BHP Billiton: Interim result 2014

When the world's largest mining company boasts of cutting costs and boosting productivity while neglecting to mention Chinese growth or indeed its own profits, you can be sure the boom has ended. BHP Billiton’s half-year result impressed but it was more important for the change it heralded rather than the numbers it presented.

Underlying net profit rose 31% to US$7.8bn. From underlying earnings per share of US$1.45, up 30%, a dividend of US$0.59 was declared (fully franked, ex date 3 Mar). Higher profits came not from higher volumes or prices, but lower costs: US$4.9bn of savings were booked. Production growth in iron ore, metallurgical coal and petroleum also raised the result.

The company’s capital expenditure, once heroically touted as US$100bn over five years, has fallen dramatically to just US$7.9bn and is expected to head lower. Competition for funds within the BHP empire is growing. With a desire to spend less money, BHP is changing strategy.

Since the merger with Billiton a decade ago, BHP has sought to deliberately diversify its production. Archrival Rio Tinto simply allocates capital to whatever business generates the highest return, a policy that has seen the company morph into an iron ore miner. BHP, by contrast, aimed to preserve diversity. Not anymore. BHP will follow Rio in abandoning the quest for diversity and pouring capital where it earns the highest return.

There are several consequences of this. As some divisions will receive no cash and others copious amounts, BHP will eventually lose its diversity. Management confirmed coal will receive no cash and is likely to shrink while iron ore and petroleum are likely to grow to dominate the business.

Cyclical risk

There is also a risk that the new strategy will increase cyclicality; that commodity groups will only expand in periods of high prices. BHP will need to take care it doesn't simply follow the cycle.

There's little doubt, though, that the diverisified giant will disappear. In its place will be a business that generates higher cash flow, spends less money and pays out higher returns to shareholders; a smaller, shareholder friendly giant. That’s the plan, anyway. We’ll have to see if it changes in the next commodity boom.

Attention is now turning to how BHP will spend its growing cash flow. Despite pending asset sales, there are no shortage of projects to invest in. In particular, the petroleum division consumes ample capital. The US shale business does not yet generate free cash flow and BHP has ambitious production plans. We suspect more money will go into expanding oil production.

As it fell towards $30 a share last year, we investigated BHP in detail and concluded that profit was likely to stagnate but that free cash flow would rise (see BHP on the edge on 17 Apr 13 (Hold – $32.14)). Free cash flow has duly risen as we anticipated, but unfortunately so has the share price, which is now up 22% since our review last April and 10% since 22 Aug 13 (Hold – $35.74). At these prices, it's simply not cheap enough to buy. HOLD.