Why Morgan Stanley analysts prefer Rio Tinto over BHP

There's no denying that BHP (ASX: BHP) is a mining behemoth that can handle just about anything from adverse weather conditions to legal and regulatory hurdles, workforce disputes and more. It could be hit with all those things and its share price might budge a little higher or lower.

But BHP might've just met its match.

On Thursday, BHP announced two 'exceptional items' which will be recognised as part of its half-year FY24 results. This includes:

• Western Australia Nickel: To recognise a non-cash post-tax impairment charge of approximately US$2.5 billion against the carrying value of Western Australia Nickel. The impairment reduces the carrying value of net operating assets to -US$300 million. The assets will record a negative underlying EBITDA contribution of -US$200 million in the first-half results

• Samarco dam failure provision: To recognise an income statement charge of US$3.2 billion post tax in relation to the dam failure. The provision for the dam failure will be US$6.5 as at 31 December 2023

To add some perspective, BHP's 2023 annual report reported US$3.7 billion in provisions to the Samarco dam failure. The updated provision represents a 75.7% increase.

The assets underwritten in Western Australia Nickel include Nickel West and West Musgrave. Nickel West's previous net operating assets was sitting at US$1.19 billion and now -US$300 million (which includes US$900 million in mine closure and rehab provisions).

"Risks playing out"

"We are Equal-weight BHP due to risks around increased provisions (and eventually cash out required for Samarco)," Morgan Stanley analysts said in a note earlier this week, adding that "lower growth and payouts for BHP vs. Rio Tinto see us prefer Rio."

"The provisions now capture the potential settlement/damages that BHP estimates to pay in response to the case by the prosecution (in addition to the previous estimate which only captured the program of works)."

Last month, BHP received a formal notification from Brazilian judges to pay 47.6 billion reals (US$9.7 billion) in damages. The fine is part of a broader claim filed in 2016 for 155 billion reals (US$31.5 billion) for collective moral damages in relation to the dam failure.

Morgan Stanley says the payment schedule of the provisions is not yet clear and will affect how much cash BHP has left over to invest in growth or pay dividends. The analysts currently forecast US$12.7 billion net debt for the first-half of FY24 compared to BHP's target range of US$5-15 billion.

Putting it all together – The mining giant we all know and love is carrying a bit of baggage. In plain English, its nickel assets are now worthless and it estimates for dam disaster-related fines continues to grow.

We don't know when BHP will need to pay out these fines. But there is potential for it to have a material impact on net debt and dividends. The risk to lower growth (due to cash/investments) and dividends makes Morgan Stanley analysts prefer Rio Tinto over BHP.