BHP: Interim result 2015

The unwinding of the great commodities boom has hurt the bottom line of BHP Billiton but it is also the catalyst for a transformation of the miner. Lower costs, less capital expenditure and a greater focus on investment returns were not simply features of BHP's interim result but the lasting legacy of the boom.

Net profits may have fallen 31%, to US$5.4bn, but considering the dramatic falls in commodity prices, this was a terrific result. Lower commodity prices stripped over US$6bn from profits but a combination of higher volumes, lower costs and greater productivity offset that sum by US$3.7bn illustrating that there are plenty of ways miners can control their finances even if they can't control prices.

The investment case we outlined in Biting into BHP – that lower profits would be offset by rising free cash flows – has played our perfectly. Despite a 12% fall in operating cash flow and tumbling commodity prices, BHP generating a 58% increase in free cash flow to US$4.1bn.

The sensational cash flow performance was driven by a 23% decline in capital expenditure to US$6.4bn and allowed the miner to decrease debt and lift dividends 5% to US$0.62.

Concentrated mining

Petroleum, copper and iron ore combined accounted for over 90% of operating profit, confirming that the diversified mining model is dead.

Despite prices falling almost 40%, iron ore dominated earnings generating 45% of operating profits. A highlight of the iron ore result was the success of cost cutting. BHP now produces iron ore from the Pilbara at a cash cost of just US$20 a tonne and aims to lower this to below US$20 a tonne. Total costs are still below US$40 a tonne and BHP continues to generate return on assets almost 40% from the division at current prices. It's easy to see why the company continues to lift output.

Results from the petroleum division were more variable. Although output surged 9% – BHP is on track to produce three times as much oil as was squeezed from the whole Australian continent – it is heavily dependent on output from US shales where output increased 71%. Shales now account for about half of production.

Although BHP reports  low, and declining cash costs of production, adding non cash costs reveals that the colossal shale operating is losing money. On an asset base of over US$26bn, BHP lost US$360m yet it will still pour US$2-4bn of capital expenditure to increase drilling. Although management claim that free cash generation is possible as production rates increase, we're doubtful. The foray into shales has, so far, been a failure. The company could cut back drilling to only the most profitable sites but that would be an admission of failure. BHP isn't prepared for that yet.

Luckily, profitable production elsewhere made up for losses from shales and BHP still reports return on assets of about 12% from petroleum, ahead of our forecasts.

On track

Results from coal were abysmal with BHP reporting interim profits of just US$180m from assets worth US$15bn. Even flagship mines are struggling to generate acceptable returns with current prices but industry supply cuts haven't yet appeared and there are few signs that conditions will improve.

In aggregate, however, this was a fine result that justifies our tepid entry into the stock. While BHP has shown impressive discipline in squeezing costs, the extent of the savings – close to US$10bn over two years – does highlight the flagrant waste that characterised the boom years and reinforces our view that BHP is a better business now than during the boom.

With the share price up 18% since our upgrade, BHP now sits above our buy price. We're likely to get another chance at buying so, for now, we're downgrading to HOLD.