Better Buy Now: Rio Tinto Vs. BHP Billiton

By Markets Fool.com

Times have been difficult for commodity producers. Both Rio Tinto and BHP Billiton did the unthinkable this year and suspended their progressive dividend plans. BHP Billiton had been paying a flat to rising dividend for over 15 years, while Rio Tinto hadn't slashed its dividend since 2009.

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Now both shareholder-friendly policies are over. Rio Tinto announced that it will be paying a minimum annual dividend of $1.10 per share in 2016, down from the $2.25 per share in 2015, and BHP Billiton announced that it will be paying aninterim dividend of $0.32 per ADR share for its first half, down 75% from its previous dividend payout.

The recent rally in iron ore prices not withstanding, shares of both Rio Tinto and BHP Billiton are well off their all-time highs. Given that both companies trade at relatively reasonable price-to-book values, which stock is the better buy?

Rio Tinto has a higher forward earnings yield
Given the consensus iron ore prices in early February, Rio Tinto management estimated that the company would earn an underlying profit of $2.7 billion for 2016, giving the company a forward earnings yield of 4.6%.

Although BHP Billiton hasn't released its 2016 earnings outlook, the company has stated that its board is committed to paying at least 50% of BHP's underlying attributable profit in the form of dividends for the medium term.GivenBHP Billiton's total ADR-equivalent share outstanding of 2.66 billion, its $0.32 semiannual ADR dividend, and a payout ratio of 0.5 or higher, the math implies that management expects to make an underlying profit of $3.4 billion or lower for 2016. That gives BHP Billiton a forward earnings yield of 4.3% or under.

BHP Billiton has moreflexibility
While Rio Tinto might be more profitable at the moment, BHP has more flexibility. BHP has a better credit rating, with the S&P giving BHP an "A" debt rating versus the S&P's debt rating of Rio Tinto of "A-".

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BHP also has more room to cut costs. For 2016, BHP has a capital expenditure budget of $7 billion, or $3 billion more than Rio Tinto's budget of $4 billion. Although both companies' 2016 capex budgets are close to their deprecation, depletion, and amortization five-year averages, BHP Billiton's larger capital expenditure budget gives the company more cash flow to potentially fund attractive acquisitions if they present themselves.

BHP Billiton has more oil and gas exposure
Rio Tinto derives the majority of its underlying earnings from iron ore and aluminum, which contributed segment underlying earnings of $3.95 billion and $1.12 billion, respectively, in 2015 versus the company's total earnings of $4.54 billion. Rio Tinto also has substantial operations in copper and coal,which contributed segment earnings of $274 million last year.

While BHP Billiton also gets the majority of its underlying earnings from iron ore and the company has substantial operations in copper and coal, BHP has a major energy presence that Rio Tinto doesn't have. Following is a table ofBHP Billiton's profit sensitivity to various commodity price changes:

Source: BHP Billiton investor relations.

As illustrated, BHP Billiton's after-tax profit will increase by $600 million if crude prices rise by $10 per barrel. Although BHP Billiton's greater energy exposure hasn't helped the company because crude prices have declined substantially, the extra energy exposure should help it in the long run as crude fundamentals improve. If crude prices rebound, BHP Billiton's cash flow and profit will surge even if iron ore prices remain below $50 per metric ton.

Flexibility wins in uncertain times
Both BHP Billiton and Rio Tinto are great companies that will do well in the long run as demand from emerging markets eventually soaks up the oversupply in the commodity markets. Both companies have quality tier-1 assets, strong balance sheets, and low costs of production. While Rio Tinto will probably be more profitable per share in the short run, BHP Billiton has more flexibility and upside because of its strong credit rating and its energy exposure. Given that times are still uncertain in the commodity markets, the stronger company, BHP Billiton, is the better buy.

The article Better Buy Now: Rio Tinto Vs. BHP Billiton originally appeared on Fool.com.

TMFJay22 has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.