We have long included BHP Billiton and Rio Tinto among the ranks of Australia's best businesses. In a nutshell these are large, low-cost, long life resource assets managed by capable boards and workforces in predominantly low-sovereign-risk locales. The proof is in the pudding, with both BHP and Rio Tinto historically delivering above-average returns on invested capital from comparatively low-risk balance sheets. Recently one of these key planks--low sovereign risk--has come under serious threat. Australia's Rudd government proposes a 40% Resource Super Profits Tax (RSPT) on any returns on capital above the 10-year bond rate.
Leaving aside arguments about fairness for all parties, including the Australian citizenry, the effective 57% rate (after capital costs are recovered) is so far above the circa 40% peak rate of the nearest competitor nations as to defy logic. It could extract an additional $10 billion from the Australian mining industry in its first two years of implementation, and this before capital shields have been exhausted. Not only is it a huge direct impost, it will also increase the effective cost of capital via the undeniable jump in sovereign risk. BHP and Rio Tinto could be among the worst impacted due to their well-established, highly profitable operations being largely depreciated. Should we retain our narrow moat ratings on these two resource giants?
We'll say yes and for several reasons. Firstly, the assets in the ground haven't changed, so this key competitive advantage remains. Secondly, as global majors, BHP and Rio Tinto can readily redeploy capital across a breadth of countries and commodities. It might not help in the short term but it's the long term that counts. Thirdly, it may be that the sovereign risk hasn't really changed. Is sovereign risk one government? When Rio Tinto's board courted the devil at the height of the global financial crisis, shareholders intervened and a crisis was averted. Could the Australian public and industry effectively achieve the same outcome with respect to the RSPT? Sovereign risk is also a function of the will of the public at large. They can pressure government and ultimately public opinion may win out, in one way or another.
We estimate that implementation of an RSPT could reduce BHP's worth by around one sixth and Rio Tinto's worth by about one ninth. Non-Australian operations water down the impact. Should a copycat tax domino effect transpire globally, it would raise the effective global production cost, crimp supply, and lift prices. While not an ideal situation for any mining company, BHP and Rio Tinto could anticipate being least impacted. Their favourable low-quartile position on the cost curve ensures that. We remain positive on both firms. The share price hammering sees RSPT more than priced-in. A free option on tax policy softening or reversal!
Mark Taylor is a senior equity analyst with Morningstar.
