Merrill Lynch has taken the axe to its earnings forecasts for the big two of Australian mining, BHP Billion and Rio Tinto after cutting its metal price forecasts.
And of the two, it’s treated Rio more harshly, describing its balance sheet as being "broken" in cutting 2009 (December 31) annual earnings estimate for Rio yesterday by 45% to $US4.032 billion.
The downgrades came after China’s latest economic stimulus failed to materialise, and confirmation emerged of yet another downturn in Chinese steel output.
As well, steady Chinese buying is supporting the prices of major commodities such as copper, zinc, aluminium and perhaps lead.
Among agricultural commodities, copper prices are the firmest, despite sharp falls in clothing sales at the retail level around the world and an equally sharp fall in Chinese clothing and textile exports, particularly to the US.
The downgrades also come as talk re-emerges of some sort of possible interest in the idea of a BHP-Rio link up.
At the moment, with Chinalco’s deal still on the table, a lot of alternatives will appear. From BHP’s point of view, Rio’s debt problem hasn’t gone away. It was still a major barrier to the last deal.
BHP has the financial clout to make that go away by getting involved in some sort of recapitalisation procedure
Merrills summed the current feeling by describing Rio as the riskier stock of it and BHP at the moment.
Merrills said BHP’s 2009 (June 30) year earnings estimate was cut 17%, and the 2010 but 30%.
"We have revised down our commodity price forecasts to reflect ongoing weakness in global economic activity and the decline in commodity prices & demand," ML said.
"Reduced metal & bulk prices drive earnings per share (EPS) downgrades for BHP: 2009E EPS -17% to US$1.58. 2010E EPS -30% to US$1.19/share.
""In our opinion, BHP’s best-in-class assets & balance sheet warrant a premium valuation vs. peers.
"While demand in China may actually be somewhat resilient we are more cautious on the outlook for the Rest of World (70% of commodities’ demand).
"While the market is encouraged by China’s positive Performance of Manufacturing Index (PMI) numbers, we believe that the key medium-term driver is the ongoing spill-over of the global financial crisis into real estate.
"Until real estate inventories stabilize, we think metal prices will struggle to persistently trade above their respective marginal costs of production.
"While BHP Billiton may no longer appear undervalued, we believe it is still a default holding for those requiring exposure to resources.
"It has a robust balance sheet, ongoing progressive dividend policy, 1st quartile assets that make money through the cycle."
Merrills said these attributes are also likely to be attractive to generalist investors who are disappointed with expensive defensive/income stocks.
"BHP may under-perform in a beta rally, but in a down cycle its low operational & financial leverage will allow it to outperform more heavily geared peers, in our opinion."
BHP shares closed down 2.3%, or 66c on Friday in Australia at $27.60.
Rio shares ended down 7 cents on Friday at $45.70. Investors are keeping it safe in case there’s a renewal of BHP’s interest.
For Rio, Merrills said that as with BHP "Lower assumed metal & bulk prices drive EPS downgrades for Rio. 2009E EPS is down 45% to US$3.10; 2010E EPS -36% to US$4.33/share.
"Rio is a riskier investment than BHP, due to uncertainty about the proposed Chinalco transaction
"Rio Tinto proposes to raise US$19.5bn from Chinalco.
"We see two potential outcomes. 1: FIRB & Rio shareholders approve proposed Chinalco deal, transaction is successfully executed, Rio recapitalizes balance sheet, shares rerate to reflect decreased financing risk. 2: Either the FIRB or shareholders do not approve deal, Rio required to opt for an equity rights issue.
"We note key strategic concerns on the Chinalco transaction: 1) potential for undue influence of China Inc. which may impact pricing power; 2) less chance of Rio shareholders achieving bid premium, in our view."
London reports suggest big shareholders there in Rio’s locally listed company remain unhappy at the Chinalco deal.
RIO CEO, Tom Albanese was in Australia last week selling the Chinalco deal.
From media reports late last week, he didn’t impress.
Local institutions want more disclosure on asset values and cash flow projections for those assets that Chinalco is proposing to buy into.
Rio seems to be avoiding releasing specific information.
That might require some sort of ruling from the regulators.
