Imagine BHP on steroids

I have never felt more frustration about the chronic short-termism and instant gratification that has taken over the Australian equity market.

The market response to BHP Billiton's $US10 billion result is so typical. BHP has invested heavily in future earnings growth, and chief executive Chip Goodyear's comments after the result provided clear confirmation that management is committed to a long-term growth strategy, aimed at significantly enhancing shareholder returns.

However, the market’s current "instant gratification" mentality resulted in BHP being sold-off sharply by hedge funds and quant momentum funds, on the basis the capital return should have been larger. The consensus forecasts expect 2006-07 earnings momentum to slow to "just" $US11 billion next year. As a well-known tennis player was fond of saying to inept umpires: "You cannot be serious!"

The real issue that is overlooked by the price and earnings momentum style is the "value" equation. At under 10 times prospective earnings, BHP is trading on the lowest multiple it has been during the current four-year cycle. Further, considering the low consensus commodity forecasts, I think BHP's earnings forecasts are 20% underestimated. The real 2006-07 multiple is probably closer to eight times.

I was amazed to hear recently that one long-standing resource analyst from a big investment bank was contemplating an underweight call on resources, considering the earnings slowdown next year. In the context of a weaker retail environment, I think Woolworths' $1 billion result was a remarkable achievement, and full credit to management. However, BHP is massively undervalued at just half the forward earnings multiple.

So how do we get BHP to an appropriate multiple?

Last week BHP Billiton reported a tremendous set of numbers and the stock promptly fell by 6%. Other stocks also reported tremendous earnings and cash flows and they rallied '” Oxiana (OXR) by 5%, Zinifex (ZFX) by 4%, Kagara Zinc (KZL) by 10% and Minara (MRE) by 11%. No offence intended towards any of those four, but their asset bases, asset lives, earnings, and cashflows are dwarfed by BHP's.

So we have to ask ourselves why did BHP fall 6% while others rallied? The main reason given for BHP's fall was "disappointing capital management", "no earnings surprise", " mixed outlook commentary", and "diversified model", according to the broker views I read. I would disagree strongly with them all, but the stock was led down by its UK listing, which widened to an 11% discount to the ASX listing.

My personal views on the UK listing are well known, and it was pleasing to see the company says it will focus the buyback program on the discounted UK listing. However, that's a Band-Aid solution, and the only way to fix it for good is a "UK amputation".

The argument for the dual listing goes along the lines that it "internationalises the company", "attracts foreign investors in their own time zone", "gives access to deeper capital markets", and "attracts international employees that an Australian company could not". These are all good arguments in theory, and I might be persuaded if I saw the UK listing swinging from discount to premium regularly. All I see now is the UK discount consistently widening, and all that says to me is that the listing is increasing BHP's effective cost of capital, and holding back the group price/earnings (P/E) multiple.

I believe the "internationalising of the register" argument is inaccurate. I've had a detailed look at the register of the UK listing, and in my view just about every significant investor on it also directly invests in Australian equities. Yes, there are some FTSE Index funds on the register, but their Australian counterparts are also on the BHP register. If these people all directly invest in Australian equities anyway, the whole "time zone" argument goes out the window. The only people who like the "time zone" option in the UK stock are European and US hedge funds, which can create short-term volatility in the stock in their own time zone. For genuine global long-term investors the time zone argument is also inaccurate.

We operate in a global world, however I believe some BHP executives fear losing global relevance by having a primary Australian listing. That's an argument I also disagree with, and would remind readers that Rupert Murdoch took News Corporation's (NWS) primary listing away from Australia only to realise that due to the power of compulsory superannuation and a big index weight, the highest rating for his stock was actually in Australia. Murdoch went through all the trouble of leaving Australia to get a lower P/E rating in the US; there's a lesson in this for BHP. There's also a lesson in bringing Brambles back home, which certainly has expanded its P/E rating and will continue to do so.

Australia used to be a net importer of investment capital, but now due to the combination of a strong economy, full employment, and compulsory superannuation, we are a net exporter of investment capital. We have the fourth largest pool of retirement savings in the world, and the best rating you can get for your Australian stock is in Australia.

Doctor Aitken prescribes

Here’s how to get BHP Billiton shares to $40 and a sustainable P/E multiple of 14 times: First, offer all UK investors a scrip-based rollover at parity, to roll their PLC shareholdings into BHP. Those who don't want to roll their scrip over for an immediate 11% uplift should be offered a cash alternative at a 5% discount to the BHP (Australian) price. As in the Brambles example, I believe you'd be surprised by how many investors would accept Australian scrip '” and by how few would choose the cash alternative.

Even better, the more UK investors that accept your scrip-based offer, the higher your ASX200 index weight will be. BHP could end up being 15% of the ASX200, the benchmark for the fourth-largest retirement savings pool in the world. BHP would be attracting 15¢ in every Australian superannuation dollar that goes into Australian equities. Assuming 40¢ in every Australian superannuation dollar goes into domestic equities, BHP would be attracting 6¢ in every Australian compulsory superannuation dollar, and that could fund decades of growth.

Domestic index funds would be forced to adjust to the new index weight, and before you know it, the P/E re-rating would have started. Australian banks now trade on a P/E premium to the world; why can't BHP trade on a P/E premium to the resource world?

While I couldn't be more upbeat on BHP's prospects, I just can't see how an appropriate multiple will ever be applied to the stock under the current dual-listing structure. The ever-widening UK discount tells me the Poms simply don't value BHP's strategy. This is a world-leading company, with unbelievable assets, and an unbelievable balance sheet. It also has world-class management, and the only factor holding back the group’s P/E rating in my view is the dual-listing structure.

I know all the global investment banks will all be telling BHP to keep the dual listing, but are they interested in the best long-term interests of BHP or just in maintaining trading opportunities for hedge funds between the two listings? My view remains that the dual-listing structure encourages hedge funds and speculators into the stock, adds volatility, and restricts the overall P/E.

There just my thoughts, and with our without the dual listing I remain a strong supporter of BHP. The broking community will probably come out of denial about commodity prices in the next couple of months, and heavy upgrades to BHP consensus earnings for 2006-07 and 2007-08 are coming. BHP will make $US14 billion this financial year and nobody sees that coming '” certainly no one in the UK market.

Every six months you get a chance to take candy from the short-termist baby, and that is right now in BHP.