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BHP, Rio in bargain territory? Dig beneath the surface

An iron ore train car enters BHP Billiton's loading facility in Port Hedland, Australia. Iron ore made up half of BHP's earnings, with underlying profit from the core ingredient in steel rising 36 per cent to $7.9-billion.


It's easy to see the temptation to pile into mining industry bellwethers BHP Billiton and Rio Tinto after the sector's recent pummelling. The miners' valuations looked depressed even before the market's recent Greece-related selloff. After a near-15-per-cent slide since May 1, the companies' shares are trading close to forward enterprise multiples last seen during the dark days of 2008-09. But any rally could be a way off.

Valuations may be flagging, but they're still double the lows they hit after Lehman went down. And even if Europe manages to muddle through, miners have plenty else to worry about. BHP chairman Jacques Nasser on May 16 became the latest top mining executive to sound a cautious note on demand for raw materials. China's April trade figures showed sputtering demand for iron ore, steel and copper. Add worries about the staying power of the decade-long commodities "super-cycle" to the sector's rampant cost inflation, and red-hot margins – running at close to 50 per cent for some miners last year – look vulnerable.

Worried that miners might destroy value if they press on with some of their more ambitious growth projects, analysts have been calling for more share buybacks. But investors hoping for a payout bonanza shouldn't hold their breath. Rio last week brushed off calls to return more cash; BHP has said it will "sequence" new investments to match cash flows.

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It would take a deeper, more sustained fall in commodity prices to convince Rio and BHP to abandon an estimated $50-billion (U.S.) worth of new projects expected to be approved over the next nine months, say analysts at Credit Suisse. The likelihood is that BHP and Rio will still spend a combined $27-billion on growth projects this year, more than half of their forecast 2012 operating cash flow.

Management may be right to take the long view. But that may not sit well with shareholders who want jam today. Low valuations may endure for a while yet.

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