BHP: So big, so cheap

The biggest Australian – BHP Billiton – did not disappoint long-term supporters such as me by delivering a "consensus" 2007-08 result of $US15.4 billion, combined with a 51% step change upwards in the final dividend. It is somewhat ridiculous that $US15.4 billion is described as "consensus". This so called "consensus number" was $US2 billion lower 12 months ago and only recently centred in on $US15.4 billion once the analysts had the full-year production report. It's not very hard to "forecast" BHP earnings when you are in possession of the production volumes and average received prices!

The final dividend of US41¢ was clearly ahead of "consensus" of US36¢ and it was encouraging to see BHP did listen to the market’s concerns about dividend yield. The full-year payout of US70¢ was up 49% on the previous period, which BHP says "is a strong signal of our confidence in the outlook". Remember this is a rebasing of BHP's progressive dividend policy, so unless the world changes dramatically for the worse in 2008-09 you won't be getting less than US70¢ in dividends from BHP this financial year.

On my forecasts, BHP can easily pay out over US110¢ in 2008-09 (out of earnings per share of US432¢), which would take the prospective 13-month yield (US151¢ = A173¢ @US87¢ cross rate) to 4.5% in Australian dollars if you buy while still cum the final dividend (US41¢). Who said you don't buy mining stocks for dividend yield? I am pleased the BHP board acknowledged the importance of sustainable dividend yield, but there's much more to come back to investors in the form of dividends over the next few years. BHP describes the dividend as "an annuity that we constantly build". BHP is cum the final dividend until August 29.

As usual, the level of detail that BHP provided to the market was exceptional. The level of disclosure is beyond any other Australian company. I suspect some of the reason BHP puts out so much detail because there are so few analysts actually covering their stock right now. There is just so much detail in the results presentation pack, and in this note I am going to focus on what I thought were the key charts in the pack. Some of these numbers are staggering, but they will be bigger next year.

To put this in context, there are only 11 Australian companies that have market capitalisations larger than BHP's EBITDA (earnings before interest, tax, depreciation and amortisation) in 2007-08! You can see why I spend some much time analysing and writing about BHP.

Similarly, the next operating cash flow was a staggering $US18 billion.

Costs were extremely well contained, considering 2007-08 was a period of "hyperinflation" in labour and materials costs in the industry. This 4.3% increase in group costs was outstanding cost containment by BHP.

Group margins were a solid 48%, yet BHP chief executive Marius Kloppers said in the results presentation that the second-half EBIT margins (earnings before interest and tax) were 50% as higher bulk contract prices kicked in. It's not easy to find another company of this scale in any industry with EBIT margins of 50%.

The margin growth was driven by production growth in its highest-margin business (iron ore, petroleum, metals and manganese). This is a deliberate strategy to grow production in the highest-margin commodities. BHP set production records in Petroleum, Base Metals, Iron Ore, Manganese and Energy Coal in 2007-08. They got the volume out in their highest-margin businesses. BHP forecast 10% group production growth in 2008-09 and again this will be in their highest-margin commodity businesses.

This chart above shows you the biggest EBIT growth contributors due to commodity price variance and it paints a pretty clear picture of where you do want to be at the moment: bulks and energy. While this is a BHP note, this chart shows you the leverage in a stock like Fortescue Metals Group and, conversely, why laterite nickel stocks are under pressure.

Commodity outlook

BHP reinforced its long-held view about China being predominantly an internal demand-driven economy. BHP management said they had seen some slowdown in export-driven sectors such as light manufacturing but no change to sectors associated with urbanisation and heavy steel intensity.

Supply remains the key issue

While BHP itself is producing a production response the industry as a whole continues to struggle to generate a meaningful supply response to higher prices. I have written numerous times in these notes that the commodity supply response is overestimated and it is supply that all the forecasters are getting wrong. BHP clearly agrees with this view and put out a series of charts to emphasise why supply is continually overestimated and commodity prices continually underestimated.

BHP believes the credit crisis is having an effect on the resource industry. The real effect is that new projects by smaller companies are struggling to get capital funding. I also think the point about new developments are increasingly tending to be "smaller, lower-grade and in higher-risk geographies" is a very key point.

The chart below simply graphs analyst supply growth forecasts for copper and show they have been pushed back two or three years. The supply response remains overestimated in time and scale, while underestimated in marginal cost of new production. For example most global copper price forecasters have Olympic Dam kicking in next year in scale when the expansion is 12 months away from even the Environmental Impact Study being completed.

Now for $US24 billion net profit

The 2007-08 result is impressive but it is historic. We are two months into 2008-09, and getting the direction of BHP shares right is about accurately forecasting 2008-09 earnings. I would usually say 2008-09 and 2009-10, but in a market that can't see past tomorrow I think 2008-09 is all we need to focus on. This financial year sees production growth again in the highest EBIT margin businesses, as illustrated below. It's also worth noting that 88% of the planned production growth is in lower-risk countries, while 97% of the production growth is in countries where BHP already operates. It's all "backyard growth", as BHP describes it.

I use an average copper price for 2008-09 of $US3.30 a pound and an average West Texas Intermediate oil price of $US120 a barrel. I assume BHP will deliver the 10% production growth in key high margin commodities this year, while I think bulk commodity prices will rise again in the fourth quarter of 2008-09. None of that is outrageously bullish considering the spot iron ore price continues to command around a 30% premium to the Indian export price and Xstrata just settled high grade coking coal contracts at a 20% premium to the BHP settlement price.

All this spits out a net profit after tax of $24 billion or earnings per share of US432¢ (A496¢ @US87¢ cross rate). On today’s share price that equates to a P/E of 7.7 times 2008-09 likely earnings. It's also worth noting we see BHP growing earnings by 55% in 2008-09, which is phenomenal for a company of this scale.

At the end of the year BHP was running gearing of just 18% and had interest cover of 49 times. Do not underestimate the power of that balance sheet strength in a world short of capital.

The Kloppers factor

It seems to me that the investment community generally doesn't know BHP chief executive Marius Kloppers that well. He's not a high-profile "noise maker" and the comments he does make are calculated and to the point. He makes the odd appearance between results but broadly he sticks to running the business. I genuinely don't think he basks in the glory of his role. I think he is totally driven by the success of the business, not his title. The only "cocktail parties" you see him at are ones where he is representing BHP's interests with a customer or a country. He could walk down Pitt Street and 99.9% of people wouldn't have a clue what he does.

Kloppers is just 45 years old. I am absolutely convinced that he is the right man at the right time for BHP. The guy is absolutely on top of his game. There's every chance in my view that Kloppers will be chief executive for the next 10–15 years and oversee BHP's rise to being the most profitable company in the world.

Rio: 2 1=5, but not at any price

Kloppers this week described the opportunity with Rio Tinto as "2 1=5". The "2" plus "1" is accurate because BHP is basically earning double what Rio does at the moment. The BHP/Rio spread has collapsed to 2.99:1 despite Rio's noisy defence and BHP's offer of 3.4:1 looks more compelling by the day. This week’s results show you Rio most likely would only have contributed 38% of earnings to a merged group yet Rio shareholders are being offered 44% of the merged group. I see no reason why they should be offered any more and it appears the market, via the BHP/Rio spread pricing, agrees.

However, investors won't have to vote on the now hostile proposal until about March next year if it gets through the European Union. You can see why arbitrage funds are getting bored and unwinding positions. Unfortunately, this is like stalking your prey and the process is a drawn-out one. Yet the prize is very large.

Best people, best assets, best balance sheet

I back the best people with the best assets. I am happy to tolerate the short-term trading volatility that comes between reporting periods because I know in the end that backing the best people with the best assets is how to generate long-term outperformance. BHP has the best people with the best assets and the best balance sheet, yet all for less than 8 times next year's 55% higher earnings.

BHP Billiton remains Australia's strongest company and one of the world's strongest companies. There is just no debate about that. Amazingly, however, it remains one of the cheapest stocks in the world on all investment criteria. In fact it remains cheaper (in P/E terms) than at any time in the past five years. I continue to recommending buying BHP shares, particularly while they remain cum the final dividend. BHP remains the world's most leveraged play on urbanisation and infrastructure. BHP is "resourcing the future" while concurrently "resourcing the future retirement savings" of millions of Australian's via rebasing the dividend.

Charlie Aitken, a director of Southern Cross Equities, may have interests in any of the stocks mentioned.