Justification of the Chosen Benchmark


BHP Billiton Limited is chosen as the benchmark for Rio Tinto Limited because of several reasons.  One is both are constituents of S&P/ ASX 20 which evidenced their financial depth.  Also, they are the only companies under the materials industry to be classified in this elite list.  With their financing and substantial operations happening in Australia, consistency in comparing financial ratios later is fostered.  Further, they are facing similar risks and opportunities because they are bounded by the same regulation, natural resources and technologies.  Such possibility is supported in the similarity of their main product line which includes diamonds, iron, coal and copper. 


In terms of performance, the annual turnover of Rio Tinto Ltd in 2006 is AU.3 Billion while BHP Billiton is AU.7 Billion.  This indicates that the extent and impact of their business activities are not far from each other. This also reflects that they have a fair market share.  Both firms shared an appetite for growth through acquisitions. In recent period, Rio acquired Alcan while BHP took-over the management of WMC Resources.  As these targets are leaders in their respective industries, it can be argued that Rio and BHP are also leaders in the materials industry in terms of business operations.            


Finally, the bid of BHP in early 2008 for Rio showed significant similarities in major aspect of their businesses.  The combination will result to production efficiencies and optimize mineral basins.  This confirms the similarity of their income assets. Another, the skills and experiences of their human resources can bring global leadership in management. This confirms that their employees have compatible work ethics and competencies.  Comparable assets, capital depth, Australian presence and operational performance are the main criteria why BHP is a good benchmark for Rio. 


 


Performance of Rio


Based on the following indicators, Rio has low efficiency, low liquidity and low leverage.  Its 2005 performance is the most poor among the three-year evaluation.  This is caused by limited turnover, high operating costs, vulnerable short-term position and inability to optimize its debt option.  The problem in one indicator created a vicious cycle to Rio that limited its 2005 performance.  However, in 2006, it regained its 2004 attractiveness as it increased its indicators.  But it is still poor in liquidity while its finance structure remained to be conservative despite good performance. It is concluded that Rio must exploits its debt option in order to minimize dependence on shareholders and enhance its ability to provide value to its shareholders. 


            Deciding between Rio and BHP, Rio is more compatible with conservative shareholders.  This type of investors are those who regard a company that has minimal finance risk exposure but with average and acceptable returns.  The strength of such investment is that the share price of Rio is likely to be underpriced.  Its improving operations and performance are the key determinants of this event.  In effect, shareholders will have a strong wealth-creating position looking on the long-term.  However, BHP is for aggressive investors that wanted high returns but with higher risks due to high gearing.  The materials industry is confronted with several other risks that choosing Rio is quite the upper hand.  With bounded finance bottleneck, Rio can easily proposed a growth strategy with minimal regard to its creditors.


 


Efficiency Indicators


In 2004 and 2006, Rio showed an efficient utilization of raw materials and physical assets.  This also indicated the capabilities of its employees at work.  However, in 2005, the firm experienced a major decline in this category.  From as high as 97% in 2004, its operating profit margin declined to 58%.  Although the indicator revived in the third year at 92%, the three-year trend illustrated that the materials industry is highly affected by out-of-control factors such as prices of raw materials.  But this trend is undermined by Rio’s benchmark, BHP that showed at least 100% net profit margin in 2005 compared to Rio’s 67%.  The discrepancy basically came from selling, general and administrative expenses as Rio have a direct influence on these accounts.  The direction of the net profit margin of Rio is similar to its operating profit margin.  BHP also overtook the upper hand in the net profit margin especially in 2005. 


When it comes in ROA, the same trend observed in profit margins is observable.  In 2005, Rio fell from 27% ROA in 2004 to 4% and improved in 2006 with 31%.  But this trend implicated another view of the heightening issue.  The materials industry employs large capital assets that resulted to small ROA.  Granting that this affected ROA of the industry, still BHP has higher ROA in 2005 than Rio.  Therefore, the source of 2005 underperformance of RIO is highly contributed by its net profit in that year.  This is confirmed in 2006 as Rio outperformed BHP in terms of ROA.  The pressure on performance is not a question of efficient utilization of assets which is an internal issue rather effectiveness to markets which is an external issue. 


For ROE, the plunge of Rio’s contribution to increase shareholder’s wealth is an upset particularly in 2005.  From the high of 49% in 2004, high expectations of shareholder’s are frustrated by a mere 8% in 2005.  Although the indicator bounced back in 2006 with strong 53% returns, high volatility in 2005 may adversely affected the investment attractiveness of the Rio.  ROE in 2005 is under the accepted level of 15%-20%.  Compared to BHP of having 32% in ROE for 2005 and consistent increase in 2006, Rio is likely to be recognized as an inconsistent performer.  There must have been a problem in 2005 but this is a matter of internal strategy since BHP showed strong performance.  This indicated absence of industry-wide adversaries.


As conclusion, Rio has problems in outsourcing raw materials, fixing wages and acquiring new equipments.  There is also an issue of overspending in marketing and administrative expenses.  Other sources of income aside from main business areas must be developed while assets that are mediocre or underperforming for sometime must be replaced or disposed.  There is minimal information about the debt structure of Rio and so interest expense are out of scrutiny.  Finally, Rio is likely forced to provide shareholder incentive to prevent capital outflow.  This may include dividend payout, share price increase and buyback programs.  Its inability to take action in 2005 bottleneck may have disrupted its income generating capacity in 2006.  However, its 2006 performance greatly exceeded the previous years as well as BHP figures.   


 


Liquidity Indicators


From 2004, Rio consistently provided increasing current asset coverage against current liabilities.  From 124% in 2004, it amplified its solvency to 156% in 2005 and 190% in 2006.  This means that the firm is in a secured position financially, that is, it can pay short-term obligations as they come due.  There is no need to collateralize its inventory or its property, withdraw from investment funds or get cash from its accounting department.  It is also protected from work stoppage as suppliers decide to cancel delivery of raw materials due to underpayment.  Compared to Rio, BHP is partly uncovered by its current assets against current liabilities from 2005 and 2006.  This established the idea that Rio is in a better position with respect to current ratio.


            The quick ratio reverses the situation of Rio.  As BHP adopted its current ratio performance to quick ratio, Rio drastically fell especially in 2006 from its current ratio performance.  This showed that the majority of Rio’s current asset that it may use to loose its short-term obligations is highly-reliant on inventories.  As inventories are the most illiquid form of current assets, Rio’s solvency position earlier implicated by current ratio is undermined.  Inventory assets in cases where creditors are demanding abrupt payment is an effective source of refuge.  This may not be the case of on-demand products such as food and other daily consumables.  However, as the products of Rio are mostly used in industries and also for high-end customers, it may not be easily converted into cash.  Payment period for such as expensive products like diamonds may have lengthier payment terms compared to mass produced consumables.  Taken altogether, a creditor bank may force Rio to withdraw its investments and liquidate its assets which will not only disrupt strategies but also delay some processes. 


            In conclusion, Rio is not in a good position in terms of liquidity.  It should increase its short term investments and ensure that it has accessible money in the bank for cash withdrawals.  Alternatively, assuming that Rio already considered current liabilities in its budgeting deliberations and announced minimal concern to increase available cash, it should create a binding agreement that place it in a position of extending payment deadline based on its cash conversion cycle.  Both Rio and BHP showed minimal concern in keeping cash as observed in virtually zero cash ratio.  All expenditures are budgeted and minimal expenses happened in the production and selling period.  In contrast, to protect its solvency, Rio must hedge its long-term position through acquisition by settling a fixed percentage of current assets annually.              


 


Finance Structure


From 2004, Rio has experienced declining debt ratio.  Such decline is likely the cause of using its high market capitalization and dual-listed position to accumulate the required funds.  Debt is riskier than equity and Rio is ensuring that its shareholders are protected, that is, when the firm is unable to reach a return of at least equivalent to the cost of capital the shareholders will suffer.  This is perhaps connected with the liquidity problems of Rio serving as its incentive to its shareholders.  BHP has a higher liquidity compared to Rio. This confirmed the earlier recognition that the former is performing better than the latter which made BHP more confident to use more leverage.  However, as BHP’s position from 2005 to 2006 reflected Rio’s position, there might have been a threat from equity outflow in the industry.        


            The same pattern emerged in debt-to-equity ratio for both firms.  This indicator clearly states that Rio is using more equity financing rather than debt while the reverse is true for BHP.  Again, the year 2006 resulted similar finance strategy for both firms.  It is showed that BHP can leverage as high as 2:1 or double its debt position compared to its equity position. This verified the confidence in performance that BHP is not anxious that they would confront flight in equity capital.  As Rio has less dependence to debt especially in 2005 and 2006, its interest coverage ratio is far greater than BHP.  It is earlier said in the efficiency section that Rio is in turnover trouble in 2005.  This affected its interest coverage since profit margin is relatively small.  But due to minimal interest expense, this indicator is affected minimally.


            In conclusion, Rio is a much safer investment destination for shareholders than BHP.  This is of course includes the fact that a less risky investment receives also less returns.  Compared to performance, BHP has the advantage.  But Rio has a safer strategy compatible with conservative investors especially in an industry full of ambiguity and political interests from host countries.  Monitoring of Rio’s finance position as well as its growth must be made to appropriately assess the need for reversing its debt-averse structure.  With gradual increase in debt financing, the firm can require less funds from shareholders.  Also, this will prove that Rio has a positive credit rating.  This rationale must be used by Rio to justify their finance structure especially during industry shocks.  Otherwise, its strategy will not be optimal.      


 


Factors beyond Rio’s Management


            Political factors influence the global economy because before goods, services, labor and entrepreneurship (GSLE) can enter another country, an approval from the host government is required.  They are responsible to weigh and assess trade-offs between national peace/ order and economic health locally.  Since the government is a mere representation of the people to reflect, protect and forward national aspirations, the former is seen of utmost importance than the latter.  A country will typically not ensue to inter-country trade where threat to inferior imports or threat to security will result to such act.  Sensitive governments like China continuously show some degree of communism and self-rule that made it resistant to revalue its currency and allow internet information usage away from infiltration. 


Sociological factors tell how a country, at least on majority, sees GLSE and determine if they are suitable to cultural and behavioral constraints.  This factor is vital to MNEs because the level of social cohesion in a country can suggest the level of elasticity in demand.  This means that other variables other than prices can influence the people’s likeness of MNEs even though they are non-product/ service specific like boycott of foreign products in times of war.  Taboo brand names are eminent in some region.  They are either dislike because culture impedes them or the standard of living makes them impractical for use.  The former illustrates how developed countries like Japan try to internalize industries to protect them from cultural imperialism from the West while the latter explains how poor countries are deficient in access to internet since basic needs nee to be resolve first before anything else.


 


Bibliography


www.investopedia.com


www.riotinto.com


www.bhpbilliton.com


   


 


 


 



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