BHP Billiton is a blue-chip staple of Australian share portfolios. The stock has been listed and popular for so long that many shareholdings are passed down between generations. But is the blue-chip tag deserved? And how do you know when to buy BHP? What does ‘blue chip’ mean anyway?
BHP is the world’s largest miner, so it offers leveraged, cyclical exposure to world economic growth and commodity prices. Investors bearish on world growth should not own BHP Billiton, and vice versa. The challenge for investors is to forecast world growth correctly. The sharp slowdown in world growth over the last five years matches the decline in BHP’s total shareholder return over the same period, while the modest share price rally of the last 15 months restores TSR.
Figure 1: BHP total shareholder return Source: StocksInValue
Profitability is also sensitive to production costs, volumes and exchange rates. A change in the iron ore price of just $US1 per tonne can swing BHP’s NPAT by 1 per cent.
These four variables – world growth, production costs, volumes and exchange rates – are difficult to forecast and can vary widely, yet they determine BHP’s intrinsic value. Therefore, we question whether the ‘blue chip’ tag is appropriate for BHP and whether some investors are clear about what the label means to them. BHP is not about to go broke but its profitability gives away its leverage to the highly cyclical resources sector. Between the 1989 financial year and the 2013 financial year, normalised return on equity fluctuated between 47 per cent (1999) and 54 per cent (2006) with an average of 20 per cent.
Asset writedowns over the period of many billions of dollars partly explain the variability in NROE. The unpredictability of our four key value drivers makes it harder for BHP to avoid overpayment for acquisitions. Writedowns can be seen as the capitalisation of future losses or earnings shortfalls relative to expectations.
Meanwhile, BHP Billiton’s 2013 financial result was soft, with lower revenue, higher expenses, higher gearing, lower NPAT and a fall in operating cashflow as commodity prices fell.
We expect somewhat stronger world growth in 2014, though still well short of a ‘normal’ fast recovery from recession. Major Australian miners report firm demand for commodities. The problem for BHP is falling prices for iron ore, metallurgical coal and copper due to increased supply after massive investment in new capacity by the industry. Eventually the slower rate of investment growth should balance supply and demand and prices will level out.
Over the long term the outlook is positive as the fundamentals of wealth creation, demographics and urbanisation continue to raise demand for commodities across Asia and other markets.
As China urbanises and transitions to a more consumption-based economy, commodities supporting the production of food, energy and consumer goods should experience demand growth. This explains the $US2.6 billion investment at the Jansen potash project in Canada. The thesis is a potential global supply gap beyond 2020. BHP’s bet is potash will one day provide valuable earnings and returns to shareholders, just as the iron ore deposits acquired in the 1960s do today.
The appointment in May of new chief executive Andrew Mackenzie heralds a new era, after the commodity price boom, of mostly operationally focused organic growth. The outlook for flat to weak commodity prices makes large, expensive M&A deals less profitable and harder to justify to shareholders.
BHP pays out 50 per cent of its earnings as dividends – more akin to a small-cap growth stock than one of the market’s largest companies. Most of BHP’s large-cap peers pay out 60-90 per cent of earnings. The relatively high 50 per cent rate of reinvestment reflects the capital intensity of the business (large fleets of transport vehicles and mining, ore processing and distribution machinery) and the constant depletion of BHP’s reserves through mining. BHP must reinvest in exploration and/or the acquisition of new mines to replace its own mines as they become exhausted or uneconomic.
The progressive dividend policy aims to steadily increase or at least maintain the dividend in US dollars at each half-yearly payment. In recent years the company stuck with this policy despite shareholder pressure for a step increase in the payout ratio. The gradual dividend increases partly compensate for the volatility in the share price.
We forecast average NROE of 23 per cent. Our required return is 12.9 per cent, reflecting sound fundamentals, large market capitalisation and excellent access to both debt and equity markets.
We have conducted a bull and bear case scenario analysis that accounts for the swings in NROE by adopting an NROE 3 per cent above and below our base case of 23 per cent. In a bearish case, using an adopted NROE of 20 per cent, we derive a valuation of $30.61, which is 20 per cent below our valuation for the 2014 financial year. In a bullish case, using an NROE of 26 per cent, we derive a valuation of $47.05, which is 22 per cent above our 2014 valuation.
Figure 2: BHP share price and StocksInValue valuation Source: StocksInValue
BHP is trading at a 10 per cent discount to our $38.50 valuation for the 2014 financial year. Given the wide range of outcomes possible when investing in BHP, and the difficulty in predicting the main value drivers, we think investors should wait for a wider margin of safety before buying.
David Walker is Head of Equities Research at StocksInValue, a joint venture between Clime Investment Management, a boutique value fund manager, and Eureka Report. StocksInValue provides valuations of 400 ASX-listed companies by Clime and equities research, insights and strategy that you won’t find elsewhere, by the StocksInValue analyst team. For a free trial please visit www.stocksinvalue.com.au or call 1300 136 225.