Is BHP finally turning the corner?

The road to recovery is becoming clearer, but don’t expect fast acceleration.

Summary: The once 'big Australian' is now significantly smaller than it was, thanks to a run of bad news. Next week's earnings result won't be good either, but there are promising signs.

Key take-out: A combination of cost cutting and other productivity improvements combined with some improvement in commodity prices should point to some price recovery.

Key beneficiaries: General investors. Category: Commodities.

In theory, BHP Billiton will next week complete its run of horror financial news after a financial year every shareholder in the company wants to forget.

And that triggers the question: is it safe for investors to take a fresh look at Australia’s biggest resource stock?

Probably, is the quick answer, but only if you have patience and believe that the company’s management team has stopped making promises that can't be kept.

Tuesday, at around 4.30pm eastern time, is when BHP is scheduled to release its financial results for the year to June 30. While the group’s net profit after tax is likely to be around $US1 billion, the reported loss could be as much as $US6.5bn.

Earlier today the investment bank UBS tipped that BHP would report a loss of $US6.8bn which, if correct, would be the biggest ever loss by the company.

The difference between the net profit and the reported loss is largely explained by asset-value write-offs, staff redundancies, project closures and other charges such as the $US1.2bn provision made at its 50 per cent share of funding restoration work at the severely damaged Samarco iron ore mine in Brazil.

After the profit (and loss), the number most shareholders will be keen to see is the final dividend. This is expected to be around US16 cents, taking the full-year payout to US32c – a long way short of the $US1.24 paid previously.

Management promises about not cutting the dividend, and a failure to keep them, has cost BHP Billiton dearly over the past 12 months. That’s perhaps even more so than the problems caused by lower prices for most of the company’s commodities, especially oil, coal and iron ore.

Building the recovery infrastructure

It’s when your focus shifts from the past and you take a glimpse into the future that the picture of a company which so badly lost its way becomes a little brighter.

Discarded is a blind belief in the “stronger for longer” slogan which misled everyone exposed to commodities. Crashing prices were a reminder that the so-called super-cycle was nothing but a normal commodities cycle which had run its course from boom to bust.

Rather than relying on high prices to do the heavy lifting BHP Billiton management, along with counterparts at other resource companies, is now doing the hard work of cutting costs, reining in budgets, and laying the groundwork for a return to rising profits and dividends.

Importantly for investors, the recovery will not be quick. The next few years will be a slow grind up, which is why patience is required and why the big resource stocks such as BHP and Rio Tinto might re-emerge as strong performers, especially when compared with returns on other forms of investment.

If, for example, UBS is correct and the full-year’s dividend comes in at US32c, the stock is currently offering a dividend yield of 2 per cent. This is roughly what you can expect on a 12-month term deposit with the big banks.

The point in that comparison is to demonstrate that while BHP Billiton has been a severe disappointment as an investment over the past three years, it might have hit rock bottom and has started to rebuild its financial performance and corporate reputation.

Signals from the stockmarket point that way and, with the benefit of hindsight, it seems that mid-January was the low point for the stock when its shares dropped to $14.06, roughly half of what they were 12 months earlier. Today, BHP Billiton is trading around $20.50, a gain of 46 per cent in seven months.

Source: Bloomberg, Eureka Report.

The long road back

What comes next in the restoration of an Australian corporate icon that so badly misread the markets for its wide range of commodities?

The process of repair, which includes Tuesday’s financial report and dividend declaration, actually started late last month when BHP Billiton reported its production numbers for the year to June 30.

While not sparkling and generally below the numbers for 2015, they were above guidance from management – a hint that the company has learned its lesson about over-promising and under-delivering.

Only metallurgical (steel-making) coal beat 2015, and that was by just 1 per cent. Petroleum output was down 6 per cent, copper was down 8 per cent, iron ore was down 2 per cent and thermal (energy) coal was down 16 per cent – stark evidence of the worldwide decline in demand for commodities.

BHP Billiton chief executive, Andrew Mackenzie, expects better in the current 12-months thanks to a productivity (cost cutting) drive and investing only in projects requiring small amounts of capital.

“These initiatives are expected to grow production by 5 per cent in copper, up to 4 per cent in iron ore and 3 per cent in metallurgical coal in the next financial year,” Mackenzie said in a statement on July 20.

Significantly for the new and humbler BHP, all of the growth forecasts are in single digits. That’s an acknowledgment that the era of double-digit growth is over and that stronger-for-longer has been replaced by the new mantra of lower-for-longer.

Production restraint, however, does not necessarily mean that profits will not be able to grow. Aiding this endeavor will be the deep cuts being made in costs and the increased levels of productivity that comes from making assets (and people) work harder.

UBS reckons that the current year could see a number of significant improvements in BHP’s performance. While revenue is expected to creep up by 2.6 per cent to $US31.8bn, earnings before interest and tax (EBIT) could rise by 69 per cent from $US2.7bn to $US4.6bn.

Credit Suisse and Macquarie also see a modest increase in revenue from commodity sales but a similar sharp increase in EBIT.

Dividends are expected to grow as the revival takes hold, with Credit Suisse tipping a payout in the current financial year of US34.25c a share while UBS is forecasting US45c.

Don’t bank on a commodities surge

None of the forecasts assume a rapid recovery in commodity prices. The new reality for all resource companies is having to generate higher profits from flat(ish) revenue.

For the more optimistic investor there is a bit of blue sky to consider. Oil, for example, could be the wild card in BHP’s pack. While it is limping along at around $US44 a barrel, and could drop below $US40, the outlook is for a reasonable price recovery in 2017.

Oil could be BHP’s “get out of jail” card because it is the commodity most likely to stage a strong recovery given that the collapse of exploration and project development will eventually cause a worldwide production shortfall.

BHP’s other commodities will have a less exciting year. Iron ore is expected to fall after its recent surge of demand. Copper seems likely to be flat because of strong supply and modest demand growth. Coal appears to have found a bottom and is showing signs of an encouraging recovery.

But before getting to the good news, BHP has to complete the process of getting all the bad news out of the way. That’s a step likely to be taken on Tuesday, which should clear the way for the company’s resurrection in the eyes of investors.

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