Ord Minnett has upgraded its recommendations on BHP Billiton and Rio Tinto to Accumulate from Hold following a detailed analysis of the next generation of iron ore and coal projects, which suggests strong prices are required as an incentive for the next wave of supply to come online.
We have examined a range of issues affecting long-term prices, including incentive pricing for project development, marginal costs and the majors limiting volume. Meaningful upgrades to prices of about 20% for iron ore, 27% for hard-coking coal and 15% for thermal coal have driven material gains to our discounted cash flow valuations for the major producers.
We note the following key findings from our review:
In our view, the sector isn’t replenishing its project pipeline. This lack of project development, either through deliberate ‘value over volume’ strategies or a lack of project options, is likely to support higher medium-term prices and so we believe the consensus upgrade cycle will continue.
Low debt levels across the sector and a favourable macro-economic backdrop are also conducive to strong shareholder returns, as debt reduction is no longer likely to be a key source of capital allocation.
More broadly, given the recent strength in the oil price, marginal cost support for all commodities has risen.
Given the majority of cash flow for the majors comes from bulk commodities, our revised pricing view has supported 20% gains in net present value.
Beside our recommendation upgrades, we have also raised our target prices for BHP to $38.00 from $30.00 and Rio Tinto to $96.00 from $78.00. Our relative preference has shifted to Rio Tinto, as we believe the rise in oil prices that has helped BHP outperform slightly this year has probably run its course.
Potential catalysts for both stocks on the macro front include China cutting rates further and ongoing strong readings in indicators, such as the global purchasing managers’ index which rose again in May. Stock-specific announcements could include asset sales, such as US Onshore (BHP) and Grasberg (Rio Tinto). Additionally, we are now back in a consensus upgrade cycle, which should act as a tailwind. Finally, spot free cash flow yields of about 10%, combined with low gearing, are likely to translate to high dividend yields and ongoing buybacks, further enhancing shareholder returns.