Deutsche has an interesting note weighing up whether or not BHP and Rio should pull back or continue to invest in new production today. It concludes:
The big miners are now focused on maximising cash flow through cost cutting and delivering brownfield expansions. This strategy should deliver benefits near term however over the long run additional projects will need to be approved in order to meet growing demand. Beyond what has been approved, BHPB and Rio have a number of high returning growth projects that should create value and increase cash flow over the long run. For Rio these include Pilbara 360 and the Oyu Tolgoi underground and for BHPB Spence hypogene, and further growth in the Pilbara, the GoM and US Onshore (see pages 9-15 for the full list).
Despite the markets concerns over further production growth we think that the diversified miners can continue to invest and grow dividends at the same time. However in order to add substance to the debate we have run a scenario where we look at BHPB and Rio Tinto without future production growth beyond those projects already approved (see Figure 1). The delta is significant. Removing high returning growth reduces valuations by c. 15% to around where the stocks are currently trading. Free cash flow yields (post capex and before dividends) would increase over the next three years by around 2% points or US$3b per annum if growth is delayed, however BHPB’s free cash flow and earnings would decline by 10-15% beyond 2016 and Rio’s by 25- 30%. In our view, the key question is whether management should delay high returning growth in order to maximise near term free cash flow and potentially dividends, however at the expense of value and future cash flow.
So that’s pretty clear then. Let’s face it, we are largely talking about iron ore here, especially for Rio:
Advertisement
Both scenarios use a long term iron ore price of $80. I expect we’d see different trajectories in reaching this price in the two scenarios. If the big miners pull back the price stays higher in the short term but still falls as competitors develop and take market share.
If they go ahead the price falls more sharply, more quickly, but in the long run the miners dominate again.
I tend to agree with Deutsche that shareholder value in the long term will be better served by more investment, sad as it is for the juniors.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
