Why Rio and BHP might not deliver on shareholder returns

Institutional shareholders in BHP Billiton and Rio Tinto have long demanded better levels of capital management, but two recent developments could leave them disappointed.

For most of the past 18 months, BHP Billiton’s Andrew Mackenzie and Rio Tinto’s Sam Walsh have been preaching the virtues of lower costs, less capital expenditure and bigger returns to shareholders in this post-commodity environment.  But a key element of their agendas may not be delivered.

Both the big resource groups have delivered and are continuing to deliver on what they call their productivity programs: the mixture of cost-cutting, volume increases and lower capital expenditures that has characterised both their results over the last year or so.

While they have been increasing their dividends, neither has yet produced the capital management programs demanded by institutional shareholders.

The absence of a share buyback or some form of capital return was evident in the initial sharemarket response to BHP’s recent full-year result, even though its proposed demerger of non-core assets could be regarded as akin to a $US14 billion ($A15bn) or $US15bn ($US2.60 to $US2.80 per share) return of capital to shareholders.

The reason that they were disappointed is that BHP had steered the market towards an expectation that the threshold for a conventional capital management program would be reached when net debt fell to $US25bn. As it happened, BHP very narrowly missed that target in the year to June, with net debt falling to $US25.8bn.

There are two developments that could threaten the ability of the two big miners to deliver on the promise of greater shareholder returns. One is obvious; the other more subtle.

The obvious one is, obviously, what’s been happening to the iron ore price.

With more than 90 per cent of Rio’s earnings and more than half BHP’s generated by their iron ore businesses, the steep decline in the price -- it fell below $US85 a tonne overnight and, at $US84.30, is at its lowest level in five years -- has obvious implications for their profits and cash flows.

While the intense focus on reducing costs and lifting volumes was sufficient to offset the price declines in both their most recent reporting periods, the current iron ore price is now about 18 per cent lower than Rio’s average realised price of $US103 a tonne in the June half-year, which was itself about 20 per cent lower than the average price in the same half of 2013.

Both the big Pilbara miners, and for that matter Fortescue Metals, are continuing to increase production. Exports out of Port Hedland are currently at record levels and about 35 per cent higher than a year ago. However, it is an open question whether the remaining scope for cost cutting and the increase in volumes can completely blunt the severity of the price decline.

In BHP’s case, there is another key price to consider. 

The big differentiator between BHP and its mining peers (and the big diversifier within its cash flows) has been its large petroleum and gas business. Since the end of the financial year, however, oil prices have fallen around 7 per cent. Both its major commodities are experiencing price falls at the same time.

Unless and until prices stabilise, Rio and BHP are likely to be acutely conscious of the threat the price declines represent to their levels of earnings and cash flows, even though the cost bases in their iron ore businesses (both would be below $US50 a tonne, with Rio closer to $US40 a tonne than $US50 a tonne) means the businesses would remain very profitable, only less so and at far lower prices that they are experiencing today.

The pressure on earnings being exerted by the price declines will, however, tend to make them more conservative about any prospective capital management activity.

The other, more subtle, factor that may shape their thinking on shareholder returns is an apparent shift away from net debt as the trigger point for capital management initiatives.

It is apparent from some of the analyst notes since the results were issued that both resource houses are taking a somewhat more sophisticated approach and are more concerned about their credit ratings than a simplistic measure of balance sheet capacity.

If BHP wants to retain its 'A ' rating and Rio its ‘A’ rating, they won’t be focused purely on their levels of net debt but on the relationship of their cash flows -- particularly their free cash flows-- to net debt.

That focus would be more acute in the current environment, given the rate at which iron ore and oil prices have declined and the extent of the freefall in the iron ore price.

In BHP’s case, it also has its demerger to execute sometime in the first six months of next year, before it even starts thinking about other changes to its capital structure. Rio, after its post-crisis brush with near-disaster, will have its own and deeply-ingrained reasons to take a conservative approach.

Shareholders in resource companies didn’t get the levels of capital management they wanted during the commodity boom and, despite clamouring for them since, haven’t received much subsequently.

The current iron ore and petroleum price settings, and the inevitable conservatism that will promote within the big miners, could mean the shareholders will remain unsatisfied for longer than they might have anticipated as recently as a few months ago.