Rio winning the “costs-out” race

While the competition to cut costs is not yet over, most mining analysts are tipping a win for Rio Tinto over BHP.

Summary: Vigorous cost-stripping at Australia’s two largest miners, BHP and Rio, is being tracked closely by the investment banks. While the verdicts differ, analysts agree there will be more money available to pay dividends in the next few years.
Key take-out: A robust cost focus from BHP and Rio has impressed most analysts.
Key beneficiaries: General Investors. Category: Shares.

And the winner is: Rio Tinto.

That appears to be the verdict of investment banks tracking the cost-cutting race that has broken out between BHP Billiton and Rio Tinto, Australia’s two biggest mining companies.

Not everyone agrees that Rio Tinto has cut deeper, or is repaying debts faster than BHP Billiton, but most agree that the race will eventually lead to rewards for shareholders in the form of either higher dividends or share buybacks, or both.

Macquarie Bank was one of the first to start keeping score in the “cost out” competition in which neither company would admit to being a starter, despite everyone in the resources sector being acutely aware of the rivalry between the two which has led to thwarted takeover attempts in the past, with each trying to buy the other at different times.

Last month, in the days after BHP Billiton reported an impressive 15% increase in earnings before tax and interest to $US12.4 billion, Macquarie noted that the company was on track to deliver on a promised an 11% reduction in overall costs in the current financial year. Rio Tinto’s targeted cost cuts totalled 10% of group spending.

Differences between the companies means there is no simple comparison between the two

But, as always when analysing the two giants of Australian mining it’s never a case of a simple comparison, not only because of a different asset focus, especially in dealing with BHP Billiton’s highly-profitable and capital-hungry oil and gas division, but also because they have different balance dates; BHP Billiton on June 30, Rio Tinto in December 31.

Another investment bank, JP Morgan, was impressed with BHP Billiton’s “upside surprises at the cost level in copper and aluminium” and that management appeared to be tracking well with significant savings achieved.

Credit Suisse chimed in with a report that started with the observation that a “capital management showdown” had started with both companies slashing costs and retiring debt at a rapid rate.

“As of December 31 Rio Tinto’s net debt was $US18 billion which compares to its target of $US15 billion,” Credit Suisse said. “BHP Billiton reported a net debt of $US27 billion versus a $US25 billion target.”

Cash flows have eased but remain strong

Both companies are also enjoying the benefits of strong cash flows from commodity prices which have weakened, but not substantially, and from record levels of mineral production and efficiencies flowing from the deep cost cuts being enforced across all operations.

Credit Suisse argues that Rio Tinto better placed to provide high returns to shareholders because it is “de-gearing” faster, a way of saying it is paying back its debt faster thanks to the benefits of greater exposure to iron ore and a greater focus on costs.

“On our numbers, Rio Tinto de-gears faster, reaching a net debt level of $US13 billion by the end of calendar 2014 versus BHP Billiton at $US24.7 billion,” Credit Suisse said.

“The main differences are BHP Billiton’s continued high spend on its shale operations, a higher payout ratio of 50% versus 35% and Rio Tinto getting a head start with $US1 billion from the Clermont (coal) sale and $US1.2 billion from the Turquoise Hill capital raising still to come.

“Going forward we forecast that Rio Tinto will have $US14.6 billion available for additional distribution by the end of calendar 2016. For BHP Billiton, we forecast $US12.5 billion by the end of 2017.”

UBS added its voice to the cost-out and shareholder reward debate by saying it expected a $US5 billion share buy-back to be announced with the full financial year result in August.

However, the UBS analysis also exposed a glitch in the BHP Billiton claim for top cost-cutter, higher-than-expected costs in the iron ore division “where costs in the (December) half were even higher than forecast,” UBS said.

The increase in costs in the BHP Billiton iron ore division was seized on by Deutsche Bank in the most definitive attempt so far to compare the cost cutting campaigns of both companies.

In a report published last week under the headline “who’s winning the cost out race” Deutsche Bank awarded first prize to Rio Tinto despite BHP Billiton being able to report a bigger number.
Graph for Rio winning the “costs-out” race

Source: Deutsche Bank

“BHP Billiton has removed $US4.3 billion, or 12% from its 2012 cost base over the past 18 months, and Rio Tinto has cut $US3.3 billion, or 9%, from its 2012 cost base over the past 12 months,” Deutsche Bank said.

“However, BHP Billiton has put more absolute costs back in relative to Rio Tinto, mostly from production growth. Overall BHP Billiton has reduced its cost base by just 1% compared with Rio Tinto at 7%. “Both companies have achieved an approximate 10% drop in copper equivalent unit costs.

“However, considering Rio Tinto’s reference point is six months behind, we believe they are leading the cost out race and have greater cost-out potential.”

What next?

Over the next 12-to-24 months both big miners will continue to bear down on costs with Rio Tinto’s focus expected to spread from  its energy (coal and uranium), aluminium and exploration operations, which have been hardest hit so far, to encompass its primary profit centre, iron ore.

BHP Billiton, which has achieved its greatest savings from its aluminium, manganese and nickel operations, is expected to deepen its cost-out effort to include iron ore and copper.

“Both big miners have hit a sweet spot with the cost out drive coinciding with record production growth,” Deutsche Bank said.

“It is likely that copper equivalent unit costs will reduce by another 4% to 6%.”

The critical question from the cost-out crusade is whether it is a process which simply adds to the short-term appeal of both companies, while not necessarily improving the long-term appeal.

The consensus view of seven leading investment banks is that BHP Billiton is a buy with a 12-month share price target of $42.07 which is 16.6% up on the stock’s most recent price of $36.07. The collective price forecast include BA Merrill Lynch at the top end with a price forecast of $45.50, and J.P. Morgan and UBS which both see $41 as the target.

Rio Tinto, in keeping with its status as the costs-out winner, is also offering the greatest potential win for today’s investors with a collective 12-month price target of $81.68 which is 32.1% higher than its most recent trade at $61.85. The consensus view includes UBS on top with a forecast price of $90, and BA Merrill Lynch at $69.

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