Stock showdown: How similar are BHP and Rio Tinto as investment propositions?

Welcome to Stock Showdown, a new feature where we’ll use Morningstar research and insights to compare the business and investment merits of two companies.

The purpose of this article is to get you to think deeper about the pluses and minuses of different businesses and the factors you might consider before making an investment.

Today’s contenders

Over time, most industries tend to gravitate towards a small number of heavyweights. Pizza Hut and Dominos in pizza. Coles and Woolies in supermarkets. And in the world of Aussie mining majors, BHP (ASX: BHP) and Rio Tinto (ASX: RIO).

BHP and Rio have a habit of being mentioned in the same sentence. They are similar in size and have also delivered remarkably similar performance over the years, as you can see in the chart below.

Figure 1: Growth of $100 investment in Rio (Dark Blue) and BHP since 2010. Source: Morningstar Direct.

Rio (in dark blue) performed worse than BHP towards the end of the China bust in 2015. But apart from that, the share prices have essentially moved as one.

Are the two companies really that similar, though? And what might decide which one you are most interested in owning as an investor? To answer these questions, I enlisted the help of our global mining analyst Jon Mills.

Comparing Rio and BHP’s commodity exposure

Assuming that all is well operationally and that costs are kept under control, the biggest swing factor for an established miner’s profits will be changes in price of the commodities it mines and sells.

When you are comparing two mining companies, then, weighing up their key commodities (and the relative importance of each) seems a good place to start. BHP and Rio both mine several of them, the truth is that both are driven almost entirely by just two or three.

For BHP, around 50% of Jon’s forecast EBITDA over the next five years is attributed to iron ore and 45% of it is slated to come from copper. The rest is likely to come from thermal and steelmaking coal, as well as other products including potash.

For Rio, Jon thinks that iron ore will provide roughly two-thirds of EBITDA over the next five years, with the remaining third split roughly even between copper and aluminum.

The big takeaway here? Iron ore is vital for both companies. But is materially more important to Rio given its share of earnings.

A slight edge on moatiness?

An economic moat is a structural feature that allows a firm to sustain excess profits and returns on capital over a long period.

Jon has given Rio and BHP ‘No Moat’ ratings on an overall basis. At a high level, this is because they sell commodities and are therefore “price takers rather than price makers”.

Jon does, however, think that both BHP and Rio’s iron ore operations would deserve Narrow Moat ratings on their own. This is because both sit low enough on the iron ore cost-curve that they would likely achieve profits and attractive returns on capital in almost any pricing environment.

In copper, the main asset for both firms is the same - the Escondida mega-mine is a joint venture between the two, with BHP owning roughly 58%, Rio 30% and a group of Japanese companies the rest. This is an excellent asset, ranking as the biggest copper mine in the world and towards the lowest quarter of the cost-curve.

The low-cost nature of Escondida and BHP’s other prominent copper mines Pampa Norte and Antamina lead Jon to a narrow moat rating for its copper business. By contrast, Rio has sunk so much capital into other copper projects like Oyu Tolgoi that he doesn’t think as attractive returns on capital are as likely.

Jon thinks that Rio’s past investments also preclude a moat in aluminium, where it paid a huge price for high quality smelting assets in Canada through its 2007 purchase of Alcan. In Jon’s view, this makes it unlikely that Rio will reap excess returns on capital employed in this business over the next decade.

As a result, you could argue that BHP has moatier operations in the commodities that matter most for each business.

Financial positions and capital allocation

Both BHP and Rio are in strong financial positions at the time of writing.

This is mostly because both firms have been far less expansive in their capital allocation since the ‘China boom’ burst in 2011. Over the past decade, the main focus for both has been discipline on the investment front and the use of profits to reduce debt and fund dividends.

Combined with a long period of high iron ore prices, this has resulted in both Rio and BHP having far sounder balance sheets than they had in the 2010s.

The chart below shows the net debt of each company compared to normalised earnings before interest, taxes, depreciation and amortisation - a decent measure of cash flow available to service debt.

As you can see, it has fallen to a far smaller percentage of EBITDA than it was previously. It’s worth noting, however, that there has been a slight tilt towards growth in the last couple of years due to optimism over demand for transition commodities like copper and lithium.

Figure 2: Rio and BHP net debt to normalised EBITDA over time. Source: Pitchbook.

Key risks going forward

The biggest potential downside risks for shareholders at both companies are also rather similar. Chief among these, according to Jon, are that China’s massive appetite for metals like iron ore and copper may not last forever.

China’s population continues to shrink and Beijing has signalled that it will focus more on boosting consumption than on huge infrastructure projects and other commodity-intensive fixed asset investments such as real estate.

Jon is also skeptical that increased investment in Chinese manufacturing will fully compensate for this, given that trading partners were already pushing back against cheap Chinese exports before tariffs were raised by the US.

With fresh supply also expected to come online from new projects like Rio’s Simandou mine, Jon thinks that iron ore prices could fall back towards the long run marginal price of production. Jon estimates this to be around $70 per ton, which is a long way from recent iron ore prices of over $100 per ton.

Another potential risk is that BHP, Rio, or both abandon their recent investment discipline at what turns out to be the top of a cycle. Unfortunately, Jon finds it hard to be completely confident that Rio and BHP will resist this urge.

This explains why BHP’s bid for Anglo American and whispers of merger talks between Rio and Glencore merger left Jon feeling apprehensive. Both whiffed of extreme bullishness and even FOMO in regard to copper assets and also showed the potential for one mining megadeal to spur another.

How would Jon choose between the two?

Jon can’t own BHP or Rio shares for obvious reasons. It would go against Morningstar’s ethos of providing truly independent investment research. Even then, I couldn’t help but ask him which company – gun to head – he would choose if he absolutely had to.

Jon’s initial answer (whichever one is cheaper) might have just been a cute way to handle the question. Or it could just reflect the fact that these two companies really are very similar.

Ignoring price, though, Jon said he would rather own BHP due to its moatier assets and better management historically.

Both companies are in ‘fairly valued’ territory and sport three-star Morningstar ratings, with BHP trading roughly 6% below Jon’s Fair Value estimate of $40 per share and Rio trading essentially in line with his Fair Value call of $116 per share.

Remember: Before you get to choosing investments, we recommend you form a deliberate investing strategy. You can read more about how to form your strategy here.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company’s future cash flows, resulting from our analysts’ independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.