Value Is In The Eye Of The Beholder

This story features RIO TINTO LIMITED. For more info SHARE ANALYSIS: RIO

By Rudi Filapek-Vandyck, Editor FNArena

They say that a "cheap valuation" is an investor's best friend, but virtually everyone who bought shares in the world's largest diversified resources leviathan, BHP Billiton ((BHP)), since April last year would have made that decision based upon "cheap valuation", yet there have been no subsequent investment returns to back up that claim.

To the contrary, BHP Billiton shares recently revisited sub-$31 price levels which means EVERYONE who has bought shares since late March 2009 is now underwater. Only those who managed to buy at the low in early March, or prior to that, can still boast an investment profit today without having to rely on the Big Australian's annual dividend payouts.

BHP shares are currently trading some 40% below price targets set by investment bankers and stockbrokers and they have been most of the time since that memorable rally in 2009. These targets are mostly derived from Net Present Value (NPV) calculations, so it seems only fair to conclude BHP shares are nowhere near where they would be if the world was a perfect place and "value" was a universal, scientific method to evaluate financial assets. Alas, we all know the world is far from perfect and when it comes to "value", well, maybe there's not enough understanding among investors and commentators how flexible the whole concept about "value" is, and about how much leverage is involved when trying to value an asset that is a direct derivative of prices for basic materials?

Commodity analysts at Citi recently went through various scenarios that possibly await BHP Billiton, and the rest of the resources sector in the years ahead. I am sure we can all come up with the potential varieties ourselves, but what would surprise, I have little doubt, is how the "value" of BHP shares will be impacted by all those possible turns and twists.

First, while resources analysts traditionally spend a whole lot of time fine tuning their models and calculations to answer the ever so opaque question on what is today's Net Present Value, it is my personal observation that post-March 2009 the plain simple Price-Earnings ratio (PE) has proved to be a much better guide to what lies ahead for sector giant BHP and most other resources stocks. Consider, for example, that in hindsight (and with the information we know today) the shares looked rather "expensive" when they reached $49.55 in April last year, as that translates into a Price-Earnings ratio in excess of 13 (translated into AUD) for that year. To make matters worse, after achieving a profit improvement to the tune of 75% in fiscal 2011, this year, according to consensus forecasts, will see BHP's profit growth turn negative to the tune of 14%.

In other words, had BHP shares remained at $49.55 and if consensus expectations are met in August, the PE ratio would have blown out to above 14.6; which is higher than what the shares traded at during this cycle, with exception of 2008. We all know, however, companies whose profits deteriorate that strongly usually don't manage to hold on to high PE premiums. BHP shares have been derated throughout the past 14 months and they are now, corrected for AUD translation and according to market consensus, trading on a PE between 9.3-8.4 (FY12-FY13).

Most experts will confirm: that's cheap.

According to consensus estimates, the dividend yield should rise to 3.7% next year (FY13) while earnings per share should improve by some 11%. The prospects for FY13 are thus a lot better than what occurred in FY12, but it also appears the explosive growth from the past is now well and truly past us. What these estimates also imply is that BHP's annual profits won't be returning to the record levels of last year anytime soon. As a matter of fact, there are quite a few analysts around who haven't penciled in much growth for the years ahead and whose estimates are thus implying BHP's profits won't match the FY11 record for the foreseeable future.

As everyone can imagine, these forecasts are key to what investors today might perceive as being "cheap" or "not so cheap". Which brings us to Citi's revealing update on calculations of Net Present Value…

Given NPV calculations are largely based upon long term price forecasts and with spot prices for many commodities now close to or even below what analysts have penciled in as long term sustainable prices, one would have thought calculating BHP's NPV today would be more straightforward than in earlier years, but Citi's update suggests otherwise.

If we put the lowest prices available in Citi's model, be it spot or long-term estimate (whichever is lower today), BHP's NPV according to Citi's model instantly shrinks from $43 to $29. In other words: the question whether BHP shares are cheap can only be answered with a sound "yes" if we assume commodity prices will rise from current levels. Were prices to remain stagnant, the opposite argument wins and BHP shares today, even after losing circa 35% over the past 14 months, would still be too expensive for comfort.

This just shows how much built-in leverage is in play and how it can work either in support of shareholders' value or to their disadvantage. "Cheap" is not what a share price automatically becomes after losing 35% of its face value.

Today's conundrum for boards in the mining and energy sectors is illustrated by Citi's next assumption: let's remove all future projects that have not been yet approved today and assume they will be postponed indefinitely. Good news for shareholders? Hardly. According to Citi's model the NPV would decline by a further $4 to $25. Which throws up an interesting question: assuming the miners would start paying out all excess cash flows to shareholders, which factor would weigh more heavily in the balance, dividend support or the declining NPV?

Remove all prospects for increasing production volumes from now onwards, and leave all of the above intact, and BHP's NPV would fall to $23, described by Citi analysts as the ultimate line in the sand.

We now have a quantifiable answer to the question: are shares in BHP Billiton cheap? There's downside potential to the tune of 27.5%, but in case things do not turn out so badly in the years ahead there remains upside potential of some 29.5% and that's not taking into account the idea that one day resources stocks might trade at a premium to NPV again (as was the case pre-2008).

The NPV exercise conducted by Citi analysts also reveals why investors should prefer Rio Tinto ((RIO)) over BHP. Similar assumptions for RIO only reduce the NPV to $62 (still above today's share price) in case of no changes to commodity prices, and to $58 in case of no further growth projects, still circa 9% above today's share price of $54.53. The ultimate line in the sand for RIO comes in at $47, which requires a very dark outlook and still only represents downside potential of no more than 11%.

Ironically, Citi analysts took on the question of "dividend support" for these stocks in 2011. Their conclusion at the time was that share prices probably would have to fall by some 20% before implied dividend yield levels of circa 4% would likely start providing support to share prices. Their conclusion in a follow up report this week is that this is exactly what has transpired since that first conclusion was published. This suggests that, given BHP's yield is not that far off the 4% mark but with Rio's stuck at around only3%, BHP shares likely offer the best protection to the downside, but Rio Tinto is likely to outperform on the upswing.

Also, Rio Tinto shares are cheaper on a pure and simple PE comparison (7.8 versus 8.4) while consensus forecasts signal a stronger growth outlook as well.

(The story above was written on Tuesday, 12 June 2012. It was sent in the form of an email to paying subscribers on that day).

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