BHP At $25?

I spent the whole weekend at the Novotel in Brighton-Le-Sands, near Sydney Airport, where the Australian Technical Analysts' Association (ATAA) held its annual national conference.

I spent the whole weekend at the Novotel in Brighton-Le-Sands, near Sydney Airport, where the Australian Technical Analysts' Association (ATAA) held its annual national conference.

The topic of my presentation was "Where fundamentals meet technicals (and vice versa)", which allowed me to showcase two of my favourite market tools here at FNArena: consensus price targets for individual stocks and dividend projections.

On Friday, I updated consensus price target calculations for the ASX200. I can now report that if all stocks in the index reach their target this year (both down and up) the implied upside is around 10%, which would take the index back to around 5200-ish, which is where it was before the correction that started in May (and which is still ongoing).

The negative news about this update is that earlier in the year the potential upside seemed to stretch to 5600, on the same calculation, but that was before analysts had started to pare back their projections and valuations for mining stocks (as well as for mining services providers). The good news is that earnings estimates are definitely on the rise now that everyone is succumbing to a prolonged period of weakness for the Australian dollar.

In other words: the exact upside potential for the Australian share market remains very much a moving feast as the Australian dollar remains a key factor. One other observation remains that behind those calculations is a share market that has never looked so polarised with a small number of stocks responsible for all the index gains this year, even including the present correction which is hitting several of those stocks really hard, and on the other hand an overwhelming majority of stocks that has only accumulated losses after losses for shareholders thus far.

Surely with such extreme divergence in the market, every possible scenario becomes a genuine probability?

Which is why I told the audience on Sunday that my presentation had effectively evaporated since the start of calendar 2013. In order to generate calculations and projections from a fundamental background, we must have a framework that can be relied upon, at least up to a certain degree. Too much flexibility and uncertainties create less reliability. Right now, I wouldn't put too much weight on the projected consensus price targets outcome of 5200.

The Australian share market very much remains a volatile moving feast. The only prediction that can be made with a lot of conviction is that the correlation between a weaker Aussie dollar and falling share prices does not make a lot of sense, from a local perspective. At some point, this positive correlation will break down. That's a prediction that is easy to make, and with conviction.

Let's hope the break down of this correlation will not come on the back of a much stronger AUD (which I regard as a low probability outcome at this stage).

My second "where fundamentals meet technicals" item started from the market observation that large diversified resources companies, such as BHP Billiton ((BHP)), at some point transform into a dividend-supported stock and the key level of support, so suggests history, lies around the 4% forward looking implied dividend yield.

This observation is especially interesting since I picked up at the Conference that, at least according to some technical analysts, BHP shares seem on their way to revisiting $25.

So.... are BHP shares destined for much lower price levels? Falling to $25 implies further losses of circa 20%.

Since this is the share market we're talking about, nothing is ever 100% impossible and who am I to exclude panic and forced selling, but on my fundamental insights I think this should be regarded as a low probability outcome. Regardless if some people can clearly see it on their charts.

The key theme at work in today's share market, I believe, is dividend support. This doesn't tell anyone anything about potential upside, but it does represent a limit for potential downside. Ask shareholders in Woodside Petroleum ((WPL)). They would have noticed that since the board decided to pay out a lot of cash to shareholders instead of spending it on new projects with doubtful financial prospects, the share price seems to find solid support in the mid-$30s area. This is not strange as Woodside's implied forward looking dividend yield for both this year and next (2013 and 2014) rises to near 6% around these price levels.

Expect this support to remain in place as long as nothing happens to those dividends. Since this is a clear promise by the Woodside board (for the short term), I think this support will remain in place, come hail, rain or shine.

The other obvious dividend-support example among resources stocks is BHP Billiton. Post the current year, the BHP board is looking to direct more financial rewards towards shareholders and less towards further increasing output while operational management has already directed focus on increasing efficiencies and cutting costs.

While Woodside's dividends are not sustainable a few years further into the future, BHP's are. This makes a share price of $25 an unlikely outcome, in my view. Granted, on current estimates and AUDUSD value, BHP's implied dividend yield would only rise to 5% in case of a 20% depreciation in share price, but I think buying support will emerge well before that point. Especially if forecasts continue to rise and investors can trust BHP management and the board that capex will be significantly reduced from FY14 onwards and the focus shall remain on shareholder rewards.

The obvious weakness in all of the above is, of course, the question whether investors can rely on current dividend projections. After all, resources and dividends? History shows that's an uncomfortable relationship even during the best of times. And isn't the Super Cycle now going through a soft patch, with prices for key materials copper, crude oil and iron ore widely projected to decline in the years ahead?

All of the above is true, but once one looks closely into the matter, a more robust picture emerges.

Investors in general tend to have a short memory (unless when it relates to investment losses) but for as long as any of us can remember today, BHP has lifted its dividends year after year after year. The company has only been paying out less than 40% of profits, so this allows for a lot of leeway during leaner times. Even during the toughest moments of the GFC, when all the banks in Australia were forced to cut their dividends, BHP still managed to lift its dividends, and it has continued doing exactly that in the following years.

While an environment of weaker prices usually means resources stocks are doing it tough, the key characteristic for both BHP Billiton and Rio Tinto ((RIO)) is both are the lowest cost producers of iron ore and the price for iron ore is projected to remain well above cost levels for both until well into the 2020s. How certain can we be about this? It's all about cost levels for everyone else in the market. Fortescue Metals ((FMG)) is hoping it will be able to reduce its own cost level of production to US$70/tonne next year. Both BHP and Rio Tinto ((RIO)) are believed to still produce at prices below US$50/tonne.

Many marginal producers in China are sitting at US$130/tonne which means by now these producers have probably temporarily shut up shop, or they are being subsidised by local governments and/or Chinese steel manufacturers. There's a rather large Chinese contingent of producers in between US$120-100/tonne. These producers will be facing the same dilemma if/when the price drops below their cost level. Many smaller producers in Australia are operating under US$100/t but above Fortescue's target. It would require a massive shake-out, such as a meltdown in Chinese demand, to drive iron ore prices to levels that make everyone else unprofitable outside BHP and RIO.

Let's not forget that all major producers have increased output on the agenda for the two years ahead. This should keep profits and cash flows at healthy levels with increased volumes compensating for a weaker price. The problem with this scenario is that it doesn't guarantee continued growth in profits. As a matter of fact, I have now been arguing for a while that such a scenario virtually guarantees that companies such as BHP will find growth an ever more difficult target to achieve. But being the lowest cost producer (or the second lowest cost producer in the case of BHP) for a bulk commodity that is likely to remain supported by relatively high cost levels for a significant group of competitors, this does suggest lots and lots of ongoing cash flows.

As long as the BHP board does not re-embark on a similar investment spree as it did in the years past, those cash flows should allow for continued increases of annual dividends and potentially even some extra shareholder rewards on top.

I know, it's an odd feeling talking about BHP and dividends. Maybe this is as good as any other time to point out that annual dividends were responsible for 50% of total investment returns for shareholders during the nineties, when prices in general were low and remained low for an extended period.

Adding to the attraction in the short term is that BHP has accumulated an excess in local tax credits so dividends in the years ahead should be fully franked.

Commodities analysts at Citi, who last year declared the Super Cycle was coming to its end, have been making predictions that large diversifieds, such as BHP, will simply turn into dividend plays in the years ahead as cash flows continue, but growth becomes harder to achieve. As a matter of fact, reported Citi analysts recently, BHP is already trading on dividend support. This is a signal of what is yet to happen to others, argue the analysts. Rio Tinto should at some point catch up and enjoy similar dividend-support dynamics.

I do not dare to predict when exactly Rio Tinto is going to close the relative valuation gap with BHP, but I agree with Citi that BHP (and Woodside) is already trading on dividend support. Which is why I don't believe the shares are on their way to much lower price levels. Projected dividends actually seem low risk.

This is also the main reason as to why a weaker Australian dollar will prove to the benefit of BHP shareholders. Earlier in the year, when AUDUSD was at much higher levels, I calculated the 4% dividend support level for BHP shares was located around $30. Now that AUDUSD is trading at much weaker levels, the 4% support level has pushed up to around $32.

Needless to say, this is not exact science and BHP shares have fallen below $32 on Monday. If I use the average AUDUSD value from the past twelve months, this now translates into a projected FY14 dividend yield of 3.9%. However, if I use today's AUDUSD value of below 92c, the yield shoots up to 4.3%. Note also that consensus forecasts for BHP have stopped falling. They are now on a gentle path upwards. I think this confirms that share prices should remain supported around present levels, give or take the usual volatility that comes with resources stocks.

Stock Analysis on the FNArena website shows BHP's annual increase in dividends has averaged more than 11% over the past three years. Using a more conservative 7% growth projection, this suggests that by 2020, the BHP share price should be supported at a level 20% higher than today's price. High $30s? Early $40s? Another way of looking at this is: if BHP grows its dividends at 7% per annum over the next six years, the yield will grow to 5.7% on today's share price by 2020.

Putting all numbers together, this suggests double digit annual returns over the next seven years, of which dividends will be responsible for half.

The irony is, of course, this is double the return BHP shareholders have enjoyed over the past seven years when annual dividends were pretty much all that has remained in shareholders' pockets.

By Rudi Filapek-Vandyck, Editor FNArena

Rudi Filapek-Vandyck is the editor of online news and analysis service FNArena, which offers investors proprietary consensus data and various unique tools and applications that can assist in researching the Australian share market. In addition, the service provides insights into the views and expectations of major stockbrokerages in the market.

FNArena Editor Rudi Filapek-Vandyck has been credited with accurately predicting the end of the bubble in crude oil prices as well as the largest correction ever in commodity prices in 2008. He offers his unique analyses and views on a regular basis to subscribers.

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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's - see disclaimer on the website)

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