2015 is shaping up to be one of the worst years the mining industry has ever seen. A slump in the prices of almost every major commodity has taken many miners by surprise, and miners are struggling to cut costs fast enough to remain profitable.
The Bloomberg Commodity Index of 22 raw materials, which includes crude, metals and grains slumped to a 13-year low at the end of last month, erasing all the gains driven by China’s explosive growth.
Unfortunately, many analysts believe that commodity prices will fall further before a rebound takes place. Bad news for the likes of Rio Tinto (LSE: RIO) and BHP Billiton (LSE: BLT).
Additional pain ahead
BHP and Rio have been the FTSE 100’s worst performing constituents during the past year.
Over the last 12 months, Rio’s shares have declined 27% excluding dividends, and BHP’s shares have almost halved, falling a staggering 43% since the beginning of August last year. In comparison, over the same period the FTSE 100 has gained just under 1% excluding dividends.
To combat falling commodity prices, Rio and BHP’s managements have set out ambitious cost-cutting targets to try and maintain margins while sales come under pressure.
However, you can only cut costs so far, and pretty soon, Rio and BHP’s earnings will feel the full effect of falling commodity prices.
BHP, in particular, is facing a perfect storm. The company’s four pillars strategy, whereby the group has concentrated its efforts on mining for key commodities iron ore, oil, coal and copper, is designed to reduce BHP’s risk, but with commodity prices falling across the board BHP’s diversification strategy is redundant.
This perfect storm has hammered BHP’s profitability. The company is set to report its lowest level of full-year net profit in a decade for full-year profit for 2014-2015. Also, BHP is planning to announce $5bn of asset write-downs and other charges alongside results.
And City analysts expect BHP to report a 49% fall in earnings per share for full-year 2014 — 2015. What’s more, analysts are predicting a further 36% decline in full-year earnings per share for 2016.
These figures suggest that BHP is currently trading at a forward P/E of 13 and a 2016 P/E of 21, which looks expensive based on the group’s crashing earnings.
Wasting cash
Like BHP, Rio’s valuation looks expensive based on the company’s sliding earnings. According to City estimates, Rio’s earnings per share are set to slide 52% this year, meaning that the company is trading at a forward P/E of 16.3.
Underlying earnings shrank 43% to $2.9bn in the first half from $5.1bn in the same period a year earlier.
To try and offset falling commodity prices, Rio is attempting to shave $1bn off its cost base this year, and management has slashed capital spending by $2.5bn over the next two years. But despite these actions to cut costs, Rio is also halfway through a $2bn share repurchase programme. At a time when the price of iron ore is collapsing, and demand for the commodity is stagnating, it would be more prudent to hold cash for a rainy day, not spend it buying back stock.
