Reasons for BHP's caution

The disparity between the views of investments banks on what BHP Billiton should do with its pristine balance sheet and BHP's own apparent inertia is widening. Not a week goes by, it seems, without another major investment bank urging the group to either make a big acquisition or embark on a massive share buyback.

BHP, having sailed through the global financial crisis and the associated bloodbaths in credit and commodity markets, appears in no particular hurry to loosen its purse strings.

At last balance date it had $US11 billion of cash within a balance sheet with only $US5.6 billion of net debt and gearing of only 12 per cent. For a company that generated operating cash flows of nearly $US19 billion last year in the most testing of conditions, that is absurdly conservative.

And yet, Marius Kloppers and his soon-to-retire chairman, Don Argus, have resisted the calls to deploy their balance sheet capacity, and temptations provided by the distressed state of many of their peers. They got close, with the aborted bid for Rio Tinto, but were sensible enough to pull the plug on that offer as conditions deteriorated and the threat posed by Rio's mountain of debt rose.

To be fair, BHP does have a lot of projects in its pipeline, which it didn't slow or truncate during the worst of the crisis. Its production report this week showed it has about $US15 billion of projects in various stages of development and plans to spend about $US800 million on exploration this year. If the joint venture with Rio Tinto proceeds, there is another $US5.8 billion that will be required to equalise the companies' interests.

Broadly, BHP can be expected to sink about $US10 billion a year into new projects. With operating cash flows of more than $US20 billion a year – its cash flows are highly resilient because of the unmatched diversity within its portfolio of operations – it can afford to.

The analysts take the view that BHP can maintain its organic growth, keep increasing its dividends and either make a major acquisition, or two, or conduct a massive buyback to put more leverage into its affairs.

The imminent accession of former Ford chief executive Jac Nasser to the BHP chair (no handover date has been announced) could, perhaps, see a change of attitude. Argus, a former National Australia Bank chief executive who joined the BHP board during its darkest days, is famously conservative and his period as chairman has seen BHP maintain a very clean balance sheet and an inherent aversion to risk.

It is possible that Nasser might be more entrepreneurial, but unlikely. His long background in the turbulent automotive industry would have made him acutely aware of the need to focus on cash and capital.

There are some headline similarities between the financial characteristics of the auto industry and the resources sector – both involve very, very large bets and very long lead times to bring complex projects to volatile markets.

Given that the current state of his old industry provides a graphic illustration of how much can go wrong when any level of financial leverage is brought next to operational leverage (something Argus understood from his banking days) Nasser is unlikely to be a risk-promoting chairman.

One interpretation of BHP's reluctance to take on any material leverage and its desire to remain highly liquid is that it isn't as convinced as some of its peers – and, it appears, most of the market – that the worst of the crisis is behind it.

While China is once again roaring along, and demand and prices for commodities are consequently strong, there are, as my colleague Robert Gottliebsen pointed out yesterday, some disturbing developments.

This week the Chinese authorities told some of their banks to simply stop lending for the rest of the month. Last week they effectively tightened monetary policy. If the Chinese are concerned about their economy and the levels of speculative activity in it, the rest of us should be as well.

A significant slowing of the Chinese economy, or even just significant volatility, could send a second wave of fear and instability through markets and the resources sector.

If BHP is in risk-aversion mode, it will sit on its cash and maintain minimal gearing until it is certain that the foundations of the global economy and credit markets are stable, and then maintain the conservative financial settings that used to distinguish both it and Rio, before Rio made its ill-timed debt-funded acquisition of Alcan.

Nasser has been on the BHP board since April 2006 and therefore is a known quantity to both Argus (who he has known a lot longer) and the wider BHP board.

It is improbable that he was anointed to oversee a radical change in the careful course Argus and Kloppers, and before him Chip Goodyear and Paul Anderson, have plotted over more than a decade. The Rio experience, where BHP came close to taking on the Alcan funding, ought to have reinforced their conservatism.

Thus, if and when BHP does make an acquisition or announces a buyback, it will either be because it has so much surplus cash and cash flow that it can both self-finance its project pipeline and still do something meaningful strategically or return cash to shareholders or because it is absolutely confident about the near to medium term outlook.