According to a quick Google search of my name, alongside the words "sell","BHP Billiton" and "Rio Tinto", there are 259 links to my previous thoughts on their investment prospects over the past three years.
To be brutally honest, I'm surprised it didn't appear more often.
Over the past three years, the share prices of Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP) have underperformed the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) by 43% and 47%, respectively.
Of course, that doesn't include the positive impact of dividends, but neither does the ASX 200.
Is the worst yet to come?
This morning I read right here that BHP will write down the carrying value of its US-based petroleum assets by $US2.8 billion, or around $3.74 billion in Australian dollars.
Carrying value?
Write down?
What does that mean?
It means, thanks to plunging commodity prices, the value that BHP ascribes to its US-based petroleum assets has been reassessed, and an expert thinks they're worth nearly $US3 billion less.
Think about it like this: If your business built an oil rig on the assumption of getting $US100 for a barrel of oil in 2013, then two years later you can only get around $US60 for it, you have to downgrade the value of your rig, as well as your profit forecasts.
The only difference between your rig and BHP's Petroleum and Potash business is that BHP invested $US27.7 billion in its business between 2008 and 2014. In the past two years alone, it's invested $14 billion.
Thank god, at least, BHP has continued to pay its dividends from debt…
I mean, where would its share price be had it not promised to keep its "progressive dividend policy" intact. Phew!
Concerningly, BHP expects its Onshore US business to be cash flow positive in 2016, "assuming that West Texas Intermediate (WTI) crude oil climbs to around US$60 a barrel," as Motley Fool writer Ryan Newman wrote this morning.
I suppose it's just a pity that WTI crude currently fetches just $US53 a barrel. Meaning, at this time, it's paying out more than it collects.
Anyway, it's not like someone could've seen this write-down coming, right?
Source: Indexmundi.com/commodities
I mean, yes there's been a very large, noticeable, obvious, contraction in major commodity prices since the frothy days of 2010. But, again, who could've seen this one coming?
Take a breath
Now, before I go any further. I should say BHP is a fantastically well-run business.
Nonetheless, its business and industry isn't a fantastic one to be in right now.
BHP is far more diversified than Rio, as we showed here. However, it's also had a big touch of luck along the way…
In 2010, BHP's merger with Rio was called off with news outlets citing anti-competition concerns from regulators and Chinese customers.
BHP is lucky because since Rio's disastrous $US37 billion – pardon me $US38 billion – acquisition of Alcan in 2008, it subsequently recorded $42.82 billion of impairments to assets, net of reversals.
Source: Rio Tinto Annual Reports
I guess BHP dodged a bullet on that one.
Are Rio and BHP worth your money?
Despite the allure, resources stocks – no matter how big or low-cost – are intensely cyclical.
Rio Tinto and BHP will likely survive a lower commodity price environment, as many analysts say, but I'm willing to bet they won't outperform the market for some years.
We're yet to see any meaningful reduction in supply for many key commodities, but heaps of new production from major committed projects is yet to come online. Meanwhile, demand from China is expected to wane.
At $26.68 and $53, respectively, BHP and Rio shares might look cheap against their historical levels. However, neither company appears cheap in absolute terms.
For example, earlier this week, I ran a simple discounted cash flow (DCF) analysis on BHP shares.
These were my base assumptions:
- In the next year, BHP produces free cash flow at a level equal to its average over the past five years: $7.3 billion
- Free cash flow grows at an average of 5% each year until 2025
- Then, annual free cash flow grows at 1.5% into perpetuity
- Market risk premium of 5%
- Risk-Free rate of 5%
At its weighted cost of capital of 7.55%, my basic DCF gave me a value of $25.75.
However, you don't need to be an analyst to know (see the commodities chart above) that BHP's historical free cash flow is likely to fall in coming years.
So that estimate of intrinsic value is likely too high.
Personally, I'd be more confident to say my estimate of its theoretical, or intrinsic, value is much lower than its current market price.
Rio Tinto shares also look expensive at today's prices – I won't consider buying it until it drops well below $40 per share.
However, although it's probably quite obvious by now, I'm bearish (meaning negative) on the direction of many of the commodities which BHP and Rio produce – so I could easily be wrong.
Even still, when we consider the heightened chance of write-offs, falling profit margins, higher debt levels, prospects of a lesser dividend payout, and slim chances of a market-beating return; there appears little reason to buy Rio and BHP shares, today.
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