The big miners are commonly considered disasters for good reason. A quick glance at long term performance doesn’t flatter the businesses or, especially, management teams.
‘This time is different’ is always the catchcry and never the truth and that goes for the propensity of management to sensibly allocate capital. Too often – perhaps always – management over-commits to acquisitions and expansion at the worst possible time.
That propensity for waste could be a source of mispricing today.
One of the oldest tricks to inflate profit, especially for asset-heavy businesses like miners, is to underinvest in the asset base.
This involves lowering capital expenditure to the bare minimum and reporting higher free cash flows as a result. Liberated cash can then be used to lower debt or to pay dividends to appease investors.
A telltale sign of this is to compare capital expenditure with depreciation. A wide and growing gap between the two sums can suggest underinvestment in assets. This is a dangerous game as it lowers long term returns from the asset base and, more commonly, simply defers spending from one period to the next. Fiddling, in other words.
Many analysts accuse BHP Billiton (ASX: BHP) and Rio Tinto (ASX:RIO) of engaging in such tactics right now. A look at the numbers might suggest they have a point. Both BHP and Rio report spending far less on capital expenditure than they are depreciating. Is this another fiddle?
In my view, no. High depreciation levels from both miners are a result of past capital allocation decisions.
Over the past five years, BHP spent about US$80bn on capex; Rio spent about US$60bn. 'Property, plant and equipment' on both miners' balance sheets is a little less than it was in 2015 (because of writedowns) but a lot higher than it was in 2011 or 2012.
Both miners are depreciating an asset base that was inflated in both volume and cost terms because of The Great Boom.
Yet they will maintain that asset base in entirely different conditions, when the price of equipment and labour is significantly cheaper and when efficiency gains release additional output.
Capital expenditure should be well below depreciation for the foreseeable future. In other words, BHP and Rio are understating profits at the moment.
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