Analysts downgrade BHP Billiton Limited and Rio Tinto Limited – what should you do?

Iron ore is expected to plummet over the next 2 years which would heavily impact earnings.

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It seems that dramatic cost cutting and productivity improvements just aren’t enough for Australia’s largest miners.

BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO), Australia’s two largest miners, will be hit hard by the falling iron ore price. At least that’s what Citi believes – the investment bank downgraded their “buy” recommendations on the two stocks to “neutral” based on the belief that the commodity (which is Australia’s most lucrative export) will fall as low as US$80 within the next two years, driven down by the “overwhelming increase in iron ore supply”. Some analysts even suggested it could fall that low before the end of 2014.

Already the commodity has dropped more than 10% since the beginning of the year. It has been at US$118.10, after beginning the year at more than US$130 a tonne. Analysts had entered the year bullish on the two stocks based on the belief the commodity could sustain prices of around US$120 a tonne over 2014.

While gas price upgrades will help to offset any weaknesses in BHP’s iron ore and coking coal divisions, Rio Tinto’s revenues are far more reliant on the steelmaking ingredient. Citi’s share price target on BHP dropped from $39 to $38 but Rio’s price target took a far bigger hit, falling from $80 to just $74 with the falling commodity price expected to offset the gains recognised from cost-cutting initiatives and increased production.

BHP and Rio weren’t the only two miners under the spotlight. Fortescue Metals Group Limited (ASX: FMG), which is a pure iron ore play, was also downgraded to neutral with its share price target falling from $6.70 to $5.90. Smaller players Atlas Iron Limited (ASX: AGO) and Mount Gibson Iron Limited (ASX: MGX) are currently rated a “sell” based on the weakness of the commodity.

Foolish takeaway

Like it did with most other investors in the market, the resilience of iron ore in the second half of 2013 surprised me. Although the miners are heavily focused on reducing operating costs (which will help bolster margins), I am not bullish on the price of iron ore and thus could not justify buying into Rio Tinto or Fortescue given their heavy reliance on the commodity.

While the falling price will certainly eat into BHP’s profits, I am more comfortable with their level of diversification and would strongly consider buying a position in the company should its shares fall to a more enticing price.

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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

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