BHP Billiton: Result 2015

Hearing the media tell it, you might think BHP Billiton reported a shocker of a result; the headlines screamed how the miner's full year result was the worst in a decade. Technically that is true but it occurred within the context of even weaker commodity prices.

Anyone can make money when prices are high and optimism reigns. The test of a miner – its mettle if you like – is how it performs in the bust. This result demonstrated why BHP remains the world's pre-eminent miner.

Underlying EBIT fell 46% to US$11.8bn and net profit halved to US$6.4bn, higher than we had expected although some were more bullish. Lower commodity prices wiped US$15bn from the operating result but that was partly offset by higher volumes, cost cuts and exchange rate movements which added back more than US$7bn.

Operating cash flow fell just 25% to US$17.5bn and capital expenditure fell by 24% to US$11bn. Over the next few years we expect capital expenditure to decline to between US$7-8bn so free cash flow, an impressive US$6.3bn this year, should rise again.

Strong cash flows are vital for BHP as the business must fund maintenance on an enormous asset base and because it has committed to paying its now (in)famous progressive dividend.

Dividend debate

That controversial dividend rose another 2% to US$1.24 for the full year. In Australian dollar terms, that equals $1.74, implying a yield of of more than 7% at the current share price.

Usually such a high yield would prompt concern but in this case we believe it is sustainable, although it is dependent on a low Australian dollar.

Despite paying, as forecast, more than 100% of profit as dividends this year, BHP still managed to reduce debt by US$1.4bn to US$24.4bn. It sounds like a huge number but BHP's balance sheet is rock solid, cash flows remain strong and capital expenditures continue to fall. Despite widespread skepticism, there is no threat to the dividend. BHP is now an income stock.

The commodities

Despite savage price falls in all its product groups, BHP still announced group EBITDA margins of over 50%. This, however, only covers cash costs and, taking full costs into account shows where the empire is hurting most.

Oil and coal have been phenomenally profitable over a long time but both businesses are now generating negative or marginal returns. On a US$12bn asset base, coal generated just US$350m of EBIT, a sum that suggests either margins have a long way to rise or assets will be written off in future years.

Despite owning the best metallurgical coal assets in the world, profits have vanished. The miner has slashed capital expenditure to the coal business and expects no immediate improvement in prices. We concur; losing money in coal, as almost every miner is demonstrating, is easy. Being forced from the market, however, is much harder and stubborn supply will need to exit before we see improvements.

It is clear that the purchase of onshore shale assets during the boom was a mistake. Although productivity and costs gains continue to be made, the shale business clocked another US$2bn asset impairment because of low prices.

BHP has cut rigs to shales by half but still expects production to be stable suggesting a vast increase in per rig productivity. That success is being replicated across the industry and is a key reason why oil prices remain low.

The oil business generates a return on assets of just 5% (although this figure includes some potash assets) and we would prefer to see shales replaced with conventional oil. Management hinted that they were looking at conventional oil opportunities and we're heartened to hear the love affair with shale assets is waning.

Despite iron ore prices falling 40%, EBITDA margins remain at 60% indicating that, along with Rio, BHP commands the finest iron ore assets in the industry. Cash costs fell to US$17 per tonne in the second half and are forecast to fall again to US$15.

Adding back depreciation, freight and other charges, BHP's total iron ore costs are still below $30 a tonne and generate strong operating margins. The division alone generated US$6.9bn of EBIT, more than 50% of BHPs total.  

The one thing

One concern we have about the result relates to the low level of capital expenditure which, for the first time in years, has fallen below depreciation. This often suggests a business is crimping on maintenance but we need to be careful before jumping to that conclusion in this case.

Over the past five years, BHP has spent more than US$80bn on capital expenditure and high depreciation partly reflects previous levels of expenditure. With so much new capacity, BHP can increase volumes without major cash outlays and, because it was spent quickly in the teeth of a boom, there are plenty of areas to cut costs. Capital expenditure, for a few years at least, can afford to undercut depreciation.

We have been rather cautious about BHP in previous upgrades and suggested taking bites as prices fell. We repeat that call again with one difference; BHP is, for the first time in more than a decade, cheap. We don't expect the cycle to turn or for profits to soar but these assets are performing as well as we had thought and there is a genuine change in management's approach to capital allocation. BUY. 

Note: The Income portfolio owns shares in BHP.