You may not have noticed, but BHP Billiton’s (BHP) and Rio Tinto’s (RIO) share prices have stopped tracking commodity prices. Their shares are rising, but the price of iron ore has been slumping.
How have they managed that?
We think both companies are hiding a fall in earnings and return on capital caused by the iron ore crash. Shareholders also aren’t taking enough notice of just how dependent BHP and RIO are on iron ore. Nor is there enough focus on their high-risk strategy of trying to drive high-cost Chinese iron ore producers out of the market.
Vital to shareholders and the economy
There is no doubt that BHP and RIO matter to shareholders and Australians. Both are major contributors to Australia’s export income; both are major world producers of iron ore, which is our largest individual export earner.
Resources account for more than half of our total export earnings, and the fortunes of our economy are aligned with these diversified mining companies.
But in the past six months commodities, including the price of iron ore, have been crashing on concerns about China’s growth outlook.
Both BHP and RIO are highly dependent upon the sustained growth in per capita income and the standard of living in China.
RIO has restated that the Chinese economic growth profile is a powerful cycle. We agree. However, as we are now witnessing, this does not mean that commodity prices will simply head higher.
The price of iron ore has now declined by over 40% in the last nine months and severely cut into the earnings of the major miners.
But shareholders seem to be ignoring that fact.
Figure 1. Australian Iron Ore stocks daily chart
So how are BHP and RIO getting away with this?
RIO’s sleight of hand
It’s because both companies have focused attention on the comparison of their June half result with the previous corresponding period in 2013, rather than on the immediate previous six months ended 31 December.
Let’s look at RIO first.
RIO is now very much an iron-ore centric company, and it has struggled in its attempts to diversify. Its annual production of iron ore has grown considerably in the last 4 years, and this has pushed group earnings higher and offset the floundering of other divisions.
In the six months to June, RIO generated 93% of its total earnings from iron ore; the results expose the poor returns generated from just about everything else that it produces.
Look closely…
RIO’s earnings report suggests solid growth in its underlying iron ore earnings.
But look closely. What it does not show is that underlying iron ore earnings were in excess of $5.5 billion in the December 2013 half. Over the six months to June, iron ore earnings actually fell by 15%, or $900 million, despite increasing production.
RIO has made good progress in its endeavours to cut costs and increase volumes over the period. However, these positives have been largely offset by the iron ore price decline, and margins have compressed by around 30%. RIO estimated that the iron ore price decline cost around $1.4bn of earnings compression based on the increased level of production.
BHP is at it as well
BHP has done the same thing. While BHP is not as iron ore-focused as RIO, the commodity has become a significant part of BHP’s business. Iron ore accounts for over 52% of earnings.
The decision to hive off poor performing minerals operations through a de-merger and to divert more capital to iron ore development suggests that BHP is directing its future towards the fortunes in iron ore and China.
For financial year 2014, BHP’s net profit of $13.8 billion was an increase from the $11.2 billion in FY13.
However, there was a marked deterioration in the June half ($5.7 billion) compared to December half ($8.1 billion). The decline in EBIT was not as pronounced with a decline of $1.4 billion – but it was a decline!
The breakdown of EBIT contribution is interesting, and especially the trends from December to June halves. For instance, while iron ore EBIT lifted by $1.0 billion over FY 2013, the June half was $900 million below December.
The Chinese battle shareholders are ignoring
Shareholders are also ignoring RIO and BHP’s strategy of increasing volumes of iron ore.
Remarkably, China produces over 44% of world production and it is this production that both RIO and BHP are attempting to drive out of the market by pushing their production higher (which results in sharply lower market prices).
Figure 2. Global Iron Ore Mine Production 2013
Source. Merchant Research & Consulting Ltd
In the main, Chinese producers have average costs of over $110 per ton and in the current environment they are clearly losing money.
It is the developing battle between Australia’s iron ore producers and those in China that must be monitored carefully.
How low do iron ore prices have to fall and for how long do they stay at that level to cause Chinese producers to halt production? Time will tell, but if it does not happen soon then RIO’s profits will be severely affected and so will its valuation.
The clear aim is to displace high cost Chinese production. This seems rational and it may well succeed, but we must remember that China will only allow its local producers to close if they are confident of future supply at a fair price.
In this context, the current free trade agreement and negotiations between Australia and China will take on extra significance. Is it free trade if China produces iron ore for its steel industry at a loss?
Value growth threatened
In the past five years, BHP has been a wonderful generator of capital from retained earnings. It had lifted equity by about $40 billion and distributed $28 billion in franked dividends over the last five years. There has been no capital raised from shareholders and this is impressive.
However, the elevated $A combined with falling iron ore and coal prices has affected ROE and profits. In FY14, BHP produced just $1 billion more in after tax profit than it did in 2010, despite employing an average $30 billion more of capital, and that is not impressive.
The above analysis and a review of the outlook statements for both companies suggest that the short term potential for value growth is threatened.
Without a sustained fall in the value of the $A, we think that both companies will struggle to grow earnings over the next 12 months.
In particular, we see a fall in the valuation of BHP; our target valuation of over $40 in mid-2015 has now declined to below $40. Indeed it is difficult to justify a purchase of BHP shares at prices much above $35 given our desire for a margin of safety.
Disclosure: Clime holds BHP Billiton
