BHP and the iron ore crash

It's easy to say that the time to buy a cyclical business is the trough of the cycle, but it's a lot harder to do. We invest amid uncertainty and, because of that, cyclical investments should be approached with caution rather than conviction.  

In Biting into BHP part one and part two, we recommended buying BHP in tranches. Buy a little and, if prices fall, buy a little more.

If you haven't yet bought BHP Billiton shares, we again recommend buying a few now. The case remains the same: returns from its four key divisions wont revisit the stellar results of the past few years but we expect them to be respectable nonetheless. Combined with less capital expenditure, free cash flows should rise faster than profits to help fund generous dividends. Finally, the valuation today represents a fair price for a decent business.

After spinning off South32, BHP is now a miner of just four commodities: iron ore, oil and gas, copper and coal. Its assets aren't a far flung collection of mines knitted together by accountants and lawyers. Uniquely among miners, BHP commands control of vast basins with enormous resources – think the Pilbara, the Bowen Basin, Escondida and onshore US shales.

With assets of this size and quality, BHP can control production rates, costs and capital expenditures to a much higher degree than peers and remain at the best end of the cost curve.

Although commodity prices have fallen precipitously we expect return on assets to remain reasonable and strong cash flows to be generated as BHP cuts costs (see Table 1). Nowhere is this more visible, or important, than in the colossal iron ore division.

ROA still A-OK

Despite a calamitous fall in iron ore prices – down from highs of US$180 a tonne to US$50 a tonne – BHP's return on assets from this division is still well over 30%, enough to generate operating cash flow of over US$10bn. That figure has been reached by cutting costs and raising output.

Over the past two years, cash costs have almost halved, from US$30 a tonne to about US$16 a tonne, helping to preserve margins. It's worth noting that when the iron ore price was under US$20 a tonne in 2002, BHP still generated ROA of 35%, suggesting the potential for further improvement.

BHP isn't alone in slashing costs. Every producer is doing the same, leading some to claim that there's a 'race to the bottom' and that historic rates of return will never again be reached.  We disagree.

It is true that everyone is cutting costs savagely. Fortescue Metals, for example, reports cash costs that have fallen to US$25 a tonne, not miles away from BHP or Rio Tinto. BHP's costs cuts, however, may prove more sustainable than those of its peers. The crucial difference is in how, not by how much, costs have been cut.

A key determinant of cost is known as the strip ratio, or the ratio of waste to ore. Generally speaking, less waste movement means lower costs. BHP's Pilbara mines call for a long-term strip ratio of 1.3 times, meaning that 1.3 tonnes of waste needs to be moved for every tonne of ore.

BHP's chase for lower costs hasn't involved a change to this crucial ratio. Instead, it has pursued numerous efficiency gains from an empire that neglected efficiency for years – lifting utilisation rates on equipment, tweaking logistics, lowering labour costs and increasing automation. BHP's cost cuts haven't come at the expense of its mine plan and should therefore be sustainable. 

This isn't the case at Fortescue. The mine plan at its primary production hub, Solomon, calls for an average strip ratio of 1.4 times, yet the business has been using a strip ratio just 1.0 times. Fortescue has pursued lower costs by selectively mining the most profitable parts of its landholding.

In some commodities, that doesn't matter; in iron ore mining, it does. Selectively mining higher grades means, at best, higher cost extraction is merely deferred to a later period. At worst, it permanently reduces mine life. This is true of many smaller producers who have cut corners to cut costs.

While smaller peers will founder and eventually fail, we expect BHP to achieve attractive rates of return from the Pilbara at almost any conceivable iron ore price.

A fair price

Using our ROA estimates, we expect BHP to generate about US$1 a share in earnings this year. As costs fall, productivity rises and prices modestly recover, we expect sustainable earnings of around US$1.70 per share. This suggests a current PER of about 26 will fall to about 16 by 2017. Even better, the free cash flow yield (which deducts capital expenditure from cash flow) should grow from zero now to about 5% over the same time. These are fair prices for a high-quality business.

Miners always warn that booms sow the seeds of a bust by encouraging overproduction. The opposite is also true. If we can generate decent returns during lean years, holding BHP when the cycle inevitably turns will be highly profitable. Due to the lower commodity prices we're trimming our Price guide to Buy below $27 (from $28) and Sell above $40 (from $45), but BHP still earns an upgrade to Buy. We recommend a small weighting now – 2–4% of a risk tolerant portfolio – but if prices keep falling, we'll recommend topping up again. BUY. 

Disclosure: Staff own shares in BHP but dont include the author.