BHP and Rio stumble

BHP and Rio are struggling … and shrewd investors, including Glencore’s Ivan Glasenberg, see through the false economics of over-producing.

Summary: While Glencore stalks Rio Tinto, BHP Billiton is trying to win support for its demerger plan, and both major miners are expanding their iron ore operations in the face of a falling price. All-in costs are likely higher than reported and investors appear to be seeing through the miners’ spin, with BHP’s market cap falling more than $21 billion since the spin-off plans were announced. Rio has rejected a merger offer from Glencore, but the suitor knows how to play the takeover game. BHP could be next in line to receive an offer.

Key take-out: The divergence between the aims of the major miners’ shareholders and management has been widened by changes in commodity and capital markets. This gives raiders an opportunity to pounce.

Key beneficiaries: General investors. Category: Shares.

Australian investors are familiar with one of their favourite resource companies being humbled from time to time by management mistakes, but rarely do they see both BHP Billiton and Rio Tinto stumble at the same time.

That, however, is precisely what they are watching today as Glencore stalks a wounded Rio Tinto and BHP Billiton tries to win support for its deeply unpopular plan to spin off assets regarded as non-core.

As if that isn’t bad enough, both giants of Australian mining are behaving as “yesterday’s men” by launching dramatic expansions of their iron ore operations despite a falling iron ore price. More ore is certain to further depress the price for years, perhaps decades.

Rather than looking forward to a changed resources world which is over-supplied with raw materials, management at both BHP Billiton and Rio Tinto are looking back at the boom in bulk commodities (mainly iron ore and coal) and hoping that the boom will return. (Both BHP and Rio are currently rated as "holds" in Eureka Report stock recommendations.)

The massive iron ore expansions announced by both companies over the past week are claimed to be the best use of shareholders’ funds because of the profit margin still available on low-cost ore sold at today’s depressed price of $US80 a tonne.

But there are multiple risks associated with the iron ore investments. More ore will drive the price lower, delivering most of the benefit to Asian steel mills, killing smaller Australian mining companies and ensuring that institutional investors are amenable to an alternative plan from alternative management – which was explored here three weeks ago (Winning Rio, September 22).

Back then the central thesis was why Glencore’s fleet-footed and value-driven chief executive, Ivan Glasenberg, could win control of Rio Tinto by marketing his success in building a world-class resources and commodity trading business, while drawing the attention of investors to Rio Tinto’s accident-prone past and poor vision for the future.

Amazingly, a similar but subtly different set of circumstances are unfolding at BHP Billiton where management has an equally chequered history of getting as many things wrong as they get right, with the decision to split the business universally condemned by investors (BHP’s big mistake, September 29).

The potential repercussions of what’s happening at BHP Billiton and Rio Tinto are enormous given that it’s happening at a time of unprecedented shareholder activism and widespread disillusionment with the performance of most investment portfolios, especially those heavy with resource-linked stocks.

Low interest rates are one of the catalysts for investors demanding that companies do more to boost returns, either by capital management (such as higher dividends, buybacks or capital returns) or by cancelling projects which do not deliver immediate returns.

It is the combination of low interest rates, poor portfolio returns, falling commodity prices and shareholder activism which has wiped $21 billion off the market value of BHP Billiton over the past eight weeks.

That collective loss suffered by all BHP Billiton shareholders has been caused by a fall in the company’s share price from $39.74 on August 19 (the day it announced its plan to split) to yesterday’s close of $33.24, a fall of 16.4% over just 37 trading days – or more than $500 million a day.

Graph for BHP and Rio stumble

What seems to be happening is that investors are seeing through the public relations spin of BHP Billiton and Rio Tinto, particularly when it comes to the future flow of profits from iron ore.

The key there is to discount the much-quoted $US20 a tonne cost of producing a tonne of iron ore at the WA mines of both companies. Rio Tinto says it is already at $US20 a tonne. BHP Billiton says it is targeting $US20 a tonne.

But what both companies are doing is trying to pull the wool over the eyes of investors in the same way gold mining companies did when they made production cost claims a few years ago only for investors to discover that the cash cost often quoted is not the full cost.

Using selective cost data caused a furore in the gold industry two years ago, leading to a famous showdown between the industry and the man running one of the world’s biggest mining investment funds, Evy Hambro, chief executive of the Black Rock World Mining Fund.

It was Hambro who lambasted gold miners at the 2012 Mines and Money conference in London for not openly revealing their full costs.

Hambro’s outburst, and similar comments from his associate, Catherine Raw, led to an entirely new form of cost reporting in the gold industry that starts with the cash cost, and then adds other charges (such as royalties and depreciation) to produce firstly a number called the “all-in cost”, and then a second and higher number called the “all-in sustaining cost” – which is what it will cost to keep a mine operating into the future.

Neither BHP Billiton nor Rio Tinto talk openly about the all-in cost or all-in sustaining cost of their iron ore operations but both are highly likely to be closer to $US40 a tonne (or more) than the $US20 a tonne widely reported.

The problem now is that savvy investors are starting to ask probing questions about what management at both companies is doing with shareholders’ funds, and whether the plans revealed for more iron ore are a good idea.

It is possible that the iron ore expansion programs are the best use of capital in the current period of depressed commodity prices which has seen most minerals (and fuels) plunge.

Coal is unquestionably a poor investment (hitting both BHP Billiton and Rio Tinto). Oil has also fallen sharply and looks to be entering a prolonged period of over-supply (hitting BHP Billiton). Other commodities are equally uninspiring.

But, pouring more capital into expanded mining operations at this stage of the commodity cycle could be the worst decision ever made by either company – as Hugh Morgan suggested last week (Morgan: Base metals to rebound first, October 1).

The key to Morgan’s comments can be found in the nature of commodity cycles with their short upward spurts (triggering investment in new mines) followed by long downward cycles as the new material is absorbed.

In the best example of the cycle at work it can be argued that the down phase lasted 30 years with the period from 1974 to 2004 broken by occasional price spikes in certain metals set against a long-term downward trend in real returns.

Glencore’s Glasenberg, perhaps more than anyone working at BHP Billiton or Rio Tinto, understands the commodities world and how it passes through regular peaks and troughs in supply and demand.

He also understands how to play the takeover game by first weakening the defences of an opponent through asking questions of the competency of management, past and present, and by then claiming to have a set of values at Glencore which is more closely aligned to the objectives of investors than those of management.

Glasenberg has the credibility to make those points because of Glencore’s success, and because he is the only chief executive at the top end of mining who has a big personal stake (skin in the game) courtesy of his 8% holding in Glencore.

For BHP Billiton there does not seem to be an immediate threat of a takeover bid, though some shareholders might welcome it to light a fire under the share price.

Rio Tinto is different. It has received a merger suggestion from Glencore and its management team has rejected that proposal.

However, it is deeply significant that Rio Tinto management chose to not tell the owners of the company that a merger proposal had been made by Glencore in July, and that since news of the proposal leaked last week the share price of Rio Tinto has risen sharply.

Yesterday’s $2.48 (4.3%) rise in Rio Tinto’s share price was welcomed by shareholders but it was a reminder that investors are prepared to put a higher value on the company as a takeover target than as a business pushing ahead with questionable mine expansion plans.

What seems to be happening is that a disconnect between the aims of management and shareholders has been widened by changes in commodity and capital markets, creating an opportunity for raiders to pounce.

Rio Tinto is the first to receive a merger proposal. BHP Billiton, after its recent poor share market performance, could be next.

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