Undervaluing Rio Tinto

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

By Greg Peel

“We suspect it will take some time for the market to accept that valuation techniques need to change in order to pick up the value inherent in long life and low cost assets that have a high probability of being expanded and replenished. In fact we suspect that institutional investors and sell side analysts are unlikely to be at the forefront of any valuation uplifts”.

Were Australian/British mining giants BHP Billiton ((BHP)) and Rio Tinto ((RIO)) to merge, as BHP is attempting to achieve, it would create the largest single diversified mining company the world has ever seen. It is thus of little surprise that both sides have elected to retain teams of advisors from across the investment banking and broking community. Under the rules, those bankers and advisors must now refrain from making any recommendation to clients, lest such a recommendation be seen as “inside” knowledge which is not publicly available. Hence currently eight out of the ten brokers and researchers in the FNArena database are on restriction, and can make no valuation of either company.

The restriction does not, however, apply to the analysts at Austock, and those analysts have recently completed a very thorough investigation of how one might indeed value Rio Tinto in light of the BHP offer now on the table and Rio’s assertion that the offer does not assume sufficient valuation. As the quote above suggests, Austock’s view is that the industrialisation of the developing world has forced a more searching appraisal of the true value of the earth’s resources into the future, and thus the companies that own them.

Another restriction arising from the BHP/Rio merger battle is that neither side is allowed to directly engage the other in discussion, should that be construed to amount some collusive deal being fashioned outside of public disclosure. Hence the two can only “communicate” via public statements and presentations. Several weeks ago BHP provided analysts and investors with a three-hour presentation on Oil & Gas in which managerial skills, risk control and growth prospects were emphasised. This, notes Austock, was BHP’s way of trying to convince Rio that minerals, metal, oil & gas can all successfully combine under one umbrella operation. If there is a single difference between Rio and BHP, it is that Rio is not into oil & gas.

Late last month it was Rio’s turn to publicly state its case, which it did so via a Value & Growth briefing.

How does one value a mining company, when a great deal of that company’s perceived value lies in as yet unmined resources which geologists are only hoping are there? Assessment techniques of underground mineral reserves might now be technologically sophisticated, but there is still a level of pure probability involved. Hence the standard “2P” measure of reserves – being “proven and probable”.

Even if one had an accurate measure of reserves, at what price does one value those reserves? Analysts use a “long term price” valuation based on a regression to a mean average price over a number of years, but already the so-called “super cycle” has blown such concepts away in the twenty-first century. “Long term” prices are now being fiddled with from year to year and even quarter to quarter not just because the average has changed, but because longer term demand/supply forecasts have moved the goal posts. If a certain mine has an estimated life of ten years, at what price does one value that tenth year’s production? And what will costs be like by then, in order to evaluate a profit? Costs in the mining industry have been running way ahead of general inflation rates of late.

[To more understand the chocolate wheel that is resource stock valuation, readers are directed to a 2006 FNArena feature entitled “How Do You Value An Oil Company?”. The story uses the example of Hardman Resources. Just enter HDR into the search engine on the website. It might specifically involve oil, but the fundamentals are true for any resource.]

Those old enough might remember the Australian nickel boom of the late sixties, and subsequent phenomenal rise of the Poseidon share price. The following crash of Poseidon shares, due to initial estimates of ore reserves being inaccurate or misleading, led to the creation of a body called the Joint Ore Reserves Committee, which is sponsored by the Australian mining industry and related professional organisations. It took until 1989, but finally there was agreement on a code for the purpose of valuing mineral reserves. This code was adopted by the Australian stock exchange as a reporting requirement, and hence all resources companies must now adhere to the method of reserve estimation based on the JORC code. While not infallible, JORC goes some way to allowing for the comparison of apples and apples when comparing the resource claims of two mining companies.

When BHP made its initial offer for Rio, Rio’s board suggested that offer undervalued the company. BHP has since increased the offer, but still Rio has been dismissive. It has thus become incumbent upon Rio to inform its shareholders, and in doing so BHP, as to why it believes the company has more inherent value than BHP is calculating. Measuring BHP’s valuation for Rio is also problematic, as the offer involves a 3.4:1 scrip swap, increased on February 8 from 3:1. The closing price of BHP on February 8 implied a price of $122.99 for Rio, and Rio shares closed at $125.00 on the day. The closing price on June 16 implies a price of $148.27 for Rio, but Rio closed at only $136.20 on June 16.

The valuation is thus a moveable feast, so it is hard for an analyst to construe an implied takeover premium. The figure 30% is a common benchmark, and the June 16 premium is only 12%. But one also has to consider that Rio shares jumped 25% in two days after the initial offer was made in November, so getting a handle on what the actual takeover premium now represents is like handling quicksilver, and given there is a long process of government and regulatory assessment yet to be completed that ratio is going to continue to fluctuate for a while yet. However, because it is a ratio, and not a simple cash price, any analysts’ assessment of what BHP should be paying in ratio terms is dependent on how one might value not only Rio, but BHP as well.

Nevertheless, Rio went some way to offering its own valuation last month, and JORC had a lot to do with it. Implicitly, Rio is not arguing required takeover premiums, but suggesting that BHP is simply undervaluing Rio’s assets (which, by default, suggests the market in general is doing the same).

At its presentation, Rio introduced a string of JORC resources for the first time, some of which are partially owned and only at scoping study stage. These include Simandou, Resolution, La Grampa, and the Pilbara expansion which is being brought forward. The company also highlighted likely capital costs for a long list of projects currently in the pipeline. The combined capital cost of the pipeline has increased by US$2.5bn, or 8% above earlier estimates, and that trend is likely to continue. Large expenditures are being made on valuation of a wealth of projects, and many teams have been deployed for the purpose of this assessment. Evaluation is being advanced at full speed.

Rio reiterated its plans to grow iron ore production at 10% per annum through to 2015, copper at 8.4%, alumina at 9.0% and aluminium at 7.2%, and energy (coal and uranium) at 11.6%, which covers the four designated divisions of the company’s operations. In total, compound growth is projected as 8.6% across the group. Austock has responded by increasing its growth assumption from 6.8% to 7.8%, remaining slightly more conservative.

All this was intended to provide shareholders with a greater appreciation of why the Rio board believes BHP’s offer undervalues the company. It was also a message to BHP. However, BHP has responded by criticising the evaluation as focusing only on volume estimates and not on profitability or returns. BHP also argues the estimates are premature, and even irrelevant given some of the projects are not even sanctioned by the board.

This introduces another vagary in the process of valuing resources. Tradition dictates that a project cannot be included for any additional valuation until the board sanctions the project as a possible “goer”, and thus begins evaluation – at least as far as BHP is concerned. Austock sums up its view on this attitude as such:

“Clearly this is a bit of a long shot. The market will make its own judgement as to the likelihood of projects proceeding and value them accordingly.”

And Austock argues BHP would no doubt do the same in regards to the Olympic Dam expansion were the boot on the other foot. BHP’s underperformance through the 1990s can be traced back to poor decision making and risky projects, Austock suggests. Rio, on the other hand, has demonstrated a more robust model of constructing projects not to achieve short term earnings per share targets, but to achieve strong returns over the cycle. The market no doubt understands this, Austock believes.

Austock also suggests BHP’s own pipeline presentations to date have been impressive but rather vague – lacking in evidence to test the company’s claim the pipeline is “unrivalled”. Nevertheless, and despite its criticisms, BHP has countered Rio with a compound volume growth profile of its own, which is estimated at 6.9% in the shorter period to 2012. BHP has estimated an equivalent figure for Rio of 6.0%. Austock estimates BHP’s growth to be 5.7% out to 2015, and suggests that lack of evidence from BHP means it is difficult for Rio shareholders to “come to an understanding on the relative merits of the two companies”.

The important distinction between the two however, notes Austock, is that BHP’s growth profile is no surprise and has already been factored in by the market, whereas Rio is still trading at a discount to net present value. On the basis of Rio’s presentation, Austock has increased its NPV estimate only slightly, from $165.40 to $166.40 per share. The analysts’ 12-month target price remains at $177.

If that’s how at least one analyst sees the value of the Rio presentation, one wonders what all the fuss is about. However, it all comes down to just how one should value a resource company. The market’s attitude tends to be that shorter term earnings certainty is more valuable than longer term growth opportunity. This works in BHP’s favour, as BHP looks more impressive on a price/earnings basis, and justifies BHP as the senior partner of a merged entity at about 60%. It also justifies BHP’s confidence in moving now to force a response from Rio’s shareholders, notes Austock.

Rio argues that the merged entity should be split on the basis of growth pipeline. Austock agrees that Rio shareholders should be compensated for all brownfield (recommission or expansion) and greenfield (nary a sod yet turned) projects. Austock also assumes a base case where global economic growth rates will moderate and new resource supply will catch up with demand. Under this scenario, Austock is predicting commodity prices will halve in the period 2012-15. And taking this to conclusion arrives at an estimated representative split of 53% BHP to 47% Rio, and a valuation ratio on NPV of 3.81 BHP shares to one Rio. (The current BHP offer is 3.4:1).

However one values the two companies, the fact remains that both have a suite of projects that will not contribute any earnings until 2012-15. If Austock uses industry average PEs for the various divisions – thus arriving at 10.5x for BHP and 10.9x for Rio – and applies them to earnings in 2008-10, then applies 9.5x to 2011-12, and finally 5.5x to 2013-17, it arrives at a value today for BHP of $64.60 and Rio of $238.00. Under this valuation the implied ratio is 3.68:1.

Wowee. But wait, there’s more.

If one were to apply today’s contract bulk commodity prices and London Metals Exchange spot prices as the proxy for future prices, BHP’s valuation rises to $84.40 and Rio’s to $319.60. Ratio 3.79:1.

But is any of this realistic?

This is where the guess-and-giggle game of resource stock valuation reaches a point of reflection – a point where one might ruminate on a changed and changing world. It has oft been proven that resource analysts in general have been slow to adapt to the new global regime, stuck, as they were, on valuation methods dictated by historical cycles. It’s a simple thesis – demand for a commodity grows during a longer term economic cycle upswing, and suddenly finds supply wanton. Supply is wanton because there had been little incentive to increase given low commodity prices to date. Suddenly there is every incentive to explore for and increase supply, as prices have risen with demand. But bringing new supply on line takes time, and by the time new supply is available the economic cycle has already begun to turn down. Added supply only serves to exacerbate a subsequent fall in commodity prices, which regress back to a long term average mean. And then we go round again.

But the industrialisation and urbanisation of China and other developing nations has thrown that book out the window, and ushered in the “super-cycle”. The last super-cycle began shortly after the war as a result of the similar emergence of Japan. However, none of today’s resource analysts were around then.

The other factor dictated by China et al’s emergence has been cost. Not only were mining projects gathering dust late last century, but no attention was given to infrastructure, equipment and labour, for obvious reasons. What mining company’s shareholders would sanction massive capital spend in times of low commodity prices based on the hope that eventually the cycle will turn up again? But now, suddenly, every Joe with a patch of dirt has become a listed mining company, extracting capital from the market to spend, spend, spend. With commodity prices skyrocketing, how can one go wrong? Just look at the patron saint of overnight success – one Twiggy Forrest – founder of Fortescue and suddenly Australia’s richest man.

But given years of understandable neglect, required infrastructure, equipment and labour is now very thin on the ground, and thus highly expensive. The cost of the energy needed to drive mines and transport commodities has also skyrocketed. For the start-up miner, it matters little what might lay in the ground beneath. The cost of extracting and selling the bounty may still prove uneconomical despite the new regime.

Yet for over a century, BHP and Rio have simply lumbered on. Two decades ago BHP was the biggest stock on the ASX, and then it dropped off the radar. The fact that it is back once more is simply a reflection of a company bogged in for the long haul of cycle to cycle. For Rio, it is a similar story. But the most important point is that these two companies boast a wealth of long-life assets that are leveraged to rising real commodity prices, are low cost given their pre-existence, and can grow volumes by replenishing reserves and resources. In a traditional mining cycle, new supply simply joined old supply and forced down prices. In the super-cycle, the extreme cost of new supply puts old supply in the box seat. Says Austock:

“In this era of highly visible demand from China, India and Brazil the flexibility to accelerate supply has an important option value to all major resource companies. BHP and Rio are particularly well placed in this regard.

“We doubt that sell-side or buy-side analysts will lead the way in appreciating such option value or put another way, ‘strategic value’. Interestingly the acceptance of this type of valuation will not be news to BHP or Sovereign Funds nor indeed any other corporate buyers of strategic resource assets”.

Yet it is Rio alone who is trying to make the point, by changing its attitude towards valuation. BHP is working off the old model. This is understandable, as BHP is trying to buy Rio, and convince Rio shareholders that the price is right. Yet both companies are aware of the cost of being overly cautious, notes Austock, on the possibilities of the super-cycle. They are convinced that developing country growth means the risk of project commissioning and expansion lies no longer to the downside, but to the upside. The more of BHP’s and Rio’s “resource footprints” become available for production, the more chance that these development “options” move from a valuation of zero to “deep in the money”.

Yet Austock maintains that the market will be slow to recognise this potential, and the need to more realistically value optionality, and will not re-rate Rio on the basis of this argument. However, the big Oil Majors – dripping in profits and looking for expansion and diversification into minerals – and the Sovereign Funds – simply dripping in dollars and looking to cut out the middle-man – will not be so reticent, suggests Austock. These entities are not looking for a quick profit, but for 50-150 year mine life.

Austock does not expect the traditional institutions (the big fund managers) to lead the way in re-rating either Rio or BHP. But the analysts suggest they will be very, very quick followers. There is also a small matter of American pension fund money which is currently very focused on the expectation the economic slowdown in the US will impact on global commodity prices. If it begins to dawn that developing country growth is here to stay, then blue chip resource companies will be very much on the radar.

And the Chinese are circling, and the world’s sovereign funds in Asia and the Middle East are primed, and even the large oil companies are potential suitors even if the other big resource companies (Xstrata, Vale etc) are not. Austock’s advice to Rio is to begin demonstrating the company’s inherent value to analysts in a more definitive way as soon as possible. The broker’s advice to BHP is to move now.

If there is one thing implicit in such advice, it’s that Austock suggests investors should also make a move. Austock has a Buy on both companies.

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