Overweight on Resources Companies: RIO, WPL, BHP

It's time to go Overweight on resources companies such as Rio Tinto (RIO), Woodside Petroleum (WPL) and BHP Billiton (BHP) says analyst Macquarie Research Equities (MRE). The global economic outlook continues to improve with world growth likely to exceed 5 percent this year. A soft landing in the US and growth in excess of 9 percent in China are the major drivers. In response, commodity prices are starting to improve again with spot prices now, on average, in excess of the analyst's year-average forecasts for the first time since mid-2006. This means that earnings upgrades are once again possible over and above the recent FY08 gains on the back of capital management initiatives. In view of the now improving earnings outlook and the widening valuation gap, MRE believe it is time to restore the resource sector allocation to overweight. MRE moved to an underweight position early last September in anticipation of a significant period of underperformance from the sector. MRE believe this period of underperformance (of over 10%) is now coming to a close. The US economy appears to be having the softest of soft landings with damage limited to just the housing and immediately related sectors. The consumer has barely noticed the housing correction with jobs still plentiful and non-housing construction still buoyant. It seems that overall growth will bottom out at around 2% pa early this year with a reacceleration likely in the second half, towards trend at 3% pa. At the same time, China is accelerating off its already high base with consumption, construction and exports all contributing. Europe, and even Japan, also seems to have at least some momentum. In total, this positive picture should then progressively boost commodity prices over the balance of 2007 after the US housing inspired slowdown of the second half of 2006. In other words, MRE believe the recent catch-up in commodity supply compared to demand will prove to be temporary.
Demand growth remains strong while on the supply side, infrastructure constraints remain substantial and recently tapped sources of scrap material appear to be topping out. MRE view this as being similar to the resource bull market of the 1950s and 1960s when Japan was industrialising. The All Mining Index took a rest every three to four years (1957 and 1960/61) when supplies temporarily caught up to demand. Demand from Japan remained strong throughout the 15-year bull market. So after each wave of new supply came on stream it took only a few quarters for demand to pull ahead of supply once again. This pause and then reacceleration is beginning to be reflected in the bottom-up earning forecasts for resources. As shown in the graph below the EPS forecasts have been consolidating around just over 20% growth for FY07. Flattening year on year commodity prices and operating cost increases have lead to some downgrades over the past nine months. Moving to the FY08 numbers the forecast EPS has risen from just 7.1% at the beginning of January to 20.4% today, a period of just eight weeks.
Most importantly, the improved commodity prices of the last few weeks have left spot prices well above those assumed in the forecasts, with the exception of zinc. In particular, copper, the flag bearer for the base metal complex, is currently US284c per lb, now usefully above the assumed US260c per lb average for 2007.
Even larger premiums exist for aluminium and nickel. So using spot prices, base metal prices for BHP would now increase the net earnings by around $US1.8bn or an EPS increase of almost 10% on the existing numbers. This is the reverse of the position last August/September. With world growth accelerating it will take very little in the way of inventory drawdowns to further boost base metal prices substantially over the next six months. The prospects for a positive result out of the March 2008 iron ore price contract are rapidly improving as well.
In a nutshell, it would not surprise to see the EPS forecast for FY08 for resources move higher to near 30% growth over the next few quarters. Once again, this is the reverse of the picture during mid-2006. By definition, the PERs and cashflow multiples have also moved from a position of being potentially understated last year to being overstated today. That is, the already low PER of around 10.1x for the sector in FY08 could potentially be even lower towards 9x, and the cashflow multiple (which is currently around 7.6x) could drop to a record low below 7x.

Woodside Petroleum Limited is listed on the Australian Stock Exchange (ASX) under stock code WPL. You can view their investor website here. WPL was listed on the ASX on 18 November, 1971. Don Voelte is the CEO of Woodside (WPL). The principal activity of WPL is the Management and operation of hydrocarbon exploration, development, production, transportation and marketing; implementation and operation of the North West Shelf Gas Project; exploration and development of gas, oil and condensate reserves. BHP Billiton Limited is listed on the Australian Stock Exchange (ASX) under stock code BHP. You can view their investor website here. BHP was listed on the ASX on 13 August, 1885. Charles "Chip" Goodyear is the CEO of BHP Billiton and Don Argus the Chairman. BHP Billiton was created through the Dual Listed Companies (DLC) merger of BHP Limited (now BHP Billiton Limited) and Billiton Plc (now BHP Billiton Plc), which was concluded on 29 June 2001. BHP Billiton Limited and BHP Billiton Plc continue to exist as separate companies, but operate on a combined basis as BHP Billiton. The headquarters of BHP Billiton Limited, and the global headquarters of the combined BHP Billiton Group, are located in Melbourne, Australia. BHP Billiton Plc is located in London, United Kingdom. The company is principally involved in minerals exploration, production and processing (particularly coal, iron ore, copper and manganese ore) and hydrocarbon exploration, production and refining. Rio Tinto Limited is listed on the Australian Stock Exchange (ASX) under stock code RIO. You can view their investor website here. The company was listed on the ASX on 1 January, 1970. Leigh Clifford is the CEO and Paul Skinner is the Chairman for this mining resources company. Rio Tinto is a leading international mining group, combining Rio Tinto plc, a London listed public company headquartered in the UK, and Rio Tinto Limited, which is listed on the Australian Stock Exchange, with executive offices in Melbourne. The two companies are joined in a "dual listed companies" (DLC) structure as a single economic entity, called the Rio Tinto Group. The Group finds, mines and processes the earth's mineral resources - metals and minerals essential for making thousands of everyday products that meet society's needs and contribute to improved living standards. Find out the meaning of the recommendations in this primer. Browse for other stockbroker recommendations. You can use Instalment Warrants to trade RIO. Check your charts and good luck with your share trading!