BHP Billiton and Rio Tinto: Not Yet a Bargain

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Includes: BHP, RIO
by: Individual Global Investor

Three weeks ago I wrote an article on the contraction in the Australian economy that will continue, particularly when annual iron ore pricing contracts come up for renewal this summer. Since then a number of forecasts and statements have come out that the 2009 contract price will be down significantly. First Australian investment banks Macquarie Group and Goldman Sachs JBWere Pty forecasted a 40% decline. Last week the China Iron and Steel Association came out to say it wants a return to 2007 prices based on weak outlook for steel production which would represent a 44% drop.

A drop in the contract pricing combined with overall reductions in volume would result in a sizable impact on two Australian mining giants BHP Billiton (NYSE:BHP) and Rio Tinto (RTP) and could have a measurable affect on Australian GDP. So I set out to determine how much of an impact. The share prices of BHP and Rio have corrected substantially since the beginning of July 2008 with BHP down 52% and Rio down almost 80% since their May 2008 highs. So the question is: Has the market accounted for this problem and are BHP and Rio now cheap or is there another leg down to go?

The Chinese customers now hold the pricing power. There is great debate regarding the extent to which the global recession will hold back Chinese growth. I took a bearish stance recently with respect to manufacturing and industrial production. The same view may not be appropriate for Chinese steel production that goes into infrastructure. The argument here is not that steel production will decline rapidly, but that the price power of Australian (and Brazilian) resource companies has collapsed. A return to 2007 contract pricing will result in a 40% decline in export revenue for the Australian iron ore industry and an even larger decline in coal revenue.

The graph above is from a Reserve Bank of Australia research report on commodities prices and shows how spot prices for iron ore and coal had been more than double the level of contract prices before BHP and Rio successfully negotiated a greater than 80% increase. The spot prices have since been more than cut in half reflecting not so much that iron ore demand or steel output had been cut in half but that the marginal buyer is nowhere to be found. An extra 10% in demand can drive a commodity’s price up substantially when supply is tight.

The graphs below show Australian government statistics on exports of iron ore (left) and coal (right) including an estimate for the current fiscal year (ending June 2009). The volume of shipments (bars) is up in 12% and 30% respectively but the revenue (line) is up 220% and 320% over this period, reflecting the significant pricing power resource companies had over those 4 years. Thus while the shipments may not drop only the 10% forecasted by the Chinese trade association, the revenue will drop after June this year proportionally with the price reductions.

BHP is fairly valued but not cheap. A look at BHP’s latest half year results allows for a good comparison of before and after last year’s price increases and thus what a return to previous pricing levels might mean. BHP’s mining operations yielded a profit of $11.9 billion in the last six months of 2008, up from $9.6 billion in the same half year of 2007. These 2008 results are pro forma and did not include a $4.7B one time write down but likely do reflect the underlying business.

The problem was not so much the write down but the composition of the profits which were boosted heavily by iron ore and coal contract pricing. As that deflates, the results for the similar 2009 half year could be $5.3B before any write downs or decreases in volume. There are likely to be some of this, so my assumption is BHP would be on track to earn $9 billion in a full year under those circumstances. Translated into BHP’s American Depository Receipts this corresponds to an annual EPS of $3.25/share.

Commodities prices and shares of resource companies leapt up last week’s following the announcement by the U.S. Federal Reserve that they will be pumping another trillion or two dollars into the U.S. economy through quantitative easing measures. The fear of inflation can cause many investors to take cover in oil and other commodities. With global demand still weakening, they are unlikely to stay there for the rest of the year.

This rush for cover drove the price of BHP’s American Depository Receipts to trade in the $45 to $48 per share range. At that price, BHP trades at a P/E multiple of about 14. This might be considered fairly valued but hardly a bargain price. BHP is a great company, well diversified, and in the best position to capitalize on the China infrastructure story (which has at least another decade to go). A long term investor will make money investing at these levels but I see no reason to think the train is about to leave the station and you need to jump on now. My expectation is that BHP gets below $30 and retests the lows of last November before global growth reinvigorates commodities fundamentals.

The Rio story is no different. A similar analysis of Rio Tinto reveals similar, albeit less reassuring results. Rio also reports “underlying earnings.” For the full year of 2008, Rio had $10.3 billion (US dollars) in underlying earnings split almost evenly between the first and second half of the calendar year. At year end, though, Rio’s one time charges netted to a $6.6 billion write down that more than wiped out all the earnings of the second half of the year. The bulk of this was goodwill write down related to the ill-timed Alcan purchase.

Looking forward, it is fair to expect that results for the iron ore segment and energy segment (which includes coal) could reflect 2007 market dynamics, aluminum (having already corrected in price) will look like 2008, and the Copper & Diamonds segment will be somewhere in between (call it breakeven as copper pricing has stabilized of late). This would result in a second half year result of $2.2 billion dollars before accounting for write downs or any other weaknesses. So figure an annual earnings of $3 billion or an EPS of roughly $10/share for Rio Tinto PLC’s American Depository Receipts. With the ADRs trading around $130/share in this recent rally, this represents a P/E multiple of 13, similar to BHP. The “less reassuring” part comes from the added risk that Rio Tinto represents over BHP because of its heavy debt load. Rio is struggling to get Australian government approval to allow the Chinese aluminum giant Chinalco to invest $19.5 billion. Without it, Rio’s $40 billion of net debt could become too large a burden for the company.

The impact to Australian GDP would be substantial. In Australian dollar terms, the total exports of Australian coal and iron ore is expected to increase from A$45 billion to A$89 billion from last fiscal year (ending June 2008) to this fiscal year (ending June 2009). This A$44 billion increase is slightly larger than the government stimulus package (A$43 billion) and amounts to 3.7% of 2008 GDP. A fall back to June ’08 levels would be partially offset by some reduction in imports (less spending on heavy equipment) but the net exports that feeds into GDP growth could easily be two full percentage negative. Thus, if Chinese and other Asian customers succeed in negotiating back to 2007 prices, Australian GDP growth drops by at least 2%.

Issues of weak commodities prices like this should give potential BHP and Rio investors pause (to wait for a better price). The world equity markets are starting to show signs of life following two encouraging weeks of financial news but this by no means global growth is back on track. Many are looking to the commodities markets as a place to invest. There are a few positive indicators such as the stabilization in copper prices and the Baltic Dry Index.

People worried that the U.S. government is going to print its way out of its problems (thus stoking inflation) believe commodities are the place to be. Gold may increase as more ETFs buy bullion and store it vaults as an alternative to paper currencies. Industrial metals may be in short supply over the long term but iron ore and coal are not seeing near term shortage issues.

BHP and Rio are great companies, but their recent half year profits were more than 70% and 100% derived from these two segments where prices have yet to correct. As iron ore and coal prices correct later this year, expect further share price erosion. These companies are not yet cheap but they will get cheap later this year. When they do, BHP in particular will be a great buy.