BHP: Interim result 2019

BHP's recent trouble-free operating run has come to an end, with three operating hiccups - a train derailment in Western Australia and production halts at copper and nickel mines - impacting its latest result. Still, if this is what disappointment looks like, we'll take it.

A train derailment that severed its intricate logistics system at Port Hedland barely made a dent, with production down just 1%. Lower commodity prices, notably oil, made more of a difference, wiping US$100m from operating profits. 

More disappointing, perhaps, were weaker productivity gains which were offset by higher costs. 

Shareholders would forgive these small misses, however, because over the past six months, BHP has returned a colossal US$13bn in cash in the form of dividends and buybacks, funded from cash flows and the sale of its shale division.

Even amid modest commodity prices, the profitability of BHP's assets was staggering. 

The basins

Iron ore continues to generate operating margins close to 60% and returns on capital around 30%. Those numbers should improve considerably in the full-year results as the surge in iron ore prices late last year is counted.

Petroleum now looks a lot better without dilution from shale, with operating margins of 70% and a return on capital of almost 20%. Margins tend to sound more impressive here because so many upfront costs are capitalised (and therefore not counted in the margin calculation) but we still think new projects should be able to raise the return on capital. 

The worst performing division was, again, copper, although this still contributed US$1.9bn in earnings before interest, tax, depreciation and amortisation (EBITDA) and margins of 43%. 

BHP and its partners have spent a lot of money on Escondida to raise returns and, despite it being the world's largest copper mine, it continues to generate returns on capital of just 4%. 

Management suggested that new investments made in processing should raise returns but higher wage costs and regulatory burdens habitually offset the enormity of the ore body.

Could do better

The worst performing asset in the entire portfolio remains Olympic Dam, arguably the most impressive geological marvel in mining. It continues to run losses but investors should be patient. With huge deposits of nickel, copper, uranium, gold and silver, it's incredibly valuable if processing and metallurgy complexity can be sorted. BHP, we are told, is working on it.

Overall profitability remains astounding. For the full year, we expect operating margins of about 55% and a net profit of close to US$10bn. Lest you think these numbers merely reflect lots of capital spent, returns on equity approach 20%. All this when commodity prices can hardly be called excessive. 

Spend small

BHP is well prepared to weather storms. The balance sheet carries less than US$10bn in debt, a relatively small sum compared to the cash it generates, and most importantly capital allocation remains sensible.

Capital expenditure of US$8bn a year for the next few years doesn't sound modest, but it compares with up to US$20bn a year during the boom. So in the context of BHP's massive portfolio, US$8bn is a sensible sum. Half of that goes to asset maintenance and optimisation and the rest on development and exploration. 

Capital expenditure should be lumpy in the long term and we should prepare for higher expenses as major projects ramp up but, in the immediate future, strong free cash flows are likely to end up back in shareholders' accounts.

With several years of excellent performance, we should not forget that this remains a cyclical business. While prices are off their highs, they could go lower and, if they do, returns would suffer. That said, BHP doesn't appear excessively dear and, with a rock-solid balance sheet, it is well position to profit from a downturn. 

We're raising our Sell price from $40 to $45 recognising that, though it remains cyclical, BHP is now a fine business. We don't want to let those go easily. HOLD.

Note: Our Model Growth and Model Income portfolios own shares in BHP.

Note: The Intelligent Investor Equity Growth and Equity Income funds own shares in BHP.