At first glance, both Rio Tinto (LSE: RIO) and BHP Billiton (LSE: BLT) look to be great value. The two companies are currently trading near 52-week lows and support hefty high single-digit dividend yields. Rio’s shares currently support a yield of 6.1%, and BHP’s shares support a yield of 7.4%.
But is now the time to buy these mining sector leaders?
Difficult to value
Cyclical and commodity companies like Rio and BHP have volatility and uncertainty thrust upon them by external factors, which makes them difficult to value. Indeed, the value of these businesses is often more dependent on the movement of macroeconomic factors and the outlook for certain commodities than it is on firm-specific characteristics.
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And since both commodity prices and economies move in cycles, investors looking to take a position have the unenviable task of trying to establish where we are in the business cycle, and what the outlook is for the resource sector is in general.
When valuing these companies, investors often fall into the trap of focusing on the most recent fiscal year of results. Unfortunately, this approach is highly misleading as the resulting valuation will depend on the market’s estimate of where we are in the business cycle.
The point is that it’s almost impossible to predict future macroeconomic trends, and as a result, it’s virtually impossible to value cyclical companies like BHP and Rio.
For example, during May last year, even the most pessimistic City forecast was calling for the price of iron ore to drop as low as $86 per ton. Most analysts believed that the price or iron ore would settle at around $90 per ton. The price of iron ore is currently in the region of $53 per ton.
Downgrading
BHP and Rio’s earnings estimates have been consistently downgraded as the price of iron ore falls. Specifically, this time last year analysts were expecting BHP to report earnings per share of $2.81 for 2016 and $3.13 for 2017.
However, current forecasts are significantly lower than those published 12 months ago. City analysts now expect BHP to report earnings per share of $1.05 for 2016 and $1.40 for 2017, 63% and 55% lower the initial predictions.
Similarly, the City has reduced its full-year 2015/2016 earnings estimates for Rio by 51% and 58% respectively.
The point is: the future is extremely uncertain for miners. As a result, it is almost impossible to produce an accurate valuation for the companies. BHP and Rio might seem attractive right now, but there’s no telling how much worse the global economy could become. China’s outlook has changed drastically during the past six months and this week BHP lowered its long-run forecast for peak China steel demand by 15%.
Still, both BHP and Rio are committed to their dividend payouts and are willing to sacrifice capital spending to free up cash.
BHP plans to slash capex by $5bn over the next two years to protect its dividend. Also, Rio is planning to reduce capital spending by around $2.5bn during the next 18 months, to allay concerns about the sustainability of the company’s dividend.
