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When you’re in a hole, stop digging – BHP and RIO

China’s seemingly insatiable demand for the steel-making ingredients of iron ore, metallurgical coal and manganese has formed the basis for the multi-year capacity expansion of the Pilbara iron ore industry.

In recent years, the high prices of iron ore in particular have fuelled enormous profits at BHP Billiton and Rio Tinto but these super-profits now appear to have abated.

Indeed, we might have said the high commodity prices have now been substituted by the impost of a high Australian dollar and rapidly rising costs.

The outlook for BHP and RIO earnings have taken on a considerably different hue over the last 12 months thanks to a greater degree of pessimism about the sustainability of China’s economic growth.

The companies have remained committed to the huge capacity expansions in the mines and the associated infrastructure in Western Australia due to overwhelming confidence that the long term demand from China is eminently sustainable.

Even a cursory glance at China’s rate of urbanisation provides a comfort factor that the companies are absolutely correct in their assessment.

But the market has taken a big bucket of cold water to the share prices of the materials sector in the ASX200 (dominated by BHP and RIO) and marked them down on the back of a series of write downs on projects and assets and the weakening outlook for global growth.

The market has instead preferred the high-yielding banks and Telstra along with a strongly bid healthcare sector thanks to CSL in particular.

But investors should be asking themselves the question about whether BHP, RIO and others in the resources sector are justifiably consigned to the sin-bin or whether they represent an opportunity to acquire high quality companies at a discount.

We think the latter applies if a sufficiently long investment horizon is accepted.

For example, RIO’s iron ore expansion to 383mtpa will be reached by 1H15. While we concede it’s difficult to forecast important factors such as the spot price of iron ore at that time, or the level of the A$, we would back the company to be selling every last tonne of its mammoth production.

BHP’s iron ore capacity is not as gargantuan as RIO but is economically significant and a quantum step larger than anything else in Australia. BHP is not as leveraged to iron ore as RIO but does have an impressive suite of world class resource assets that seem to be decidedly under-appreciated.

A newish factor has emerged in the current financial year that augments the argument to be topping up on these stocks. Both companies have consciously undertaken sales of second tier assets and have heavily scrutinised the capital expenditure budgets of existing and potential projects.

The best example of this has been BHP’s review and delay of the Olympic Dam expansion.

The consequence of asset sales and capex reviews is to substantially boost the free cash flow outlook for these companies.

Many investors lament the lack of capital management from the companies, especially with the increased balance sheet capacity to accommodate this, but it does seem incongruous to expect a world-leading resource company to elect to reward shareholders with dividends and share buybacks when the longer term earnings opportunities from their assets could be substantially larger.

Within the Australian market context, it also seems excessive to demand large dividend yields from the resource sector when investors are more than adequately rewarded from the financial sector.

With two new chief executives in charge at BHP and RIO, can we expect anything discernibly different in terms of strategy?

Perhaps. But we believe both Andrew McKenzie and Sam Walsh will make decisions based on the long term outlook for commodity demand and supply.

Earnings momentum may not look compelling for now, but these companies will not trade at such big discounts to their net present values for an extended period.

With new leadership in China keen to establish their credentials, clear signs of economic recovery in the US and surging cash flow inside the companies, investors should be accumulating BHP and RIO.


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