Rio Tinto announces a 55% increase in profits and a 31% increase in dividends. But are the huge profit margins of the big miners sustainable in the long term?
Many commodity prices have come off the boil recently. As well as oil, major metals such as copper, lead, nickel, zinc and aluminium have all seen significant price falls. This has hit the shares of the big mining companies and led many people to ask whether the commodity boom has come to an end.
On the evidence of the latest results from Rio Tinto (LSE: RIO), it would seem there is still some way to go. Although the bottom-line numbers were boosted by profits from disposals, the company still managed to post a 55% increase in underlying earnings and hiked its dividend by 31%.
There was some increase in production levels, but profits were mostly boosted by higher prices compared to the first half of last year. Rio’s three major sources of revenue are iron ore, copper and aluminium, with iron ore accounting for almost half of profits for the last six months.
The FTSE 100 index currently has the pleasure of including four of the five largest miners in the world, namely BHP Billiton (LSE: BLT), Rio Tinto, Anglo American (LSE: AAL) and Xstrata (LSE: XTA). Only Brazil’s Vale, the second largest, doesn’t have a main London listing. Indeed these four miners now account for 11% of the value of the index so their performance is a key factor in the UK’s market overall direction. All four have generated excellent returns over the last five years, but is there more left in the tank?
A busy sector for bid activity
As well as higher commodity prices, merger activity has driven the growth of all the major mining groups in recent years. Rio Tinto gobbled up Alcan last year and Vale and Xstrata were in talks a few months ago but couldn’t agree on a price. However, the bid that is attracting most interest is BHP’s move for Rio.
Such a takeover has been rumoured for years but BHP formally revealed its hand late last year and launched a bid a few months later, offering 3.4 of its shares for each Rio share. This bid currently values each Rio share at £55, about 10% higher than its current share price of £50. This gap indicates there is some doubt that the bid will proceed.
Indeed, the bid is in limbo at the moment as various regulatory processes are carried out. Last week, Australia raised its concerns about the dominant position the enlarged group would have in the Pilbara iron ore region of north-west Australia. However, it’s the European competition rules that are expected to be the biggest stumbling block, with a full investigation concluding at the end of this year.
Are big miners cheap?
You could argue that there’s not a lot to choose between the big miners. They earn profits from a different mix of commodities but are all quite well diversified. BHP is only one of the four to earn substantial revenues from oil, however, and this extra division also makes it the largest by market value. Rio is by far the most indebted of the four, due to its recent purchase of Alcan. It has debt of over $40bn while the other three have debts of about a quarter this amount.
On a forecast price earnings basis BHP, Anglo and Xstrata are valued at eight times. Rio, thanks to BHP’s interest, is valued at eleven times making it most expensive of the four. All these forecasts are for the year ending December 2008, except for BHP which is for the year ending July 2009.
Using the most basic analysis, these low price earnings ratios make all four companies look cheap. However, the clue as to why lies in their profit margins. Before depreciation is taken into account, the profit margins in many of the commodities they produce are currently well in excess of 50%. Indeed Rio, being one of the lowest cost producers, can boast 60% for iron ore and an astonishing 70% for copper.
The low valuations being given to these companies suggest the market doesn’t believe these profit margins will be sustainable in the long term. Either prices will fall or costs will rise, or perhaps both.
I suspect margins will fall back but this will more than offset by decent production growth for the next few years driven by the ongoing demand from China, India and other developing nations. While this demand has moderated in recent months it’s still very much in evidence.
Both BHP and Rio have been making medium-term forecasts as part of their bid battle. BHP is forecasting production growth of 6.9% pa from 2007 to 2012 while Rio is going for 8.6% pa from 2008 to 2015. For companies of this size, these are impressive numbers.
I’d class myself as a commodity bull, but not a huge one. So I think all four of these companies will do well over the next five years although, with its higher debt and valuation level, Rio is the least attractive the moment.
