1. Rio Tinto versus BHP boils down to investors’ choice of commodity

Rio Tinto versus BHP boils down to investors’ choice of commodity

The backgrounds of the leaders of the world's top mining companies illustrate the choice facing investors, with BHP Billiton's chief executive having worked in the oil industry and Rio Tinto's new boss more focused on copper.

By: | London | Updated: September 7, 2016 12:28 PM

The backgrounds of the leaders of the world’s top mining companies illustrate the choice facing investors, with BHP Billiton’s chief executive having worked in the oil industry and Rio Tinto’s new boss more focused on copper.

After aggressive cost-cutting and asset sales to drive down debt, the two mining giants are positioning themselves to capture growth as commodity markets begin to recover from a crash that dented company balance sheets.

French-born Jean-Sebastien Jacques has led Rio only since July, while his counterpart at BHP , Scotsman Andrew Mackenzie, has been in place for the turbulent past three years.

Both men sang from the same songsheet when presenting financial results last month.

They ruled out the reckless spending of the past that almost led to financial ruin and promised to be safe, boring and disciplined, buying assets only when the price was right and maintaining the focus on lowering costs.

Rio is widely regarded as the better pick, with more analysts rating it a “Buy” than BHP, according to Reuters data.

Rio has the advantage of having cut debt faster, while investors have also been put off BHP by a dam burst at an iron ore mine in Brazil last year that could lead to years of litigation.

But there are signs of a shift in sentiment as investors weigh the two miners’ exposures to different commodities.

Since the start of the year, BHP has rallied more than Rio — 31 percent versus 17 percent on the London stock market — and some analysts see better potential for BHP’s coking coal and oil assets, compared with Rio’s greater exposure to iron ore.

“It’s pretty much a tie. Both are cautious and both have had big failures in the past,” one industry source said, speaking on condition of anonymity. “Oil is the swing factor and that’s a fairly safe bet longer term.”

Chris LaFemina, managing director at Jefferies, upgraded his recommendation on BHP to “Buy” from “Hold” last month, having already rated Rio a “Buy”.

He cited BHP’s potential to cut costs further and its bigger exposure to coking coal and oil.

Coking coal has rallied because of demand in top consumer China, while oil needs an output agreement from the Organization of the Petroleum Exporting Countries to get a meaningful boost.

RISKS REMAIN

Frances Hudson, investment director, at Standard Life says it is pragmatic to have exposure to at least one of the two big miners given their heavyweight presence on the FTSE index of leading British stocks.

Rio’s market capitalisation is 43.7 billion pounds ($58.7 billion), while BHP’s is almost 59 billion pounds, according to Reuters data.

Reuters lists Standard Life Investments as the 15th largest investor in Rio’s London-listed share. It does not appear among the top investors in BHP, but does have a smaller stake.

Not everyone feels it is time to reinvest in the mining companies after BHP plunged more than 40 percent last year and Rio lost around a third of its value.

Liberum investment bank rates both Rio and BHP a “Sell”.

Liberum analyst Richard Knights said BHP’s Samarco Brazilian joint venture, liable for last year’s dam burst, was a small asset for the company in financial terms. However, the concern is that no one can rule out massive damages being awarded after legal arguments.

Rio has been boosted by its greater exposure to iron ore which has rallied by around a third this year on the Dalian Commodity Exchange.

Iron ore, used in making steel, results in higher profit margins than oil because it requires less reinvestment to maintain output, analysts say, so it provides cash to improve Rio’s balance sheet and boost dividends.

Analysts, however, question the durability of the iron ore rally given the global oversupply.

“Rio has the best assets in iron ore and aluminium, but those are commodities have two of the worst supply/demand outlooks in my opinion,” Knights said.

DIFFERENT PORTFOLIOS

Jacques got the top job at Rio after winning praise for his work on the Oyu Tolgoi project in Mongolia, which when completed will be the world’s third-biggest copper mine.

Known as “JS”, he is the first copper man in decades to run the company and his appointment was seen as a shift away from iron ore.

Rio gets less than 10 percent of its core profit from energy and roughly 60 percent from iron ore.

BHP’s boss Mackenzie held a number of senior roles at oil company BP, and also headed the diamond and minerals division at Rio.

For BHP, iron ore makes up roughly 40 percent of its EBITDA – earnings before interest, tax, depreciation and amortisation – and oil assets around 30 percent. Coal, including thermal and coking, accounts for some 5 percent.

BHP last month listed the swing factors that could affect its core profit.

The firm would receive a $42 million boost for each $1 increase on the price of a tonne of coking coal.

Another dollar on the oil price would add $79 million to EBITDA in the current financial year, while an extra $1 per tonne for iron ore means $217 million in extra profits.

This year hard coking coal has nearly doubled, while oil has increased roughly 25 percent.

Rio sets out its exposure differently. “Rio Tinto’s exposure to commodity prices is diversified by virtue of its broad commodity base,” it said in its results statement.

COPPER BET

Analysts say its geographical reach takes Rio into riskier parts of the world than BHP, which is focused on OECD countries, giving Rio more potential to grow and broaden that base, especially in copper.

Combined with diamonds, copper now provides some 11.5 percent of Rio’s EBITDA.

Essentially flat since the start of the year, copper has failed to match rallies elsewhere, but analysts and executives say the laggard could become a leader.

In an interview with Reuters shortly after becoming CEO, Jacques said he believed copper could be the first commodity to “get out of the over-supply environment”.

At the end of 2015, Rio had 252 million pounds of copper sales provisionally priced at 217 cents per pound.

A 10 per cent change in the price of copper from provisional prices, would increase or reduce net earnings by $36 million.

For some investors, the sluggishness of copper, regarded as a commodity bellwether, fuels their doubts about further gains even if low interest rates have renewed interest in miners.

Roger Jones, head of equities at London and Capital, said he believed investors had limited their exposure to the mining sector for the last few years “but the magnitude of the underweight has been reduced”.

London and Capital, which has around $3.2 billion of assets under management, does not hold share in either Rio or BHP.

“In our view, both share prices are assuming a strong recovery in end markets which we believe is unlikely as current commodity markets are likely to move sideways at best over the medium term,” he said.

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