PORTFOLIO POINT: Improvements in Europe, China and the outlook for iron ore should hearten investors.
Buried in the BHP Billiton half-yearly report was some good news both for the company and for Australia. Most Australian share portfolios have BHP (and often the banks) as key inclusions. The banks might be facing a struggle but BHP is looking in very good shape and does not look over-priced, given that its annualised half-yearly earnings, at about $3.50 a share, gives it a price/earnings multiple of about 10.5 times.
Now to the good news. BHP is much more optimistic than when it was clearly concerned about the rate of the China slowdown and the possible European meltdown.
There is a high likelihood of tough economic conditions in Europe but in BHP’s view the fear of a meltdown is fading. And China is beginning to stimulate its economy again. You will remember that in the past couple of weeks I have highlighted the fact that last year (at the time when BHP was most nervous) mainland Chinese had halved their buying of Sydney and Melbourne inner-city apartments, according to Meriton’s Harry Triguboff.
Come January and they are back in the market. So the BHP view is reinforced by the actions of the Chinese themselves.
This is good news for all of Australia but it will particularly underpin BHP. My second piece of good news is actually portrayed by the daily newspapers as bad news. It is clear that BHP paid too much for its US shale assets and might even need a writedown. The company thought that the high US gas prices would be maintained or increased but instead they halved. The good news in this is that historically BHP shareholders are most at risk when the company gets too confident.
The US shale purchase may be a good one longer term but it has dented the confidence of management and they will be careful about what they do next. BHP has a long string of new investments and chief executive Marius Kloppers says that there will be careful prioritising and at least one project may be deferred to lessen the BHP risk. That means BHP will not let gearing get too high.
The third item of good news from the earnings report is that the increased supply of iron ore expected in 2012, as a result of new projects around the world, has been delayed and will not be coming to market this year, as had been thought likely.
At the same time, a better outlook for China means the demand for iron ore is rising, which means that in 2012 the Chinese are going to require high outputs from their own high-cost and inefficient mines. So the iron ore price will probably rise during 2012, particularly as India is cutting back its exports.
This will underpin BHP earnings for calendar 2012 and underpin the share price. Longer term, that rise in the iron ore price will lock in many higher-cost iron ore projects, which in the end might cause an oversupply problem in the market.
BHP and Rio Tinto are both planning major expansions of iron ore, possibly to deter both the Chinese and the banking community from backing high-cost projects. China is increasingly dominating the processing of minerals and the BHP strategy is to minimise its processing to concentrate on being a major ore provider has turned out to be a very wise one.
BHP has three major project decisions in 2012: to expand Olympic Dam; to develop Jansen Potash; and to build an outer harbour at Port Hedland. The company had planned to proceed with all three during 2012, which would have meant an enormous capital outlay in the next two or three years; without a very big boom, BHP borrowings could rise. Now BHP is talking about living within its means and could postpone one of the projects.
The most obvious project to drop is Olympic Dam because it would require digging an enormous hole for the open-cut mine, which would take four or five years involve a large capital outlay without rewards for a long period. But former South Australian Premier Mike Rann was canny in granting BHP tenure at Olympic Dam on condition that the project would be started within a certain time frame.
Moreover, both China and India want that uranium so my guess is Olympic Dam will proceed on schedule. Given the iron ore situation it will be very difficult to defer the Port Hedland outer harbour, which means Jansen Potash is the project most likely to be deferred. I must emphasise that these conclusions are mine and I have not been briefed by BHP on this subject.
BHP also has a number of very profitable brownfield additions at Escondida, Queensland coal and US oil/gas. Both Escondida and the US projects will proceed but I don’t think the Queensland coal will go ahead because of union action.
The unions are determined to gain control of the management of the BHP Queensland coal operation and BHP is simply not going to let them do it. Unless there is a radical union change they will cancel the Queensland expansion and even shut the mines if necessary. BHP has similar coal reserves in Indonesia and it may shift its funding from Queensland to Indonesia. But the scale of the project is nothing like the big three.
The institutions are constantly wanting dividends and capital returns from BHP. This is a total nonsense and reflects their misunderstanding of the company. This is a stock that is generating enormous amounts of cash and is using that cash to undertake a huge expansion program which will change the face of the company in four or five years’ time. It would be totally irresponsible to have a capital return and lifting the BHP dividends is not all that sensible in this situation.