BHP Billiton: Hedge or hog?
Recommendation
The popular image of BHP Billiton is as a cyclical business that makes decent money in the good years but loses it by the bucket load in the bad years. In truth, BHP has not made an operating loss for more than 20 years. That period includes major global upheavals: the Asian financial crisis, Russian and Argentine debt defaults, September 11 and, of course, the global financial crisis.
Yet despite the multitude of crises, BHP has remained resilient, generating operating profits in the face of each calamity.
That's not to say it has all been smooth sailing. The acquisition of Magma Copper in the 1990s ultimately cost more than $4bn and almost brought the company down. The complex Ravensthorpe Nickel project cost more than $3bn a decade later. And then there are the years of accumulated losses from steel.
Key Points
- BHP’s past losses have been mistakes of capital allocation
- Profits have already peaked
- Remains the pick of the sector
Losses from those ventures, however, were absorbed by profits from elsewhere in the empire. Time and again, BHP has been saved from disaster by high-quality, low-cost assets that make money throughout the cycle. Writeoffs and restructures, rather than lower commodity prices, have caused losses. BHP’s errors are of capital allocation – failures of management. In this review we’ll delve into the decisions that management might make in the future and how they might affect the business.
Impressive assets
The commodity boom has undoubtedly helped but, even before China became a by-word for boom, BHP’s operating divisions were making ample profits.
Return on assets (ROA) | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 |
---|---|---|---|---|---|---|---|---|---|---|
Iron ore | 34% | 27% | 25% | 44% | 64% | 56% | 54% | 71% | 44% | 76% |
Petroleum | 24% | 23% | 24% | 31% | 39% | 31% | 46% | 33% | 36% | 34% |
Base metals | 1% | 6% | 14% | 20% | 42% | 46% | 51% | 7% | 31% | 43% |
Coal | 17% | 5% | 4% | 11% | 34% | 21% | 22% | 64% | 25% | 29% |
Total | 9% | 10% | 14% | 20% | 30% | 32% | 32% | 15% | 22% | 30% |
Table 1 shows the return on assets (ROA) since 2002 by commodity group. Iron ore, celebrated today as the focal point of the boom, has always been a terrific business.
In 2002, iron ore prices were about $30 a tonne, yet BHP still generated ROA of 34%. In fact, since 2002, the lowest ROA recorded for iron ore has been 25% in 2004. ROA has been growing steadily as prices have risen to over $130 a tonne, but there is more to BHP’s success than simply riding the bull. It operates the second-lowest-cost mines in the world (after Rio Tinto), an ideal base from which to catch the wave of rising prices. If prices fall again, as we expect they will (see Iron ore: It’s (not) different this time) BHP will be making money from the Pilbara long after competitors have gone broke.
The same can be said of the petroleum, coal and base metals divisions. In each case, BHP operates low-cost assets that will continue to mint cash throughout the cycle.
Unless, of course, management stuffs it up (as they are known to do every decade or so). Some suggest new mistakes are now being made. The decision to spend up to $100bn on expansion has been controversial. BHP argues that as the lowest-cost producer in the industry, it benefits from expanding output throughout the cycle. Weaker competitors can’t invest billions among falling prices but the mighty BHP can. And it should, they say.
To critics, such as fund manager Blackrock and, yes, us too, such cries reek of hubris. The aim of business shouldn't be to get as large as possible. Acting less like Napoleon is no bad thing.
Three scenarios
With capital allocation so important it’s worth thinking about how those decisions might change over the next few years. We’ve modelled three possible futures for BHP. Each leads to very different outcomes.
In the first scenario, we assume the company maintains the immense capital expenditure program it has promised. About $100bn will be spent, mostly in iron ore and petroleum, over the next 5-6 years. That money alters the relative importance of each commodity to BHP and it does change the business.
As Table 2 shows, we assume BHP’s asset base increases and return on assets falls, first to the company’s 10-year average, and then below it. By 2017 we assume BHP will earn only 50% of its historic ROA. This makes sense: A miner as big as BHP can’t expect higher prices and higher output simultaneously for long.
2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
---|---|---|---|---|---|---|
ROA (%) | 30 | 21 | 17 | 17 | 17 | 13 |
EBIT ($m) | 31,255 | 23,642 | 20,198 | 21,483 | 23,197 | 18,683 |
NPAT ($m) | 21,179 | 15,849 | 13,439 | 14,338 | 15,538 | 12,378 |
EPS ($) | 4.00 | 2.99 | 2.54 | 2.71 | 2.93 | 2.34 |
DPS ($) | 0.80 | 0.30 | 0.25 | 0.27 | 0.29 | 0.23 |
PER (x) | 8.0 | 10.7 | 12.6 | 11.8 | 10.9 | 13.7 |
Yield (%) | 2.5 | 0.9 | 0.8 | 0.8 | 0.9 | 0.7 |
Even as the return on assets falls, higher volumes ensure that profitability stays high. By 2017 BHP will be earning half the ROA but about 65% of last year’s profits. Lower margins are replaced by higher volumes. The company’s position as the custodian of large, low-cost assets makes this transition possible and it constitutes a vital change; as margins decline, more capital is required to generate additional cash. Last year, for example, 90% of the increase in profits was due entirely to price increases. Easy profits of that sort won’t reappear. This alters how much cash is available to shareholders; in scenario 1, we assume BHP’s payout ratio falls to half its long term average. The effect on dividends is calamitous.
In scenario 2, we assume BHP drops its ambitious capital expenditure plans. We also assume BHP’s ROA returns to its 10-year average. Profits will ultimately be smaller in the absence of an enlarged asset base, but BHP will be able to pay out more cash as dividends. The financial results of such an outcome are shown in table 2.
2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
---|---|---|---|---|---|---|
ROA (%) | 21 | 21 | 21 | 21 | 21 | 21 |
EBIT ($m) | 22,132 | 22,657 | 23,182 | 23,707 | 24,232 | 24,757 |
NPAT ($m) | 14,792 | 15,160 | 15,527 | 15,895 | 16,262 | 16,630 |
EPS ($) | 2.79 | 2.86 | 2.93 | 3.00 | 3.07 | 3.14 |
DPS ($) | 0.59 | 1.14 | 1.17 | 1.20 | 1.23 | 1.26 |
PER (x) | 11.5 | 11.2 | 10.9 | 10.7 | 10.4 | 10.2 |
Yield (%) | 1.8 | 3.6 | 3.7 | 3.7 | 3.8 | 3.9 |
In the third scenario (see Table 4), we assume prices fall from a demand shock and BHP responds by canning its expenditure plans. Lower prices force ROA down to half the company’s 10-year average. This is our bear case. Amid lower prices, BHP still remains stupendously profitable, generating earnings before interest and tax of over $11bn, but return on assets falls from last year's 30% to a more modest 15%. Even in such a scenario, the twin profit engines of iron ore and petroleum generate ROA of 25% and 19% respectively.
2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
---|---|---|---|---|---|---|
ROA (%) | 21 | 21 | 15 | 15 | 15 | 15 |
EBIT ($m) | 22,132 | 22,657 | 16,559 | 16,934 | 17,309 | 17,684 |
NPAT ($m) | 14,792 | 15,160 | 10,891 | 11,154 | 11,416 | 11,679 |
EPS ($) | 2.79 | 2.86 | 2.05 | 2.10 | 2.15 | 2.20 |
DPS ($) | 0.59 | 0.60 | 0.43 | 0.44 | 0.45 | 0.46 |
PER (x) | 11.5 | 11.2 | 15.6 | 15.2 | 14.9 | 14.5 |
Yield (%) | 1.8 | 1.9 | 1.3 | 1.4 | 1.4 | 1.4 |
In such a world, the rest of the commodities sector wouldn’t emerge unscathed. Miners reliant on a single commodity or those further up the cost curve (almost everyone other than Rio) would generate cash losses and miserly rates of return.
Faring even worse would be mining services businesses. Many of these businesses, even high-performing ones such as Monadelphous and WorleyParsons, now trade on PERs over 20. Investors are treating cyclical businesses as growth stocks and hard times will lead to both lower prices and lower multiples.
Today’s BHP investor won’t face that double whammy. Today's modest PER of less than 8 already assumes lower commodity prices. This is as it should be. All three of our scenarios suggest BHP’s profits have already peaked.
That doesn’t necessarily mean owning the stock today is a mistake. It is possible that concerns about China are misplaced and that commodity prices rebound. Perhaps the stronger for longer chorus is right, after all. Not holding BHP or Rio at all is an implicit short of the resources sector. If you don’t wish to make such a bet and want exposure to resources, BHP is the best way to get it.
Value hounds will complain that the stock isn’t quite cheap enough. We agree. Assuming an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple of 8 suggests a price of about $26. We’d be interested in building a small exposure to the Big Fella below $30 and would recommend increasing the portfolio weighting, up to about about 6%, at around $26. It’s quite possible that with growing pessimism, those prices appear. Even if they don’t, BHP is no hog. It is, in fact, the perfect hedge for China bears. HOLD.