BHP Billiton: Pricing for Doomsday

Friday, October 10: I went for a run along the Sydney Harbour foreshore this morning with the Labrador. It was a beautiful morning and the harbour was at its very best. About 6am I looked at my "crackberry" and saw the Dow was down around 200 points. In the current environment that's a number you just shrug your shoulders at and think "that's OK".
An hour later the dog and I both trotted back to the house, I flicked the "crackberry" back on and it lit up like a Christmas tree with email alerts. The Dow had managed to fall more than 400 points in an hour, to close down 679 points with the VIX off the scale at 63! Then just to rub salt into the wound, I see the reason for the last hour collapse was that Standard & Poor’s had downgraded the credit ratings of GM and Alcoa. Talk about late to the party!

Let's just say credit ratings agencies, the very same people who contributed to this mess with their overly optimistic ratings on various forms of US household debt, are notorious for downgrading after the event and at the bottom. It actually gives me hope to see these clowns downgrading credit ratings, but it's not often or ever you see the S&P500 down 25% in a week, or the ASX drop below 4000 points as it did briefly earlier today.

To top it off, shorting bans were lifted on US financials and they got destroyed.

Good Lord above! This is a meltdown of unbelievable proportions in a week and to think there will be a quick recovery from this is probably misplaced. There will be trading bounces, big trading bounces, but the fundamental recovery will be prolonged and painful.

In the current environment of "glass completely empty" I believe the most prudent approach to stock picking is to attempt to "backsolve" what a current share price is discounting while currently running "doomsday economic scenarios" through our models.

I am attempting to work out what a given stock price is discounting, while also trying to work out the absolute worst case share price scenario is in an attempt to work out the margin of investing error between today's share price and doomsday. In some cases, today's share price may well already be below a "doomsday scenario".

Quite interestingly, investors who took up this week's $2 billion Commonwealth Bank capital raising at $38 were actually given a highly unusual chance to buy CommBank below my "doomsday scenario" share price target of $38.18. That placement was priced at "doomsday" yet the bank itself is right now the strongest bank in the world.

It is impossible, in my view, to find a stronger bank anywhere in the world, yet investors were given the chance to buy new equity at "doomsday prices". With the benefit of hindsight that will be seen as a tremendous opportunity.

The demise of the once all-powerful global hedge fund community, and the clear breakdown in the relationship between prime brokers and many of the hedge fund clients is now prompting equity capital raisings being priced at appropriate discounts to appropriate investors. Look how good the secondary market in CommBank has been. It went into tight hands even though the book was only slightly more than covered. This is telling me I should be looking to "write the cheque" over the next few months for capital raisings, particularly if I get to subscribe for new equity at "doomsday prices" while simultaneously strengthening the balance sheet of the company I am writing the cheque to.

BHP. Let’s run the numbers

It’s time to run the "doomsday scenario" over our largest company and largest index weight stock, BHP Billiton. Now clearly, BHP's balance sheet is superb and it will not be doing any form of discounted equity issue (except to lucky Rio Tinto shareholders if the deal goes through). The only chance to buy BHP at "doomsday or below" will be from the market, there will be no new equity issue.

Below I am going to run the "doomsday" commodity price scenario. We can all debate these prices, and I agree this isn't a perfect science, but I have picked commodity prices at which producers will make a cash profit but do not make a return on capital.

Of course the big variables in the modelling are copper, oil, nickel, iron ore and coal. The rest are a bit of a sideshow. All the prices above are in US dollars. I model BHP in US dollars then translate my US dollar net present value (NPV) to Australian dollars using the doomsday cross rate of US65¢.

The doomsday scenario spits out a US dollar NPV of $US18.83 for BHP, which translates to $28.97 at my doomsday cross rate.

So $28.97 is "doomsday" for BHP (Friday closing price $27.74). I suppose it’s unsurprising that at the absolute peak of fear, equity risk premium and forced liquidation that my BHP doomsday NPV is at the current share price. However, I must caution readers that BHP has traditionally traded in a range between a 40% premium and 20% discount to NPV.

And $23.18 is "Armageddon" for BHP. On that basis, the ultimate Armageddon scenario for BHP is a 20% discount to $28.97. That generates a share price target of $23.18. I personally don't see that as a share price at which BHP will trade, but if it is we should all stock up on baked beans, candles and ammunition because it's going to be every man for himself and BHP's share price will be the least of our problems!

At least we know we are buying BHP today at "doomsday" and within 23% of 'Armageddon". That is the margin of investing error right now. If you are like me and you neither believe in "doomsday" nor "Armageddon" then today's BHP share price is an investing and trading opportunity right now. I realise it feels like "Armageddon' today.

BHP using "long-term" inputs

Now I am going to run my BHP model using my long-term commodity price assumptions that I use in my modelling of resource stocks. Again these are debatable, but the key ones are conservative and mostly significantly below the even the depressed spot prices we see today.

$46.87 is "long term" for BHP

Using my long-term price assumptions, the model calculates a BHP NPV of $US36.09. At an assumed long-term cross rate of US77¢ that translates to $46.87, so the current BHP share price represents a 46% discount to my long-term NPV.

In the current environment of absolute fear its unlikely we will see BHP hot my long-term NPV share price target. However, I believe BHP shares will "settle" over the next few months somewhere between my "doomsday" price target of $28.97 and long-term NPV of $46.87. There should be no doubt BHP shares will rally from today's "doomsday" levels as fear eases in global markets over the next few months.

$38.82 is the mid-point between "doomsday" and "long-term"

I suspect BHP shares will settle around $38.82, midway between the “doomsday” and long-term NPV figures. That will not happen tomorrow, but I can see BHP gravitating to those levels over the next six to 12 months despite global economic headwinds. That would be a 29% return from BHP shares over the next 12 months and that will cream cash (at say, 5.5%) as an alternative if I am right. The return will be larger if BHP gets control of Rio and the market starts pricing in synergies and index weight increases.

Consensus earnings to come down, but are already discounted?

Clearly there have been very, very large falls in industrial metal and oil prices and it appears clear that consensus earnings forecasts for BHP for the current year are too high. But before we get worried about that, there is no doubt the stock has fallen significantly more than the consensus earnings need to be revised down. BHP has clearly suffered prospective price/earnings (P/E) compression over the past few months and I am of the view these consensus earnings downgrades are more than reflected in BHP's current share price.

BHP 2008-09 P/E of 5.78 times

Adjusting 2008-09 forecasts to reflect the lower industrial metals and oil prices, I see BHP generating earnings per share of $US4 in 2008-09. Remember, about half of BHP’s earnings are contracted so the downgrades come from tradeable metals and oil, etc. I am lowering our average AUD/USD cross rate for 2008-09 to US77¢ and that translates to earnings per share for 2008-09, in Australian-dollar terms, of $5.19. At the current share price, that places BHP on 5.8 times 2008-09 earnings, which you can hardly argue is expensive.

Then add dividends and capital returns

Remember BHP has a progressive dividend policy and will pay out no less than US74¢ in dividends this year. At an average cross rate of US77¢, that equates to 96¢. I'd be of the view that is the minimum dividend payout a shareholder could expect from BHP in 2008-09. At today's prices, that places BHP on a minimum prospective dividend yield of 3.3%, which is actually not that much worse than cash!

BHP: the resource world's Warren Buffett?

What the market also refuses to price in is the optionality BHP's huge cashflows and balance sheet give it in a world that is completely short capital and funding.

The second and third-tier resource world has been abandoned by investors and banks. There are now hundreds of unfunded resource projects all around the world (which is a huge positive for the long-term supply/demand equation). There is clearly a role for BHP to play to fund some of these unfunded projects via being issued preference shares in the style Warren Buffett has been doing lately in industrials.

However, those hoping for BHP to fund their marginal project will be sorely disappointed. I could only see BHP funding tier-1 resource projects in politically stable countries. The point is that BHP could become" the Fed of resources" and pick up some wonderful projects on excellent terms from forced sellers.

I realise we are in a world that can't see past tomorrow, but BHP's balance sheet, cash flows, and ability to source funding are a monumental advantage in the current environment. In my mind BHP deserves a significant P/E premium to the sector for these factors alone.

So here we are and Australia's strongest and biggest company is being priced at "doomsday" and on its way to "Armageddon" in the eyes of some people. Perhaps that is appropriate in the current environment of absolute fear, but as credit markets reopen and indicators of fear ease a notch, BHP's shares will move into a higher trading range between “doomsday” and “long–term”. That mid-point price target is $38.82.

The first stock I would be buying for any short-term relief rally is BHP, while the first stock I'd be buying from a medium-term investing perspective is also BHP. Nothing wrong with buying great assets at doomsday prices from forced sellers.