Material Matters: More On Henry, More On Resource Stocks

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This story features RIO TINTO LIMITED, and other companies.
For more info SHARE ANALYSIS: RIO
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Chris Shaw

The possibility of a proposed resources rent tax being applied to Australian mining companies has seen investors flee that sector of the market, with price falls over the past couple of days of around 5% (for the majors).

In the view of analysts at BA-Merrill Lynch, these falls reflect a sector rotation out of the resources sector, one the stockbroker suggests has much further to run. This is based on the view the proposed tax isn't the only issue confronting the sector at present.

As BA Merrill Lynch notes, the 5% fall in resource company shares is still much less than the estimated 15% impact on net present value the tax implies. As well, risks from a further policy tightening in China appear to be growing, which has clear implications for commodities demand. Finally, BA Merrill Lynch points out leading indicators of western world production are continuing to deteriorate.

What this means for the resources sector is share prices remain vulnerable as investors have been aggressively overweight cyclical assets in recent months. This comes at a time when valuations in the sector are not cheap and risks are accumulating, which BA Merrill Lynch sees as a truly awful combination.

There remains significant uncertainty as to what form any tax will finally take, but assuming a tax is imposed BA Merrill Lynch suggests it would close some of the valuation gap that currently favours Rio Tinto ((RIO)) when compared to BHP Billiton ((BHP)).

In contrast, stocks in other sectors are cheap, BA Merrill Lynch suggesting the media, gaming, Telco and utilities sectors are at close to record low valuations relative to the market at present. The banking sector is seen trading around fair value currently but even this represents a better alternative to resource stocks at current share price levels in the broker' view.

Outside the resources sector however, BA Merrill Lynch suggests the Henry review is largely a non-event. Financial stocks appear winners from the changes given increases in superannuation over time, but any benefits won't be significant for earnings for several years.

Potentially BA Merrill Lynch suggests the commercial services sector generally and the mining contractors more specifically may be impacted given a possible decline in long-term capital expenditure.

In order of earnings exposure, BA Merrill Lynch suggests United Group ((UGL)) is most at risk at 13% of earnings before interest and tax (EBIT), followed by WorleyParsons ((WOR)) at around 9%, Leighton Holdings ((LEI)) at around 8%, Boart Longyear ((BLY)) at around 6% and Downer EDI ((DOW)) at around 5%.

Credit Suisse has an alternative view on the resources sector, arguing it is world growth that is driving the resources boom and not the Australian government. In other words, while the Henry tax review has investors nervous, resource stocks are being oversold.

According to Credit Suisse, world growth remains surprisingly robust, as ISM Manufacturing and industrial production numbers are at elevated levels compared to the current level of global risk appetite.

While conceding there are legitimate medium-term concerns about the health of both US consumers and China, Credit Suisse remains of the view the global economy is unlikely to unravel this year. This argument is supported by the view the global inventory cycle has not finished and policy stimulus continues to support consumption.

As well, Credit Suisse estimates a proposed resources rent tax, while significant, would only see the effective tax rate on resource companies rise back up to its long-term average. In recent years, the effective tax rate for resources companies has fallen to under 20% from around 40%, as while production volumes have not increased, prices have.

The proposed tax would correct this trend, while on the earnings side, real earnings per share (EPS) would simply fall back to the long-run trend rate as Credit Suisse notes the new tax would replace some existing royalties.

If resource stocks are valued on current trend earnings rather than actual real EPS then the sector is around 25% expensive, but Credit Suisse suggests relative to the market, which is also overvalued, the sector is in fact slightly cheap.

In terms of how best to play this view Credit Suisse has not changed its pre-Henry views, meaning among the miners Rio Tinto and BHP Billiton are preferred, while in the energy sector Woodside ((WPL)) and Oil Search ((OSH)) are preferred.

Morgan Stanley offers more details on the implications of the Henry tax review for the LNG sector and its view is somewhat in line with that of Credit Suisse as it suggests it will be the markets that determine which projects actually go ahead.

To summarise its view, Morgan Stanley suggests while no project clearly means no tax implications for a company, no tax doesn't mean every possible project will end up being developed.

Given a large number of proposed projects in the global LNG market at present, Morgan Stanley is of the view only a limited number of high-quality, low cost conventional projects and brownfields expansions will get up by 2020. Greenfield and higher cost and technology dependent projects will find it much more difficult.

According to Morgan Stanley, the outlook for LNG demand in the period 2015-2020 is lower today than it was a few years ago, thanks to growth in unconventional gas supply around the world. Long-term LNG demand growth is tipped to be around 4.5% annually.

In Australia the opportunity is to take advantage of expected strong demand from Asia, but much of this demand through 2017 appears to have already been captured by deals signed over the past year or so. At the same time, Morgan Stanley sees scope for prices to soften in coming years given the expected increase in supply, meaning it is far from an ideal time to launch a greenfield LNG project.

For Australian companies specifically, Morgan Stanley notes oil and gas fields located offshore are already subject to a resource rent tax, so those companies with assets governed by this will be able to choose which tax regime they wish to operate under going forward. This implies no increase in taxes going forward.

For onshore companies, which includes the Cooper Basin in South Australia, the coal seam fields in Queensland and the Perth Basin in Western Australia there is scope for tax payments to rise under the new proposals, but any final impact is not yet known.

Assuming the Henry changes are implemented, Morgan Stanley sees those companies most at risk are Santos ((STO)), Beach Petroleum ((BPT)) and Origin Energy ((ORG)), while Woodside stands to face only a minimal impact.

On Morgan Stanley's analysis Oil Search, Karoon ((KAR)), Roc Oil ((ROC)) and Australian Worldwide Exploration ((AWE)) will not be affected by any changes. On the back of its review the broker retains Overweight ratings on both Woodside and Oil Search.

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