Goldman Reports Spark Rio Confusion

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By Greg Peel

Last night Goldman Sachs global stock analysts in London downgraded iron ore producers BHP Billiton ((BHP)) to Neutral from Buy and Rio Tinto ((RIO)) to Conviction Sell from Neutral.

This morning the Goldman Sachs local resource sector analysts in Sydney downgraded their share price targets for the two majors and for pure-play Fortescue Metals ((FMG)), but maintained previous ratings of Buy for BHP and Neutral for both Rio and Fortescue.

Why the contradictions within the same broking house?

The clue lies in statements within each of the separate reports. The global report suggests “No escaping US$80/t iron ore; on relative valuation [Rio moves] onto Conviction Sell list”. The local report says “[BHP, RIO and FMG] are still appropriately positioned within our Australian stock coverage universe”.

It is important for smaller investors to understand that in providing stock recommendations, brokers, and particularly large houses, are speaking to equity fund managers who, by default, must hold an equity portfolio. Indeed, equity fund managers only hold an equity portfolio, thus it is only the make-up and weightings of stocks in that portfolio that can be managed. Equity fund managers cannot decide to sell stocks and buy bonds instead, for example.

Hence when brokers offer Buy, Hold or Sell ratings, or equivalents such as Outperform, Neutral, Underweight etc, those ratings are intended to be relative and not absolute. They are relative to a particular benchmark portfolio, which may be the Australian resources sector, or the ASX 200, or an MSCI international share index, et cetera.

The downgrades to BHP and Rio from Goldman’s global equities team were sparked by a decision by Goldman’s commodities research team to downgrade their price forecasts for iron ore. The price downgrades represent a back-flip from the commodities analysts, given last year their view was one of iron ore recovering following the downturn in prices in the second half of 2012 led by a decline in marginal-cost Chinese domestic production. Last night the broker reported “domestic production has surprised us on the upside recently”. Add to this an increase in Chinese scrap recycling and lower than previously expected steel production and the analysts have decided their earlier forward price forecasts look too ambitious.

Seaborne ore (from Australia and others) will still be in demand in China, Goldman believes, but with supply increasing globally, particularly from the likes of BHP, Rio and Fortescue, an oversupply down the track has always been on the cards. An oversupply would lower prices but there would always be a price floor, given marginal Chinese domestic production would be forced to shut down at too-low prices, reducing net supply. Given greater than expected domestic production in early 2013, increased scrap usage and lower than expected steel production, Goldman now sees the oversupply threat sending the market into surplus by 2014, earlier than previously assumed.

Goldman has thus reduced its average annual iron ore price forecasts by 3% in 2013 to US$139/t, by 11% in 2014 to US$115/t, and by 9% in 2015 to US$80/t. Reduced commodity prices lead to reduced earnings forecasts for commodity producers and reduced target prices for their shares. Within a global portfolio of stocks, and bearing in mind that BHP and Rio are both large-cap global companies, Goldman Sachs’ global team has downgraded BHP to Neutral and Rio to Conviction Sell. A “Conviction Sell”, as opposed to just a “Sell” means the broker is particularly convinced. These ratings are relative within said global portfolio.

Within a local portfolio of Australian stocks, Goldman has retained Buy on BHP and Neutral on Rio and Fortescue. This implies a recommendation that an Australian equity fund manager overweight the fund’s holding in BHP but retains an index weighting for the other two.

Locally, Goldman prefers BHP over Rio given Rio has the greater exposure to iron ore production within its own portfolio of commodity production ventures, while BHP offers a more diverse commodity base, particularly with its large oil & gas exposure. At an iron ore price of US$80/t, Fortescue will struggle under the weight of debt and higher costs than the legacy majors. The analysts believe, however, that FMG’s intended sale of a stake in its port and rail infrastructure will alleviate the pressure by reducing costs.

Locally, Goldman analysts also point out commodity prices can be quite volatile.

Locally, Goldman has reduced its 12-month price target on BHP by 2% to $41.00, on Rio by 9% to $64.00, and on Fortescue by 13% to $4.10.
 

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