Reviving the Olympic dream

PORTFOLIO POINT: BHP Billiton’s lower result reflected consensus forecasts, but the miner’s shares remain a strong hold.

BHP Billiton reported this week and created much controversy with its decision to pull back on expenditure at the Port Hedland harbour and to shelve the development of the massive Olympic Dam project.

BHP’s full-year net profit in the year to June 30 slumped by more than a third to US$15.42 billion (A$14.77 billion), reflecting lower commodity prices and large asset write-downs. Revenue was up 0.7% to $69.18 billion.

I will cover some of the key aspects of the financials a little later, but up front I would like to reflect on the Olympic Dam decision. In doing so, I profess that I have no specific or in-depth knowledge regarding this resource. I will simply be relying on the widely reported statements that it is a massive potential mine with a 100-year resource covering copper, uranium and gold.

Its development would create a project of “national significance” with benefits flowing strongly to the South Australian and the Australian tax payer for decades to come. The following table from the BHP result actually notes that the expected demand for copper continues to exceed the supply coming to the market going towards 2020.

Figure 1. Forecast supply additions relative to anticipated 20 year demand growth (2000 to 2020)

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Source: BHP Billiton

So let me pose this question. How can Australia get this project done?

We now know that BHP as the owner cannot afford to fund this mammoth project in the current environment. It would consume too much free cash flow and the first returns on the investment are a decade away. Further, the massive increase in debt could affect BHP’s credit rating and lift its cost of debt.

Fair enough in the short term, given lower commodity prices, the slowdown in world economic growth, the tightening of credit, the European debt crisis and the US fiscal cliff. However, is that a reason for the nation of Australia to wait?

This is a difficult political and philosophical question. By how much and at what time should governments get involved in projects of national interest?  When they do so, what is the return that they should require? When they determine returns, should they consider the direct financial return or the total returns flowing through the tax system?

Ideally it is the private market, owned by public shareholders (if they are truly competitive and efficient), that should finance and undertake major resource projects. However, when that cannot occur what should a community do?

To answer this we need only to reflect on the current NBN rollout. Here there was no real public debate on the decision to roll out the NBN across Australia. This $40 million project could have been a public/private partnership but that was not considered. The Commonwealth decided to do it alone, funded by debt and the whole project was conceived by Kevin Rudd on the back of an envelope. OK, maybe that is not true but it is good story.

So why not consider whether Olympic Dam could be a public/private/overseas partnership? I mentioned a few weeks ago that the Australian government has a wonderful opportunity to draw upon bond markets that are wildly mispricing risk. That is the direct result of the GFC and the European debt crisis. The cost of debt offered to the Australian government is remarkably low, and it is a logical way to fund both the NBN and now part of the Olympic Dam project. We don’t have to project out 100 years; a mere 20 years will suffice to come to the conclusion that borrowing at 3.5% for 20 years is cheap debt.

When the world recovers (it always does) then growth will appear, volumes will rise, commodity prices will lift and, importantly, the cost of debt will rise. Supporting this is the knowledge that growth in the developing world of China, India, across Asia, South America and Africa will continue for decades.

Importantly the financing of a 100- year project will benefit future generations and support the retirement aspirations of the current generation. Funding major long-term projects with cheap long-term national debt is absolutely the way to go.

How would it work? Well, on the back of my envelope I have written $30 billion – $10 billion of equity from BHP; $10 billion of funding from the Australian government (hybrid/bridging debt) and $10 billion (debt/equity) from offshore parties who want long-term supply of Olympic Dam outputs. The terms of the agreement and the timing of the inflows need to be worked upon, but with a 100 years of output there is plenty of scope.

Importantly for the Australian taxpayer, a proper 20-year funding package which costs 3.5% pa (interest cost) to service, should generate a real return well above this cost. Arguably it would generate a higher return than a minerals resource rent tax, and this is not even currently levied on copper, uranium and gold. Then there are the tax collections from income, company, payroll, levies and royalties.

Finally, from a BHP perspective it would diversify its earnings stream, for as the following table shows its business has become very iron ore and petroleum centric.

Figure 2. Underlying EBIT

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Source: BHP Billiton

Ultimately it all depends on a nation’s will to bring a project of national significance to fruition. If that is not possible, and I suspect that it isn’t in this political climate, then it is truly a sad reflection on the state of the country and those that lead us.

The BHP result

Back to reality, and I can report that the BHP result comfortably met market expectations. However, those expectations had been massaged down over the last six months. The result has been extensively reviewed in the press, so I will focus on what I regard as the key issues for our decision to hold BHP in our growth portfolio.

The key metrics for shareholders (apart from the profit) were:

• Net operating cash flow was $24.3 billion, which is about 20% down on the previous year’s $30 billion;
• Net debt rose by $12 billion as BHP spent over $32 billion on capital investments;
• Dividends to ordinary shareholders lifted from $5.1 billion to $5.8 billion;
• Tax and royalties paid lifted to $8.8 billion from $6.6 billion.

Going forward, the company has significantly cut back on its forecast of capital investment. $22 million is earmarked already for 2012-13 and if it sticks to this level then the projected operating cash flows should cover this without significant recourse to debt.

As noted above, the decision to shelve Olympic Dam was made essential by the slowing in forecast cash flow. Indeed, with iron ore prices drifting lower the company and shareholders must monitor export volumes to ensure cash flows are maintained above forecast expenditure.

A review of the return on equity shows a normalised (including franking credits) return on equity (NROE) of 33% for 2011-12. This is a decline on recent years and a weakening commodity outlook suggests that sustainable NROE will be just 28%.

From this I can derive a current valuation of about $40 per share, which will rise over 2013 if earnings are as forecast. On that basis the shares remain a solid hold in my portfolio.

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Clime Growth Portfolio

* Market prices as at close August 23, 2012.  ^ Purchase price as of close June 29, 2012

John Abernethy is the Chief Investment Officer at Clime Investment Management. Register for a free trial to MyClime – online stock valuation service, or attend a MyClime investment seminar in your capital city.