BHP: facing the falling knife

It’s sliced cash from many investors in the past 12 months – BHP management’s next moves are crucial.

Summary: BHP Billiton’s half year result included a pre-tax loss of $US5.67 billion and a revision of its progressive dividend policy. Investors should ask whether the company is going a similar way to other resources giant, Anglo America, given both are exposed to flooded commodity markets. Investors should seriously consider how long the commodity downturn will last, whether they believe in BHP’s management’s ability to seriously the situation around, and what the opportunity cost of sticking to the stock would be should it take a significant period of time to recover.

Key take out: Management at BHP should be learning from Anglo American’s mistakes – even so, BHP investors should treat the stock more carefully than they have before.

Key beneficiaries: General investors. Category: Commodities.

BHP Billiton’s dividend cut, and a promise to reform its management structure, has been accepted by investors but questions remain about whether it has a viable plan for the future or if it will replicate the mistakes of another one-time resources giant, Anglo American.

For much of the past 100 years, BHP (with or without Billiton attached) operated in much the same way as Anglo American, dominating their respective markets. BHP in Australia, Anglo American in South Africa.

The two companies have traditionally produced a similar mix of minerals, with some significant variations, and both have recently been buffeted by the sharp fall in commodity prices.

Even the numbers in the latest results are eerily alike, albeit one for a half-year and the other for a full year.

BHP Billiton’s underlying pre-tax loss of $US5.67 billion for the six months to December 31, reported this week, neatly mirrors Anglo American’s underlying $US5.62bn loss for all of 2015, reported last week.

In both cases the result is a worst ever financial performance, leaving these companies busy repairing damaged reputations – though that’s were a key difference can be seen.

Anglo American’s problems are worse than those of BHP Billiton, but whether that’s simply a matter of timing is what investors should be thinking about.

The critical issue is that both companies are exposed to flooded commodity markets, with excess supply and sluggish demand in key markets such as China and Europe crushing prices, and with limited signs of a sustainable recovery.

Perhaps even more importantly, both mining companies are carrying uncomfortable amounts of debt; BHP Billiton with an estimated $US25bn, Anglo American with $US12.9bn.

Debt and mining never mix well for the simple reason that income from mineral sales can vary enormously (as has been seen over the past two years) while debt has to be serviced at a regular pace. That’s why credit ratings agencies have downgraded both.

In time, prices for commodities will recover as high-cost sources of supply are driven out of the market, but how long that will take is a question that no one can answer correctly, with the surprisingly long period of depressed prices for oil and gas a warning that markets can behave irrationally for longer than some companies can tolerate.

At BHP Billiton the company’s chief executive, Andrew Mackenzie, has promised that the company will stick to its core business interests of producing iron ore, petroleum, coal and copper, while possibly looking around for acquisition bargains from distressed vendors, such as some which Anglo American wants to sell.

That plan for the future follows BHP Billiton breaking its progressive dividend promise, slashing the half-year payout from US62c to US16c, as well as re-setting the dividend to a minimum of 50 per cent of underlying future earnings. Strictly, if BHP had applied the new dividend policy to the latest interim return, the dividend would have been $US4c not $16c...as it turned out the company did not apply the policy immediately, but it is something for every shareholder to think about because it will happen soon.

Most of the damage to BHP Billiton’s half-year performance was a result of lower commodity prices which slashed revenue by $US7.8bn, but hefty asset-valued write-downs also weighed heavily on the latest result.

Underlying pre-tax earnings, perhaps the best measure of how operations performed before extraordinary charges, were down 54 per cent to $US6bn.

At Anglo American, the annual pre-tax earnings number also look at lot like those of BHP Billiton at the half-way mark, down 38 per cent to $US4.8bn.

Interesting as it is to draw a financial parallel between the two companies (even if one set of numbers is for 12 months and the other for six months) the more important point is to consider the mess made by Anglo American of its once-great reputation and wonder whether BHP Billiton will do something similar.

The latest version of Anglo American’s survival plan is to accelerate an asset sales program which the company’s chief executive, Mark Cutifani, acknowledges has been too slow, resulting in missed opportunities to sell.

Desperation is too strong a word to described what’s now likely to happen but in order to please rating agencies Anglo American is expected to try and sell more than half of its assets, including its iron ore, manganese and nickel assets in order to focus on just three business units, copper, diamonds and platinum.

It is a spectacular melt-down of a business which was once so dominant that it represented 30 per cent of the value of the entire Johannesburg stock exchange, and held the title of world’s biggest mining company – a title now held by BHP Billiton.

A key part of the Anglo American survival plan is to drive debt down from the current $12.9bn to $6bn over the next few years, a target which will require successful asset sales and a commodity-price recovery.

BHP Billiton, once known as the big Australian, is not at the same point in its evolution as Anglo American but there are seasoned investment analysts asking whether the proposed changes will ensure that it avoids a similar fate, especially as it remains a captive of commodity markets.

UBS, an investment bank, started its review of yesterday’s BHP Billiton result by noting that: “Some changes at the big Australian. Is it enough?” The answer to its own question is yes, if its 12 month share price target of $22 (up 33 per cent today’s price) is a guide, plus a buy tip.

Deutsche Bank has a similar cautious view of the outlook for BHP, warning that it appears to have “no clear strategy to lift growth and returns”, though that warning shot is offset by a 12 month price target of $20.50 and a hold tip on the stock.

Credit Suisse has a buy tip and a price target of $20 plus a comment that the half-year result was a mix of “the good and the not so good”, adding in the body of its analysis that the outlook for the short-to-medium term for the resources sector remains challenging with prices taking time to recover and likely to remain volatile.

Long-term investors in BHP Billiton have suffered through previous periods of the company making strategic mistakes and botching acquisitions, followed by a recovery phase as commodity markets rebounded and strong cash flows washed away the blunders.

It will probably be the same this time around, but there are five questions for investors to consider. They are:

1. How long will the recovery take given that the commodity downturn is likely to be prolonged after the mother-of-all commodity booms?

2. What is the lost opportunity cost of sticking with a stock that might take years to shake off the effects of the downturn?

3. Whether the management changes will deliver a positive result or if they are the equivalent of “circling the wagons” to defend head office and ward off outside attacks.

4. Will BHP Billiton buy distressed assets simply because they’re look cheap and risk inheriting someone else’s problems? and

5. Is BHP Billiton tracking Anglo American and will it eventually be forced to make radical changes to its business model for survival?

That final point represents an unlikely outcome because management at BHP Billiton should be learning from Anglo American’s mistakes.

But, given the way the history of the two companies has moved in parallel for the best part of a century, and the fact that they are both heavily exposed to similar commodity markets, and it would be wise for investors to treat BHP Billiton more carefully than they have in the past.

It is a company which has a place in most investment portfolios but over the past 12 months it has behaved like a falling knife, slicing cash from everyone who bought when they though it couldn’t fall any further.