Three questions for BHP

Never make promises you can't keep: that is likely to be the leading accusation levelled by shareholders at the board of BHP Billiton during the Australian leg of the company's annual meeting in Perth tomorrow.

The theme of broken promises is just one that will dog directors of the big resources company as they are forced closer to abandoning the pledge of a “progressive dividend” (BHP looking at a dividend cut?, November 11).

It is the generous dividend, running at an annual $US1.24 per share, which implies a cash yield of 8.5 per cent at the company's current share price, which has lured thousands of investors to BHP Billiton at a time of low interest rates.

But, even a drover's dog can sniff out the problem of paying out more in dividends than a company is earning, which is what BHP Billiton seems likely to do this year, and for at least the next two years.

If the investment bank UBS is correct in its latest analysis of BHP Billiton, the company's earnings per share in the three years between 2016 and 2018 will total $US1.91 while the promised dividend of $US1.24 per year will cost $US3.72 – close to double earnings.

Believers in BHP Billiton being able to stick with its promise of a progressive dividend point to the company's strong cash flows and its ability to continue cutting costs and restricting capital investment in new projects as a way of sticking with the $US1.24 annual payout.

Cost cutting, however, can only go so far before it eats into the core of a business. Meanwhile limiting capital investment on project development and exploration in a resources business is a proven way to shrink a company.

While the progressive dividend is a hot topic for investors relying on BHP Billiton's generosity (or concerned about it) a number of other subjects are likely to be raised during the meeting which is the second leg of an AGM process which started in London on October 22.

Unlike previous BHP Billiton AGMs where what is said at one is repeated at the second this year will be different because so much has happened in the past three weeks, and so much which has gone wrong recently looks like a repeat of past problems.

The immediate issues, and the ones which will set the Perth meeting apart from the London meeting, are:

• The Samarco tailings dam disaster in Brazil which killed at least 11 people (with 12 still missing), closed a big iron ore mine and looks likely to take years to repair at an unknown cost.
• A further steep fall in commodity prices, including a sharp (4.5 per cent) drop overnight in the iron ore price which is now trading at $US45.48 a tonne, and
• Concern about the directors suggesting that they might increase the company's debt level to service the promised dividend.

The similarity between the past and the present will have older shareholders reminding directors of a series of hugely expensive (and failed) investments, such as US copper mining, WA iron ore processing, complex nickel processing, titanium minerals production and African platinum mining.

Collectively, the botched projects in the 1990s cost BHP Billiton around $10 billion in asset-value write-offs, cost senior executives their jobs, and even triggered a proposed takeover from arch-rival Rio Tinto.

The latest list of setbacks has not created a corporate crisis, yet, but they will cause shareholders to ask whether all of the problems have been caused by the downward turn in commodity prices or by poor management decisions.

Samarco is the immediate problem for BHP Billiton and while it falls into the category of tragic accident it also calls into question the company's claim of being safety conscious given that five workers were killed on other company sites last financial year and the Samarco death toll seems likely to climb.

In defence, BHP Billiton has been quick to point out that the mine is a 50/50 joint venture with Brazil's Vale – though that leaves open the question of whether anyone at BHP Billiton was overseeing a project in which it had invested at least $3bn of shareholder funds, and if not, why not?

The Samarco dam failure, and a hurried examination of all other dams on BHP Billiton mine sites, could lead to a suggestion that cost cutting has gone too far and that shedding skilled professionals has deadened the company's corporate memory.

The steep drop in prices for most of the company's commodities will also be raised and while management will correctly argue that prices always rise and fall shareholders will question why the company has continued to expand production at a time of falling prices.

BHP Billiton is not alone in boosting iron ore production at a time of low prices but the urge to retain a place as one of the world's lowest cost suppliers of the steel-making material appears to be based on two beliefs which might prove to be expensively misguided:

• That over time high cost iron ore mining rivals will be forced out of business, and
• That Chinese demand for steel will continue to rise.

The first assumption is likely to be correct, but it could take years for sufficient high-cost iron ore to disappear from the market for the price to recover.

The second assumption about Chinese steel demand looks to be hopelessly out of touch with reality, as well as being the opposite of what the Chinese Government is forecasting.

Other issues which could have older BHP Billiton shareholders suffering a dense of déjà vu include heavy investment in US onshore oil production just in time to be hit by a collapse in the oil price and an ill-timed investment in a trial potash mine at a time of sluggish demand for the crop fertiliser.

South32, the BHP Billiton spin-off which saw it shift a load of second-tier assets into a separate business, will also be raised by shareholders who have seen the value of their investment in the new company plunge by 40 per cent since it listed on May 18, worse than BHP Billiton's 35 per cent fall over the same time.

A repeat of the problem-plagued 1990s is the last thing BHP Billiton needs, though it is important to not forget the list of past failures that include:

• The 1996 investment in Magma Copper which ended with a $3.2bn write-off.
• A poorly designed Hot-Briquetted Iron (HBI) project which also cost around $3bn and killed a worker.
• The Hartley platinum mine in Zimbabwe (at least $500 million but also marred by the worker deaths).
• Beenup titanium in WA (about $300m), and
• Ravensthorpe nickel, also in WA (costing at least $3bn).

“What comes next” is a question that might be raised at tomorrow's Perth meeting because BHP Billiton does have issues similar to those historic failures that need cleaning up, including whether to persevere with the Nickel West business in WA which is posting heavy losses and might cost up to $1bn to close.

But the issue closest to shareholders is the dividend with everyone keen to hear whether it can continue to remain progressive across the commodity price cycle – a heavy lift given that no-one knows how long it will take for the current cycle to turn.