December 11, 2013 / 5:02 AM / 6 years ago

COLUMN-Investors may be buying BHP, Rio cost-cutting story: Clyde Russell

By Clyde Russell

LAUNCESTON, Australia, Dec 11 (Reuters) - It’s taken some time but there are signs that the cost-cutting efforts by major commodity producers such as BHP Billiton and Rio Tinto are starting to convince investors.

“My principle aim is to create value and free cash flow,” Andrew Mackenzie, the chief executive of BHP , said at an investor briefing on Dec. 10.

To this end he confirmed that capital expenditure at the world’s largest mining company has been too high in recent years, with the $23.3 billion spent last year poised to shrink by 25 percent in the 2013 fiscal year, and again in subsequent years.

The presentation slides anticipate capital expenditure for major projects being a quarter of the 2013 level by 2016.

Rio Tinto , the world’s second-biggest miner, is also slashing spending, announcing plans to halve capital expenditure and slash debt.

Rio Tinto said on Dec. 3 that it will cut spending to $11 billion in 2014 from just under $14 billion this year, and sees capital spending at $8 billion in 2015, which would be less than half what it was in 2012.

The cuts are more than that of its bigger iron ore rival Vale of Brazil, which unveiled on Dec. 2 a 9 percent capital spending reduction to $14.8 billion for 2014.

While it’s too simplistic to say the savings in capital expenditure will flow directly to net income, the aim of the chief executives of the mining giants is definitely to improve profits, and thereby share prices.

Assuming BHP does manage to cut capital expenditure to somewhere closer to $6 billion by 2016, it could potentially double the $17.87 billion in net income before taxes recorded for the 2013 fiscal year.

Of course, this assumes that all other parameters, such as operating expenses and commodity prices, remain constant, which they likely won’t.

But it does serve to illustrate just how big an impact the capital expenditure savings could have on profits, especially if BHP can do what Mackenzie promises, namely continue to deliver output growth in addition to the cost savings.

Mackenzie said he isn’t focused on boosting volumes, but nonetheless expects output growth of 16 percent in 2013-14.

The aim for BHP and its competitors is to concentrate on the high volume, high margin parts of their businesses, such as iron ore.


It also appears equity investors are starting to buy into the story, with BHP and Rio Tinto shares showing some outperformance.

BHP’s Australian-listed shares are down 0.8 percent from the start of the year to the A$36.82 close on Dec. 10. But they have gained 19.5 percent since the 2013 closing low of A$30.81 on June 25.

The S&P GSCI Index, which is a good proxy for BHP given it contains energy and about a third of BHP’s revenues comes from petroleum, has lost 2.5 percent this year, and has only gained 4.8 percent since its year-low on April 17.

Rio Tinto’s shares closed at A$66.17 on Dec. 10, up 0.2 percent so far this year. Since their closing low on June 26, they have gained 31.7 percent.

Given that Rio makes the bulk of its profits from iron ore, a comparison with the Asian spot price is reasonable.

Iron ore has lost 3.8 percent since the start of the year to the close at $139.40 a tonne on Dec. 10, and it has gained 26.2 percent since the year-low of $110.40 on May 31.

What these numbers show is that since the lows for both commodity and share prices, the Anglo-Australian giants have done better than the commodities they produce.

However, both have a long way to go before scaling the heights reached in 2011, when BHP peaked at A$49.55 in April and Rio Tinto reached A$88.68 in February.

In the year to June 2011, BHP’s net income before taxes was $31.25 billion, about 75 percent more the amount achieved in the year to June 2013.

However, the cost-cutting programme may be enough to return profits close to the 2011 levels even if commodity prices remain constrained by the gradual slowing of demand growth in China, the world’s biggest buyer.

Disclosure: At the time of publication Clyde Russell owned shares in BHP Billiton and Rio Tinto as an investor in a fund. He may also own other shares mentioned as an investor in a fund.

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