RIO Tinto Ltd
Rio Tinto Ltd (ASX: RIO) is an Australian-British corporate and one of the world's largest mining and metals companies. Founded in 1873, the company has expanded and grown, both organically and through a series of mergers, and is now a key player in the production of many commodities. RIO recently reported its 2018 half-year results, missing market expectations. Two main themes driving the narrative were capital returns and cost inflation.
Cost inflation has been flagged by the company for almost 12 months now and is clearly noticeable in RIO’s recent result. RIO’s CEO, J-S Jacques, reinforced mounting cost pressures again, with cost inflation evident across most commodities and geographies (although somewhat less pronounced in North America). It, however, is being felt most acutely in the Aluminum division. Upside pressures on contractor and labour costs in the Pilbara region in Australia are driven by concurrent projects by three large miners in the region, with raw material prices also trending upwards. While management acknowledged this as a headwind, it nevertheless is cautiously optimistic that cost inflation will improve its competitive positioning given that cost pressures are most acute for higher-cost aluminum producers thus benefiting RIO’s assets at the bottom of the cost curve. As a side note, while RIO supplies 1/3rd of all the aluminum in the US, they have seen limited impact from the aluminum tariffs on the business.
While operational performance was somewhat underwhelming, RIO rewarded shareholders with, effectively, US $7.2 billion of cash returns. The company announced a US $1 billion buyback, a US $2.2 billion interim dividend and committed to returning proceeds from recent divestments to shareholders. This excludes the recent non-binding agreement to sell RIO’s 40% interest in the Indonesian Grasberg mine for US $3.5 billion. Pending the successful conclusion of the sale, Grasberg can be the source of additional capital returns to shareholders. Furthermore, in the most recent roundtable with analysts, J-S Jacques has indicated his desire to change the perception of RIO from a pure miner to a more rounded industrial with reliable and stable shareholder returns. So far, in the calendar year 2018, RIO raised US $8.5 billion from assets sales, including Grasberg, its Australian coal assets and some aluminum smelters. Some market participants see further divestments and productivity initiatives supporting shareholder returns going forward, while others highlight increasing CapEx and slowing volume growth to build a bear case for the stock, which was trading at $ 74.570 as at August 14, 2018, market open, down 12.2% in last three months.
BHP Billiton Ltd
BHP Billiton Ltd (ASX: BHP), similarly to its peer Rio Tinto, is a dually listed Australian-British mining company. In addition to producing commodities and minerals, BHP also has substantial oil and gas assets and is involved in the production, exploration and refining of petroleum.
Late in July, BHP announced the sale of its entire US onshore business for US $10.8 billion. In a brief recap, BHP entered the US shale space in 2011 through a US $4.75 billion acquisition of the Fayetteville shale assets from Chesapeake Energy. It then invested further US $15.8 billion in equity and debt into an acquisition of Petrohawk in the same year. Following the two purchases, BHP has spent circa US $19 billion on developing these shale assets. After multiple impairment charges and shareholder pressure, BHP undertook a strategic review of the business and decided to pursue a sale. As such, the recent transaction was viewed favorably by the market, although overall, BHP’s foray into the US shale has been seen as a significant misstep by the management. BP agreed to acquire the Permian, Eagle Ford and Haynesville assets for US $10.5 billion, while Merit Energy Corporation will buy the relatively high cost, dry gas shale assets in Fayetteville for US $0.3 billion. With US shale generating substantial losses over the last few years, BHP expects to pay no significant taxes on the sale as it utilizes the carry-forward provision. BHP has already confirmed that all the proceeds for the sale will be returned to shareholders. It has multiple options and can pursue on market buybacks, off-market buybacks or special dividends. Regardless of which option the management settles on, the return of capital is expected to be EPS accretive.
With the divestment of US shale assets, the remaining conventional offshore assets produce roughly a balanced split between liquids and gas, with 2018 estimated production split of 52% to 48%, respectively. While petroleum production, ex shale, has been consistently declining the business nevertheless is highly cash generative and remains an important part of BHP’s business strategy.
Portfolio optimization has been a key focus of the CEO and the Board of BHP. In addition to the US shale exit, BHP sold its Cerro Colorado mine in northern Chile, for total proceeds of US $320 million. Nickel West appears to be the last non-core assets in BHP’s portfolio.
When it comes to operational performance, BHP has recently delivered better than expected Q4 production while managing the industry cost pressures well. Improved performance, cost improvement targets and debt levels at the lower end of BHP’s US $10-15 billion target, combining with the successful divestment of the US onshore business, could be potential catalysts for the share price going forward.
BHP stock was trading at $ 33.790 as at August 14, 2018, market open, up 11.4% in past six months.
Fortescue Metals Group Ltd
Fortescue Metals Group Ltd (ASX: FMG) is an iron ore production and exploration company, with operations located in the Australian Pilbara region. FMG is a low cost producer and its ore is generally low grade. Despite iron ore prices holding at persistently high levels, the discounts for low grade ore have widened significantly leading to lower price realization for FMG. Market consensus is that the discounts for low grade ores are more structural than cyclical and many also expect iron ore prices to trend down to more sustainable long-term levels.
Due to these pressure on low grade pricing, FMG introduced its high grade (HG) strategy in late 2017, as Elizabeth Gaines was appointed CEO, succeeding Nev Power. Eliwana project, with capex of roughly $1.3 billion, has recently been approved by the management and is a key pillar of the new strategy. Production at Eliwana is expected to commence in December 2020. The mine is expected to replace the depleting Firetail mine and has a higher grade ore, which FMG expects to blend with its other premium ore to create a new 60% Fortescue Premium product. While the HG strategy makes sense given the prevailing market dynamics, there is limited clarity on the costs and whether the product grade can be increased for the majority of FMG’s production.
In late July, FMG delivered a quarterly production update with shipments and costs roughly in line with market expectations. FMG’s ability to ship record quarterly volume, in a market that discounts lower grade ore, can be seen as a positive. Cost discipline and roll out of automated trucks and drill rigs will help offset the cost inflation in Pilbara. However, with the discounts for low grade ore seen as structural, FMG’s future is primarily dependent on the execution of its HG strategy. Meanwhile, the group has lately announced for partial sale of shareholding in Atlas Iron. FMG stock was trading at $ 4.345 as at August 14, 2018, market open, down 13% in the past three months.
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