Due to weak macroeconomic conditions, as well as tempered demand from China, we've seen several materials firms announce structural changes. BHP (BHP) announced plans to focus on cost cutting rather than production increases in the wake of weaker iron ore prices and end markets. Rio Tinto (RIO), one of our favorite miners due to its attractive cost position, also announced cost cuts in its Australian mining business due to a long-term decline in demand growth from China. The firm thinks economic growth in the country could slow to 5%-6% by 2020, and we think a policy shift in favor of consumption rather than production could occur in the nation. Another diversified miner, Anglo American, has had strikes ravage production and expects weak results for 2012. AK Steel (AKS) also must focus on the cost side of the equation, as it warned earlier this week that it would lose $0.34-$0.39 per share during the fourth quarter, almost twice the loss it previously expected. Though iron ore prices are lower, steel prices have also been lower.
With weak end markets for most commodities and declining optimism regarding Chinese resource consumption, we're seeing cost control become more paramount than ever before. In 2010, following Chinese stimulus, companies were scooping up assets and struggling to meet demand, a condition far different than what we're seeing today. Falling demand for steel production could impair demand for both metallurgical coal, as well as iron ore. On top of that, lower demand for energy, as well as carbon taxes could put some pressure on thermal coal consumption. Luckily, both BHP and Rio are in fairly solid cost positions.
We think both will be able to sustain declines in iron ore prices, though cash flow generation won't be nearly as robust. And while China shifts in favor of adding marginal consumption rather than marginal production, the country will still require inputs for building roads, cars, and shopping malls to give consumers places to shop and a way to get there. Other emerging markets, including India, Vietnam, and the African continent, will also need to consume resources; thus we think the long-term demand picture remains fairly strong.
As a result, we continue to hold shares of Rio Tinto in the portfolio of our Best Ideas Newsletter (click here to download a white paper that supports this portfolio). Though BHP has a superior cost structure, its valuation isn't nearly as compelling, and we think the company's strategy of "empire building" could backfire. It tried to acquire Potash (POT), for instance, right at the peak of the fertilizer market. Shares of Rio Tinto score a 9 on the Valuentum Buying Index (our stock-selection methodology) and look incredibly undervalued.
Additional disclosure: RIO is included in our Best Ideas portfolio.