If you think that the shares of miners have peaked, you may well be right.
Landscape
The shares of BHP Billiton (LSE: BLT) (NYSE: BBL.US) are down more than 4% on Tuesday. Those of Rio Tinto (LSE: RIO) and Anglo American (LSE: AAL) are in negative territory, too, although their valuations are holding up relatively well.
If benign stock market trends persist, upside for the shares of these three miners may be in the region of 5% to 10% to the end of 2014 — yet downside risk is much greater than that.
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A Brave BHP At The Wrong Time?
BHP’s latest announcement didn’t go down well with the investor community. BHP will spin off most of the assets it consolidated when it merged with Billiton in 2001. In doing so, management plan to crystallise the value of more profitable operations, focusing on production of iron ore, copper, coal and petroleum.
Nickel mines, aluminium and silver assets, as well as others, will be owned by a separate entity that will be listed on the stock exchange in Australia, with a secondary listing in South Africa.
As a result of the break-up, synergies will be lost. Moreover, the demerged entity will be fully exposed to cyclical headwinds, and I wouldn’t want to hold stock in the new company.
On the one hand, BHP is making a move ahead of rivals, which is encouraging. On the other hand, this business cycle points to plenty of downside when it comes to execution in spin-offs. The enterprise value of the spun-out entity may be much lower than the rumoured $16bn suggested by analysts.
Time’s Up For Diversification?
BHP’s move signals that diversification isn’t the preferred option at this point in the business cycle. Rather, further divestments are. Anglo and Rio will take heed. The benefits and the risks associated to a dual-listing, the reasons behind it and why investors may not like it, aren’t too important, in my view.
What counts is that BHP’s move is financial engineering at its best. In fact, operational changes will yield minimal benefits to BHP stock. The spun-out entity will also command low trading multiples, in my opinion. Moreover, the break-up heightens the level of uncertainty surrounding the valuation of a stock that tends to be highly volatile even in normal market conditions. Hence, further weakness in BHP’s share price shouldn’t be ruled out.
The drop in BHP’s share price on Tuesday is not a big surprise. Investors were disappointed as they expected the announcement of a large stock buyback of up to $5bn. But BHP is playing it safe, which is one element I like. Strategically, these changes make a lot of sense. When these actions are performed by public companies, however, it’s hard to say where value will ultimately reside. And, equally important, the timing isn’t great…
Anglo & Rio
In recent weeks, Anglo shares have performed pretty well as investors have backed management’s decision to undertake a comprehensive portfolio reshuffle.
Anglo’s divestment programme, however, is challenging. In a market where many of its assets will unlikely fetch a premium valuation, Anglo faces an uphill struggle to deliver value. I am not convinced it’ll be easy to record a stated 15% return on capital employed in the next couple of years. What’s next then?
A smaller BHP may decide to go for Anglo, and this is why I think Anglo shares are safer than those of competitors.
Elsewhere, first half results for Rio recently beat market estimates. The miner is keeping a low profile on costs and capex requirements; Rio’s problems aren’t too different from BHP’s problems.
At Rio, iron ore and aluminium assets were behind a good performance, which was impressive with regard to cash flow, earnings per share and debt position.
Still, Rio will unlikely be able to grow earnings the same way it did the last couple of years, and its trading multiples show that its shares are fully valued — and they’ll likely to underperform those of BHP and Anglo for some time.
