHP and Rio as Buy and Fortescue as Neutral.

JP Morgan has a long term price assumption for iron ore of 80 and a long term Aussie assumption of 80. As noted earlier, JPM is positive on both BHP and Rio and also has a Buy on Fortescue.

Is there a moral to this story then?

It is understandable that investors in BHP and Rio in particular are (a) nervous about iron ore and other commodity prices and (b) ticked off at brokers who seem to be almost perennially positive about these stocks even as their prices have been sinking into the sunset. The current consensus target price in the FNArena database for BHP is $38.67, suggesting 16.6% upside, and for Rio it’s $80.57, suggesting 39.2% upside. When is this upside going to materialise?

Well for starters these are forecasts, and not promises. But what brokers are trying to say is that the market, in their view, has become too reactionary, too panicked, and has now sent BHP and Rio share prices down to levels which makes then relatively attractive, even if iron ore prices do trend down over the next few years.

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