BHP vs Rio: which would you choose?

Financial journalist and commentator on 3AW and Sky Business
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One of the most obvious longer-term investment exposures to lock-in – and hold – in recent years has been to follow the economic rise of China.

The transformation in the Middle Kingdom over the last 30 years has been astonishing. What was a smaller economy than Australia in 1981 is now the biggest influence on the global economy, and is poised to overtake the United States as the world’s largest economy within the next three years.

Australian investors have been in the box seat when it comes to investing in the China theme – for them, it is as easy as buying Australia’s big miners, which have become major suppliers of raw materials to China.

And not only China: the emerging economies of India, Indonesia and Vietnam will all need raw materials to power their continuing industrialisation.

Resource riches

This is where Australia’s global diversified ‘bulk’ miners  BHP Billiton (ASX:BHP) and Rio Tinto (ASX:RIO) – both of which started corporate life in Broken Hill more than a century ago – come in.

For generations the names of BHP and the old Conzinc Riotinto of Australia (CRA) were the bluest of blue-chip Australian companies, with the shares treated as family heirlooms. Although BHP Billiton and Rio Tinto long since departed Melbourne for life as dual listed companies (DLCs), with major listings in London and New York, they are still very important to Australian investors, for good reason.

BHP has a global production portfolio covering most major commodities, including petroleum, copper, gold, iron ore, coking coal, energy coal, aluminium and nickel. (Until last month, diamonds were also part of the mix.)

Rio also has a world-class portfolio of assets in aluminium, coal, copper, diamonds, gold, iron ore, industrial minerals and uranium.

This diversification is a highly attractive – and comforting – attribute for retail investors, because it lessens the risks associated with a single-commodity exposure; for example, Fortescue Metals, which only produces iron ore.

But while the two companies are similar in their wide diversification, they are also quite different in terms of the breakdown of where their earnings come from.

A critical element

Iron ore is expected to account for just over 50% of BHP’s 2012 earnings, with petroleum and base metals contributing about 22% and about 18%, respectively.

Rio Tinto is significantly more top-heavy, with iron ore expected to generate more than three-quarters of its calendar 2012 earnings.

This means that the iron ore price is a pretty important number for both companies. And there, after several lucrative years, the last year has been a horror show.

In 2008, as the global financial crisis worsened, some steel mills deferred or cancelled orders to iron ore miners, causing a supply overhang and sending prices lower. The price in mid-2009 was US$60 a tonne. But by September 2011, that had surged to US$181 a tonne, with a consequent rub-off on the big miners’ earnings.

However, with the economic downturn in Europe – China’s biggest customer – savaging export demand, China’s economy began to slow and by August this year, iron ore was back below US$90 a tonne.

It has since recovered to US$115.30 a tonne, but the price volatility is not going to go away, as the demand side relies on China’s growth rate recovering, and on the supply side, additional supply starts to hit the market.

Both BHP and Rio Tinto – along with their global peers – have adjusted their plans accordingly.

Cost cutting

BHP has frozen more than A$50 billion of big Australian projects from its near-term growth plans and shelved an already-approved Queensland coking coal expansion. The company has put on hold (until at least July 2013) plans to spend about $30 billion expanding the Olympic Dam copper-gold-uranium mine in South Australia to become the world’s biggest open-pit mine, and the world’s largest uranium mine within 11 years; and spend almost $20 billion expanding the outer harbour at Port Hedland in Western Australia to boost its iron ore volume.

BHP chief executive Marius Kloppers says current spot prices are above BHP’s long-term targets for virtually every single commodity, and notably for its big profit drivers – oil, coal, copper and iron ore.

For its part, Rio says it will press ahead with US$21 billion worth of mine, port and rail work to boost its Australian iron ore capacity, but acknowledges that it has to strip US$7 billion from its cost base to cushion the effect of weaker commodity prices – and sell more assets. (That may be code for the company’s disastrous aluminium business, the US$38 billion Alcan acquisition from 2007, which has been more than half written-down already.)

The differentials

In Rio’s favour is that it earns much higher margins than BHP for its iron ore. But then again, it is far more exposed to iron ore, and that’s what makes BHP look a touch more attractive at present.

The crucial difference is petroleum. BHP has been in the oil business since its first discoveries in Bass Strait in the 1960s, and remains a big global player involved in oil, gas and liquefied natural gas (LNG) on six continents. BHP produces more than twice as much oil and gas as Australia’s biggest stand-alone oil company, Woodside Petroleum. Last year BHP spent US$20 billion on shale gas assets in the USA, positioning itself for the coming boom in this form of petroleum. Some analysts even estimate that petroleum could edge past iron ore this financial year as the largest contributor to BHP’s profit.

Rio Tinto has a star diversification of its own, its mineral sands business, in which BHP no longer participates (it sold the last of its assets to Rio earlier this year.) The principal product, titanium dioxide, is mainly used as a refracting and whitening element, in paint, sunscreen and food colouring: demand is expected to grow from Asia as people become wealthier and spend more on their homes and themselves. This should be a nice little contributor to Rio’s earnings down the track – but it is starting on a low base.

Which stock?

Neither BHP nor Rio could be spoken of in glowing terms as a yield stock, although BHP in particular has lifted its dividends significantly in recent years. (The last time the company cut its dividend was 1931.) But investors must understand that BHP and Rio Tinto have payout ratios much less than industrial stocks (48 per cent and 32 per cent respectively), because they prefer to reinvest more of the profit back into their businesses. They are not meant to be income stocks. (It should also be remembered that both have acted to return surplus capital to shareholders through share buybacks in recent years.)

The market consensus forecast has BHP paying a dividend yield of 3.3% in 2013, which converts to about 4% for an SMSF in accumulation mode, and about 4.7% for a fund paying a pension.

Rio is expected to deliver a fully franked dividend yield of 2.7% in 2013, which equates to about 3.3% for an SMSF paying 15% tax and 3.8% for a pension income stream.

However, yield isn’t the reason why you would have these stocks in your portfolio: it is to benefit from the long-term trends for commodity prices and earnings generated by a massive and protracted investment theme – that of industrialisation and urbanisation in China and the other major emerging economies.

BHP represents a more diversified and more attractive conduit for this earnings flow than Rio Tinto – and the slight yield sweetener augments that relative case. There will be earnings volatility in the medium-term as commodity prices fluctuate, but longer-term, BHP’s earnings streams represent a relatively low-risk way to tap into the ongoing rise of China.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should consider the appropriateness of the information in regards to their circumstances.

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