This article appeared in the November 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Resource stocks are among the most challenging to value as profitability is often erratic, and forecasts are volatile because of unpredictable commodity prices. Therefore, it makes sense to be conservative and insist on a large margin of safety when investing in them. PAUL ZWI of Clime Investment Management reports.
By Paul Zwi, Clime Investment Management
In the past few weeks we have learned that China’s gross domestic product expanded by a “disappointing” 7.4 per cent in the third quarter from the same period a year earlier, marking the seventh consecutive quarter of slowing growth in the world’s second-largest economy.
China is on track for its weakest annual growth since 1999 thanks to slowing domestic investment and limp demand from major export markets. In the US, Caterpillar, the maker of earthmoving, construction and mining machines and often seen as a barometer of activity in the resources sector, cut its full-year profit forecast sharply, saying dealers were pulling back on orders in the face of economic uncertainty.
We first started hearing about the commodities “supercycle” back in 2003-04 and watched in amazement as a range of commodity prices took off, driven by seemingly insatiable demand from a rapidly urbanising China. Much has happened since then and we face a different post-GFC world. So how should investors approach two of the most important shares listed on ASX, our great diversified mining companies, BHP Billiton and Rio Tinto?
(Editor’s note: ASX is hosting the Australian Resources Conference and Trade Show in Perth from November 12 to 14. Visit ARC for information on the event.)
Understanding the big miners
BHP is the world’s largest diversified mining company with a market capitalisation of $100 billion (the value of its shares on ASX) and is also listed in London. It makes up 10 per cent of the S&P/ASX 200 index and is about four times the size of Rio Tinto.
Both are bellwethers of the Australian sharemarket. They are so dominant that where they go tends to point to the market’s direction; they are the barometers of the resources industry, which is of such importance to the Australian economy. So are the bellwethers ringing?
(Editor’s note: Do not read the ideas below as stock recommendations. Do further research of your own or talk to your financial adviser before acting on themes in this article.)
BHP has a wonderful and rich history. It listed in 1885 and has a clearly enunciated strategy of owning a diversified portfolio of large, long-life, low-cost and expandable assets. Today, the focus is on iron ore, coal, base metals, oil and gas (including shale oil) and potash. Diversity of production is an attractive attribute, as prices across the commodities spectrum often move in different directions.
BHP will make a net profit of around $20 billion this year and next, and has a strong balance sheet that can be used to fund growth capital expenditure, acquire companies, pay dividends or re-activate a share buyback.
Rio also has a long and proud history, and a similar diversification strategy. But it made a series of blunders in the run-up to the GFC that have taken five years to work through. In late 2007 Rio acquired aluminium miner and producer Alcan at the top of the commodities price cycle, in a US$27-billion deal, and took on massive debt to do so.
Six months later, the GFC meant the aluminium price was collapsing, debt markets were in turmoil, and BHP saw its opportunity to bid for a weakened Rio. The bid was made and withdrawn over the course of 2008, with Rio forced to conduct a deeply dilutive capital raising at the depths of the market in 2009.
The boom days are over, but …
BHP and Rio are now driven by different forces than the mergers and acquisitions mania that tends to herald the end of long booms. Today, both companies have solid balance sheets and chastised managements committed to living within their means. They are focused on cutting costs and exploiting existing brownfield opportunities within their large portfolios.
Over the past year, BHP and Rio have massively underperformed the market. Since peaking at $49 in April 2011, BHP’s share price has fallen by 24 per cent to $34 (at October 24, 2012). Rio peaked at $89 in February 2011 and has since fallen by 37 per cent to $56. During that same period, the market index has declined only 9 per cent.
Of course, this underperformance reflects a range of factors, including the peaking of commodity prices, nervousness about global growth amid the eurozone turmoil, a slowing China and a spluttering US economy, a search for the supposed refuge of “quality” government bonds, and uncertainty about what BHP and Rio will do with their free cash flow.
This last factor is particularly interesting in the case of BHP, because its capital management decisions are likely to have a large bearing on its longer-term share price.
BHP’s capital management options
Like all companies, BHP has four main options for deploying the vast profits it produces:
- Organic growth
- Acquisitive growth
It is the capital management choices management makes that significantly influence value and shareholder returns over time.
Organic growth options
There are a number of mega projects competing for BHP’s growth capital, including US oil and gas, Olympic Dam (copper and uranium), potash in Canada and the Outer Harbour iron ore expansion in Western Australia. BHP has shelved or curtailed immediate plans for these projects but is likely to revisit them as and when markets consolidate and risks diminish over the next few years.
Although one might be sceptical about whether some of these projects will ever receive the green light, the fact remains that they are growth options available to BHP should the situation be favourable. These projects have the capacity to be transformational over the next 15 or 20 years. But they come with risks.
All meet BHP’s criteria that they be long life, low cost and expandable, but they have very large upfront costs and long lead times before shareholders enjoy significant cash flows and increasing profitability. In the short term they are likely to lead to pressure on return on equity (ROE) levels.
Acquisitive growth options
These are best done opportunistically. Acquisitions always entail heightened risk and all too often an excessive price is paid for “strategic” reasons. Unfortunately, BHP’s management has not been very successful in this area. After missing the deal of a generation by not acquiring Rio during the height of the GFC, BHP has a mixed track record in mergers and acquisitions, and significantly overpaid for Petrohawk’s shale gas assets in the US.
Because of the nature of the industry, we do not expect management to stop trying to acquire assets, but would prefer the focus of investing capital to be on the large number of organic areas.
Where there are slim opportunities for organic or opportunistic acquisitive investment and the share price is not meaningfully cheap, dividends are a perfectly rational response for managers seeking to maximise value and to reward shareholders for their support. The hurdle rate to retain earnings in Australia is higher than in other jurisdictions because of the benefit of franking credits. But paying a dividend when the share price is remarkably cheap is not a rational capital management decision.
In the decade to 2012, BHP increased gross dividend payments by 21.7 per cent compound annual growth rate (CAGR) at an average payout ratio of 45 per cent. Over the same period, the market increased dividends by 5.4 per cent CAGR at an average payout ratio of 75 per cent. BHP has a progressive dividend policy; that is, it seeks to steadily increase dividends each year. Our view is it would make most sense to re-activate a buyback of shares.
These should be considered by financially sound businesses when their shares are trading at meaningful discounts to a fair valuation. Buybacks conducted cheaply increase ROE and add value to remaining shareholders at the expense of departing shareholders. Conversely, buybacks at expensive prices destroy value and reward leaving shareholders at the expense of those remaining.
At today’s share price of $34, compared with our fair value for BHP of $39, a share buyback makes sense. Compared to the current organic growth options on a value-creation basis, it is hard to see the logic of BHP not undertaking some form of buyback. The challenge is that buybacks do not increase the size of the balance sheet.
Resource businesses are among the most challenging to value as the profitability achieved is often erratic and forward estimates volatile because of unpredictable commodity prices. Therefore, it makes sense to be conservative and insist on a large margin of safety, arguably present in BHP. Clime values BHP at $39, which is a discount of 13 per cent to the current market price.
Clime has a valuation of $56 on Rio, which is similar to the market price at the time of writing, and therefore we are less attracted to Rio compared to BHP. Both companies rank highly on our qualitative ratings system (equal 8.5 out of 10), which assesses a large range of financial and solvency ratios. We assess Rio’s normalised return on equity to be 21 per cent in the next few years, whereas the figure for BHP is a little higher at 27 per cent.
Over the next decade, BHP’s earnings mix will tilt towards energy-related commodities such as oil, gas and uranium, and also potash, in line with the view that the world is becoming more energy constrained as energy consumption ramps up in emerging economies and they consume more protein-rich foods as GDP per capita increases. BHP appears well positioned for this transition - better than Rio, which is much more focused on iron ore production.
Neither BHP nor Rio is likely to appeal to an investor with a bearish view on global growth, although the grossed-up dividend yields are now above the long bond return. But since their prices have come back, much of the risk has come out of them.
For BHP, at around $30 we feel the margin of safety is adequate to warrant investment in a long-term portfolio. We would be a little more cautious about Rio and would be attracted to it at share price levels at or below $50. Perhaps the bellwethers are beginning to ring.
About the author
Paul Zwi is a Director, Private Clients at Clime Investment Management.
To learn more about ASX-listed resource companies, watch the current series of ASX Corporate Profile videos.
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