Why BHP belongs in neutral territory

The mining giant’s consensus $40 price target is subject to change.

Summary: On the surface, BHP Billiton’s latest financial results ticked all the right boxes. But digging deeper into the mining giant’s numbers, and in assessing external influences on the company’s operations, the outlook for investors will be heavily dependent on the $A, the iron ore price, and bulk commodity export volumes.
Key take-out: BHP’s market value has lifted despite a declining return on capital employed, while a slip in normalised return on equity has constrained the growth in the value of the miner’s shares.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Neutral.

This week I am reviewing BHP Billiton, but before I go into discussing its valuation I feel it is worth reviewing the following charts that were recently published by the Reserve Bank of Australia.

These charts put into proper context the performance of BHP.

The first is the returns generated by various sectors of the Australian sharemarket over the last 10 years. It is immediately discernible that, contrary to many views espoused by commentators, the resource sector of our market has outperformed all other sectors. It has even returned significantly higher shareholder returns then our much-lauded financial services sector.

This is interesting, because Australia’s two fastest-growing sectors over 10 years have been resources; courtesy of the Chinese industrial growth cycle, and our major banks, courtesy of a household debt binge and growth in superannuation assets.

The above chart (Figure 1) emphasises that share prices got ahead of themselves prior to the GFC. Resource stocks fell hardest and recovered quickest. Recent years saw them drift back as the reality of lower commodity prices and a strong $A acted to dampen profits.  

The next chart (Figure 2) shows the direction over the last five years of Australia’s main export commodities. It is apparent that bulk commodity prices mirror that of resource share prices.

When I review BHP later I will note that these recent commodity price declines have been offset by significant volume increases. It is remarkable, and a little disconcerting, to realise that about 60% of Australia’s total export income of about $350 billion is generated by bulk commodity exports. These charts, and the observation of the significance of bulk commodities, suggests that Australia has never been so vulnerable to an external price shock that emanates from just one commodity - iron ore.

Similarly, BHP is becoming more exposed to the fortunes of iron ore but nowhere near to the extent of Rio Tinto Ltd (ASX code: RIO). That is why I let RIO go from the portfolio a few weeks ago.

With regards to iron ore and coking coal, the next chart (Figure 3) shows that their specific pricing levels are clearly influenced by steel prices in China. The gentle decline of Chinese steel prices, from the heady days that followed China’s massive fiscal response of 2008-09, is obvious to see. The question for investors is to determine where the steel price will ultimately settle, because it will influence iron ore and coal prices.

The BHP first-half result

I do not propose to go through the details in great detail, as they are comprehensively covered by BHP in its ASX release. However, I can confirm to readers that it was a good result as measured by all the metrics that matter. Earnings, dividends, cash flow and gearing all improved. The result has led to market earnings upgrades and our forward valuation in “StocksInValue” has lifted because the projected return on equity has risen.

The first-half did benefit from a number of factors. In particular, these revolve around iron ore. Production of iron ore increased by 19% and iron ore contributed to just over 50% of total group cash profit. Interestingly, iron ore generated nearly three times the profit of the petroleum and potash divisions, with approximately 50% fewer assets employed.

Also, iron prices remained firm throughout the second-half at about $US130 per tonne and the $A drifted lower. Higher $A prices and higher volumes meant that BHP’s iron ore profit had to be higher.

Of the other major divisions, copper stood out. Its profit represented just under a third of group profit and its return on assets was good at about 16%. The weak division was coking coal. Despite a 22% lift in volume the profit represented less than 5% of group profit and the return on assets was very poor at 3.5%. Of much less significance to profits was the struggling manganese, nickel and aluminum divisions. Their contribution was negligible.

Group cash flow was particularly strong as a result of iron ore cash flows and a reduction in capital investment. In particular, BHP noted a significant reduction in exploration expenditure. Therefore, the company forecast net debt to fall to $25 billion by year-end – equivalent to gearing of about 34%. Indeed, the company foreshadowed the potential for capital management initiatives later in the year, despite adhering to its progressive dividend policy.

The valuation

Readers should note the following five-year financial report from StocksInValue closely. In doing so, I suggest that you focus on a few key lines.

First, rather than focus on net profit performance, readers should note the normalised earnings performance. This normalisation adjusts for changes to reserves or carrying values and includes the benefit of distributed franking credits. This line shows a remarkably steady profit performance.

However, and this is the crux, the profits are holding steady on significantly increasing capital invested. The equity employed by BHP has nearly doubled over five years, whilst the profit has lifted by 15%. Thankfully, dividends over five years have lifted a little faster, growing by about 30%.

Source: StocksInValue

As a result, the above table (Figure 4) shows that normalised return on equity has declined and this has constrained the growth in the value of BHP’s shares. Whilst more equity is positive for value, the lower returns on equity are negative for value. BHP has employed a lot of equity in recent years and so its value has lifted despite a declining return on capital employed.

This leads me to the forward estimate of value, which I suggest is about $40 as at June this year.

Source: StocksInValue

The valuation is based on market consensus earnings and is subject to change, with the $A, iron ore price and export volumes all playing a role.

For investors, this leads to me to suggest that BHP is a hold for our growth fund at current prices. An appropriate margin of safety of at least 10% is required for purchases (i.e. $36). Based on what I know now, a sharp lift in the share price above $43 would lead me to reconsider my position.

Further, if BHP proposed a buyback at above $40 per share then I would seriously question its logic. To my eye, higher dividends would be more sensible.

Mineral Resources Ltd

Finally, followers of the Growth Portfolio should recall I flagged that Mineral Resources Ltd (ASX code: MIN) would be sold if it rallied to above $12 per share.

This has occurred and the portfolio has lifted cash holdings yet again. This is not a reflection on MIN but rather an acknowledgement that it is a highly volatile stock, which is also heavily exposed to the iron ore price. However, it does not have the diversity of BHP and it has reached fair value.

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au

Clime Growth Portfolio Statistics

Return since June 30, 2013: 9.62%

Returns since Inception (April 19, 2012): 28.93%

Average Yield: 5.80%

Start Value: $141,128.64

Current Value: $154,712.11

Dividends accrued since June 30, 2013: $3,622.96

Clime Growth Portfolio - Prices as at close on 25th February 2014
FY14 (f)
GU Yield
BHP Billiton LimitedBHP$31.37$39.104.46%$40.172.74%
Australia and New Zealand Banking GroupANZ$31.00$32.027.76%$34.407.43%
Westpac Banking CorporationWBC$28.88$33.427.78%$31.54-5.63%
Woolworths LimitedWOW$32.81$36.605.46%$35.91-1.89%
The Reject Shop LimitedTRS$17.19$10.575.00%$11.337.19%
Brickworks LimitedBKW$12.70$14.604.01%$12.80-12.33%
McMillan Shakespeare LimitedMMS$16.18$11.155.77%$12.058.07%
SMS Management & Technology LimitedSMX$4.55$3.926.20%$5.1330.87%
SecurityCode Value 

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