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At mid-point in 2011, world markets were confronted with a never ending series of potentially cataclysmic events looming in the future. 

The China story over a hard landing of economic collapse versus the soft landing of an economic slowdown bounced back and forth like a tennis ball. 

The United States had its credit rating downgraded for the first time in history in the face of apparent governmental paralysis. 

The never-ending European sovereign debt crisis droned on with every potential solution lasting a matter of days before some other factor changed the picture.

Yet despite all this, the Australian brokerage community continued to urge conservative Aussie investors to buy the twin towers of Australian economic might – BHP and Rio Tinto.  Here is some data from Reuters on analyst opinion for these two companies over the past three months:

Recommendation

This Month BHP/RIOLast Month BHP/RIO3 Months Ago BHP/RIO
Strong Buy8/87/87/8
Buy6/85/86/7
Hold3/04/02/0
Underperform0/00/00/0
Sell0/00/00/0

Source: Thomson Reuters

 

As you can see, no major broker is telling investors to sell.  And despite both RIO and BHP suffering from hefty share price falls over year, the bulk of broker opinion is in the buy camp.  The following chart shows the fall of these giants in the past year:

So what is going on here?  Are any of the distressing macroeconomic concerns factually based or are they representative of the kind of doomsday scenarios that come out of the closet when investor fear approaches panic levels?  In tough times, the Bears come roaring in slashing every share in sight with predictions often more typical of blatant fear-mongering than fact.

However, in many cases there is a kernel of truth buried in these warnings.  Here are some legitimate concerns for companies like BHP and RIO that are hard to deny and ignore:

* Iron ore prices are in decline, dropping 30% in October.

* Iron ore pricing mechanism is in transition. Contractual arrangements are likely to be shortened beyond the existing quarterly basis.

* China plans to step up efforts to increase its own domestic production of iron ore.

* World demand for commodities may be in jeopardy from European debt problems. China’s economy is slowing.

* Recessionary pressures in Europe or worse will have a negative impact on Chinese exports.

* No one yet knows the impact of the Australian carbon tax.

* First came Ireland and Portugal and then there was Greece.  Now there is Italy.  Who is next?  Contagion fears are spreading across Europe.

In light of all this, the question is:

Are there opportunities for investors in both RIO and BHP right now?

So far the brokers have lowered growth and earnings estimates slightly to reflect these real issues, but still see opportunities. Although there are risks involved, longer term rewards are real. Let us look at four reasons that make the case for continuing to hold BHP and Rio:

1.    History

2.    Diversification

3.    Management Performance

4.    Management Confidence

History

Since the dawn of man, individuals and countries possessing abundant natural resources have amassed wealth from intelligent use of those resources.  This has held true in the face of repeated global crises of all sorts.  Australia has resources in abundance and China is not the only growing country on the planet with increasing needs for those resources.

No matter how bad things get, the demand for our resources will not disappear, although demand may slow down.  In the long term, resources win out.  As an example to support this view, we only have to look back to the GFC.  Credit markets froze and global demand fell off a cliff.  Here is a 5 year chart showing the movement of both RIO and BHP going into that cataclysm and coming out of it:

You can see both the run up during the boom; the bust; and the subsequent recovery.  Shares of RIO have regained their glory and BHP is not far behind.  However, not all market participants are brimming with confidence about the future of these companies.  Here are some market valuation ratios for RIO and BHP along with their current dividend yields:

 RIOBHPSector
P/E7.468.7611.05
P/B2.123.431.23
P/EG.61.700.52
Dividend Yield1.8%3.0%4.3%

 

Both the P/E and the P/EG ratio for these companies indicate they are relatively inexpensively priced at current levels.  RIO is trading at a bargain price of about 2.1 times its assets.  As you know, a P/B less than 3 is a signal to value investors to take notice.  Both provide investors with a safe, if not spectacular, dividend yield.

Diversification

As a hedge against downturns, it is hard to argue against the strategy of portfolio diversification.  Some sectors get hurt more than others under different economic conditions.  As a corollary principle, companies that are diversified in their product offerings and geographic markets also offer hedging protection.

Although universally recognised as iron ore miners – RIO and BHP along with Brazil’s VALE are the top three in the world – both these companies have other revenue streams.  In fact, BHP is also a major oil explorer and producer, which is one of the reasons some analysts prefer BHP over RIO whose Energy business unit is limited to coal and uranium.  Both operate in geographic areas relatively safe from sovereign risk, including Australia and New Zealand and North America.

Of the two, RIO is more dependent on its iron ore production, another reason some analysts prefer BHP over RIO.  RIO is structured into five business operations units and two support units:

– Aluminium

– Copper

– Diamonds and Minerals

– Energy (Coal and Uranium)

– Iron Ore

– Exploration

– Technology and Innovation

BHP operates ten different customer sector groups (CSGs):

– Petroleum

– Aluminium

– Base metals (including uranium)

– Diamonds and specialty products

– Stainless steel materials

– Iron ore

– Manganese

– Metallurgical coal

– Energy coal

– Minerals Exploration

While some would argue these companies are at risk when the entire commodities complex falters, others counter the demand for coal in a world where coal is the principal fuel for the generation of electricity is less subject to downturns.

Management and Financial Performance

RIO ends its fiscal year in December while BHP ends in June so comparing the financial performance of the two companies on a year over year basis is difficult.  RIO’s numbers include the dire economic conditions of early 2009 while BHP’s do not.  However there is value in looking at year over year changes in both companies.  Here is a financial performance table looking at some key measures:

 BHP 2011-2010RIO 2010-2009
NPAT ($m)20,191 – 14,62914,094 – 5,432
Revenue ($m)66,969 – 62,10055,668 – 46,632
Long Term Debt ($m)11,535 – 15,92524,701 – 13,064
Gearing (%)35.58% – 48.25%50,1% – 22%

 

RIO’s performance improved on every measure.  Revenues and profit increased while the company reduced long term debt and its debt to equity ratio (gearing.)  BHP also showed healthy increases in profit and revenue but took on more debt to finance its expansion projects.  

Management Confidence

While the rest of the world worries, both these companies are investing heavily in their future.  It is one thing to pronounce a rosy outlook for the future.  It is quite another to back those pronouncements up with cold, hard, cash to go towards expansion.

Rio Tinto had already invested in increasing iron ore production output by a staggering 50% by 2015.  They now are accelerating the pace of the expansion project with a goal of 333 million tonnes a year.  They are also bidding to acquire the world’s largest public uranium producer, Hathor Exploration Ltd.  Currently, RIO derives approximately 60% of its revenue from iron ore and this acquisition will help their product mix.

BHP is also expanding.  Recent news highlighted their planned 1.6 billion dollar involvement in the Olympic Dam project in South Australia.  

The management of BHP and RIO may be on solid ground in their belief in the future of the mining boom.  A recent research report by HSBC sees the same future.  Looking forward to 2025, their analysts forecast Australia’s export trade will double to more than 700 billion dollars.  Of that figure, only 148.8 billion is seen going to China.

While the opportunities are substantial and somewhat predictable, the risks are not.  We live in strange times and the threat of a European country defaulting becomes more plausible every day.

In early November 2011 Forbes released the news the “bond vigilantes” were turning their attention to France.  Bond vigilante is a term used to describe investors who protest fiscal policies or lack of them by dumping their holdings, thus increasing yields.

Spain is already on the radar and the continued existence of the Eurozone and the European Union may be in jeopardy.  In the tangled financial world in which we live, it is hard to imagine how a default of one of these countries will not impact us all.

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Is it time to ditch BHP and RIO?

18 Share Tips – 28 November 2011

Peak of the mining boom, collapse of the property market

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