We’ve long argued BHP Billiton’s weakness has historically been management, not mines – and there was plenty of evidence to back up that theory in its 2016 full-year result.
The US$6.4bn headline loss streamed across newspaper front pages is a big, bad number, but it’s one that reflects past mistakes of capital allocation rather than failings of asset quality.
On an underlying basis – that is, stripping away the US$7.6bn of impairments and provisions that have haunted BHP the corporation – BHP the miner generated net profit of US$1.2bn. Considering where commodity prices have been, that’s a decent outcome.
Decent underlying result
Headline result reflects past mistakes
Free cash flow growing
We can’t ignore mistakes of capital allocation. BHP’s decision to pay US$26bn for US shale assets at peak prices has been a disaster. The company has written off about half that value and lost billions of dollars trying to turn a profit from shale.
Yet there are signs that ambition and hubris of the past have gone. Capital expenditure, once proudly wielded at over US$20bn a year, was just US$7bn and should fall again next year. There are no grand expansions, trophy projects or bullish forecasts. Mining has returned to what it should always have been: the grim task of bleeding money from ore.
To that end, BHP’s mines performed splendidly.
|Year to June (US$m)||2015||2016|| /(–)
|Op cash flow||19.3||10.6||(45)|
Iron ore and copper
Although US$10bn was wiped from earnings before interest, tax, depreciation and amortisation (EBITDA) due to commodity price falls, iron ore still generated decent returns.
By itself, the iron ore division generated US$3.7bn of earnings before interest and tax (EBIT), a healthy return on assets (ROA) of 18%. Unit costs are under US$15 a tonne today, generating generous margins. Although we expect iron ore prices to fall, BHP’s advantages of geology and logistics should ensure returns remain attractive under almost any conceivable price. We think BHP can sustain returns of about 20% from iron ore.
Copper was less impressive. Despite operating two of the world’s richest orebodies, Escondida and Olympic Dam, BHP generated lower than expected EBIT of $1bn, or an ROA of just 4%. That should climb as unit costs fall and expansions of both assets are finalised.
The worst result came from the petroleum division which reported an aggregated loss of US$500m from an asset base of US$25bn.
That sum masks divergent outcomes from the conventional oil portfolio and BHP’s US shale assets.
Despite low oil prices, conventional oil delivered EBIT of US$1.5bn, ROA of 16% and unit costs of under US$10 a barrel. That fine result was overwhelmed by losses from shale.
Taken alone, shales lost US$1.7bn and attracted yet another impairment. BHP has slashed capital expenditure on shales from US$4bn to US$1bn which will result in dramatically lower output. About US$12bn worth of assets sits in that division and we expect more writedowns unless prices recover meaningfully.
The worst of BHP is evident in the shale division. The division is capital intensive with low variable returns and has assets that were bought at the top of the cycle with debt. That, at a grander scale, is what has always been wrong with BHP.
Dividends and cash flow
The new dividend policy may help tame the boom bust cycle. BHP now aims to pay at least 50% of underlying profits as dividends, implying that cash returns to shareholders will now be cyclical rather than ever rising. For this year, it means dividends fall to just US$0.14 per share for a full year dividend of US$0.30.
Over the cycle, it means BHP will probably pay higher dividends in boom years, starving management of cash to waste, and lower dividends in lean years to preserve cash for countercyclical investment.
The company has already suggested it may look for cheap assets as peers such as Anglo implode. An acquisition in metallurgical coal has been rumoured while exploration costs have crept higher. These are all welcome changes.
Cash flow remains a highlight of the result, with the miner generating US$10.6bn of operating cash flow. Subtracting capital expenditure, BHP generated free cash flow of US$3.4bn – a free cash flow yield of over 4%.
Our key investment case, made back in Biting on BHP, was that free cash flow would increase even as profits fall. That is certainly happening.
And it should improve further as capital expenditure falls again next year and operating cash flow improves. Like Rio, BHP is depreciating an asset base inflated by boom-time costs and we expect depreciation to exceed capital expenditure for some time.
Perhaps the greatest lesson from BHP this year has come from the share price, which has bounced about 50% in the past six months. It’s not good enough to wait for improvements in business conditions before buying shares. Uncertainty and pessimism are what create opportunity and expectations will always lead reality which is why we’ve long advised buying BHP in tranches. With the share price now past our Buy price, though, we’re downgrading to HOLD.
Note: The Intelligent Investor Growth Portfolio and Equity Income portfolios own shares in BHP Billiton. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.