Digging Deep

BHP reported an annual profit for the 12 months to June 2005 of US$6.5bn or AU$8.6 bn (up 86 per cent), at the high end of consensus expectations. Key features of the result included:

1. Sales rose 28 per cent to US$31.8bn.
2. Operating profit (earnings before interest and tax '” EBIT) rose 70 per cent to US$9.3bn.
3. EPS (earnings per share) rose 89 per cent to US$1.06.
4. Return on capital rose to 32 per cent from 21 per cent

Despite the US$7.2bn cash Western Mining takeover, the balance sheet remained strong. Gearing was a comfortable 36 per cent at year end with interest cover an exceptional 35 times, up from 21 times last year.

COMMODITY EARNINGS

BHP is a diversified resources company. The following table shows that BHP’s earnings are most dependent on iron ore (carbon steel materials). This contributed 30 per cent of EBIT in the 12 months to June 2005 (FY05) but is expected to rise to nearly 40 per cent in FY06. Energy is the next largest contributor with petroleum contributing around 20% of earnings and thermal coal contributing another 10 per cent. Base metals (mostly copper) contribute 16–22 per cent of EBIT. Following the Western Mining acquisition, stainless steel (mostly nickel) should increase its contribution to about 10 per cent of EBIT in FY06. The remaining commodities aluminium, diamonds and specialty products, contribute the remaining 10–15 per cent of EBIT.

The following table highlights the earnings growth by commodity in the last 12 months. It shows that every commodity showed significantly improved earnings. The largest increases came from iron ore, coking coal, copper and thermal coal. It is interesting to compare the profit increases with the underlying price rises of some selected commodities. For example the underlying price of iron ore and coking coal rose about 55 per cent (6 months impact only), however their profit contribution increased nearly 150 per cent. Every commodity except petroleum, experienced a profit rise greater than the underlying commodity price rise highlighting the operational leverage within the businesses. However petroleum’s earnings (up 32 per cent) disappointed in the context of a 46 per cent rise in average oil prices and reflected lower second half volumes and higher costs.

COMPANY PROFIT DRIVERS

The FY05 result reflected three main company profit drivers – rising volumes, exceptionally strong prices, partly offset by significantly higher costs. The following BHP charts highlight how each of these profit drivers impacted the FY05 result.

Volume
Price
Costs
Summary

CASHFLOW

Operating cashflow rose 61 per cent to US$10.9bn. After interest and tax BHP had cashflow available for its use of US$8.7bn, a rise of 70 per cent.

Of this about 20 per cent or US$1.8bn was used to buyback stock. Another half was used for investment. Capex rose 48 per cent to US$3.8bn and exploration spend increased 17 per cent to US$.5bn. In addition BHP acquired Western Mining for US$7.2bn during the June half.

BHP has flagged further investment of US$6bn in FY06. Even after allowing for this level of spend in FY06, conservatively BHP is likely to have US$4bn left over for either further acquisitions or capital management. The following BHP charts highlights BHP’s expansion program. The first charts shows the projects on which the company has delivered in the last 4 years. The second chart shows the projects planned over the next 5 years.

One of the few disappointments with the result was the dividend. Despite a good result, BHP only raised dividends 8 per cent to US$.28c per share. This was below market expectations of US$.29–.295c. The resulting 26 per cent payout ratio was the lowest for many years. As a result the cash paid on dividends actually fell in FY05 to US$1.4bn (from US$1.5bn).

CHINA

As with so many other resource stocks, BHP is a China play. The following chart shows how significant this has been for BHP’s revenue. In FY02, BHP only sold US$.4bn worth of products to China. In the last 6 months of FY05 they sold US$2.4bn worth of product which represents nearly 13% of total revenues.

However this table only tells half the story. China’s influence has been much more persuasive than just buying product from BHP. Its exceptional economic growth rate has been the major influence driving commodity prices to hitherto unheard of levels. This culminated earlier this year with iron ore price increases of 71 per cent and coking coal increases of over 100 per cent.

SENSITIVITIES

BHP is clearly most sensitive to commodity prices. The following table summarises BHP’s key sensitivities. BHP’s earnings are most sensitive to iron ore prices (which rose 71 per cent in 2005). The next highest sensitivity is oil whose current spot price is up more than 40 per cent compared to the average received in FY05. Whilst BHP’s earnings in FY05 clearly benefited from surging commodity prices, they are also clearly vulnerable to any material weakness. From the following table it can be seen that a 10 per cent drop in the prices of all BHP’s main commodities, could cause a 25 per cent plus fall in BHP’s NPAT.

The following table takes this analysis a step forward. We use current spot prices and BHP’s earnings sensitivities to estimate likely FY06 earnings. The resulting forecast of US$8.9bn equates roughly to consensus earnings.

INVESTMENT RATIONALE

Although BHP’s earnings rose 86 per cent in FY05, the market was expecting an excellent result. That’s why the BHP stock price has risen 61 per cent in the last 12 months. And that’s partly the reason why the stock fell 4 per cent in the immediate aftermath of the result.

The market discounts the future. So now that the 2005 result is 'done and dusted’ all eyes now turn to the likely 2006 result. As I showed earlier, I calculate that market estimates calling for another 35 per cent profit rise in FY06 are based more or less on current spot commodity prices. I also showed earlier that a 10 per cent change in the prices (up or down) of all BHP’s commodities, would have a leveraged impact on BHP and change earnings by about 25 per cent (again up or down).

So the risks are high. On the one hand the China growth story may continue. On the other hand, and this is what I consider the biggest risk, higher US interest rates and high oil prices could undermine global growth leading to significant commodity price weakness. Already there are some concerns about this scenario creeping into stock markets.

After the 4 per cent fall since the result BHP is trading on a P/E of about 10.6x. Given this may be top of the cycle earnings, the valuation is no bargain. My instinct says don’t rush out and buy it now. Certainly below $19, the P/E multiple starts to fall back to single digits. And that is more in keeping with 'top of cycle’ commodity pricing.

Despite this caution, I think there is an obvious switch. Many portfolios contain smaller, more speculative mining and oil stocks. Many of these have shown exceptional returns in the last 12 months. However if (when) commodity prices start to drop, these same stocks could look very ugly. Therefore if this scenario develops I would strongly urge investors who wish to retain an exposure to commodities to switch those speculative positions into diversified miners like BHP. When commodity prices begin to fall, all commodity stocks will fall. But iconic stocks like BHP should lose less altitude, and at a slower pace than the more speculative end of the market.

Leading stockmarket analyst Mike Mangan previously worked for Deutsche Bank. The author has an option position in BHP