BHP versus RIO

About the author:

Author name:

By Tom Sartor

Job title:

Senior Analyst

Date posted:

15 August 2014, 9:21 AM

Sectors Covered:

Junior (Emerging) Resources, Bulk Materials

Rio Tinto Limited's (RIO) first half result set the tone for the August reporting season. The market is clearly rewarding the stock for the increasing likelihood of higher dividends, however we think that risks to RIO's underlying capital value do not justify the potential returns relative to BHP Billiton Limited (BHP).

RIO's 1H result

It was difficult to find negatives in RIO's 1H result reported last Thursday as earnings were ahead of expectations on most key segments. Most surprising though was RIO's ability to beat its own aggressive guidance on sustainable operating cost savings (another US$1bn to go) and capex guidance for FY15 which was a whopping US$2bn below previous guidance. 

This has ongoing negative implications for Mining Services providers/suppliers, but it's music to the ears of yield seeking shareholders as RIO have reduced net debt faster than expected.

Still the question remains - Is cost reduction and deferred growth the right reason to go overweight on a leveraged commodity stock?

The market is rewarding capital management

RIO management has all but promised higher capital returns beyond the progressive dividend levels at its February result, providing equity price support. We think the bigger implication from RIO's result was the potential for BHP to similarly beat expectations on cost savings, net debt reduction and potential returns. 

We expect BHP to announce its capital management intentions with its full year result on August 19. We're not holding our breath for any large 'one-offs' (like a large buyback), but rather expect a more sustained initiative such as another step up in the progressive dividend. 

This would similarly support the BHP share price.

Retaining a preference for BHP over RIO

The earnings sensitivities above demonstrate our preference for BHP over RIO for retail investors. While RIO is cheaper on several metrics, its reliance on iron ore is too excessive relative to the achievable upside in our view (especially when downside to iron ore markets probably outweigh the upside). The capacity for RIO to pay higher dividends and/or fund a buyback is far more leveraged to the health of the iron ore market relative to BHP. 

Iron ore has shown signs of strain in 2014 as the seaborne surplus has grown. With forecasts showing the iron ore surplus to nearly double in 2016, we think that RIO will eventually resume equity price action in parallel with iron ore pricing rather than capital management potential. BHP also offers superior absolute volume growth in the near term across a more diversified product mix, and its major growth options are located in far more stable political jurisdictions.

What we recommend

The share price for RIO has shown strength on the back of the first half result. Investors overweight in RIO should consider adjusting their portfolios and increasing their holding in BHP.

More information

Morgans clients can access our detailed research on BHP and RIO. If you are interested in finding out more, please contact your nearest Morgans office.

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