BHP: Where the pigs fly high

‘Some of our best short ideas over the years’, says legendary short seller Jim Chanos, ‘have looked cheap all the way down’. Chanos—perhaps the world’s most famous shorter—has made a fortune selling stocks that don’t look expensive. Investors now have to make a similar call with the world’s largest resource company, BHP Billiton.

On PER of 8.4, it certainly appears cheap. Other measures reinforce the case. BHP trades on an enterprise value/earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple of 5.2. Last year, the company generated US$30bn in operating cashflow and reported net profit of over US$22bn.

These are truly staggering numbers. Yet appearing cheap doesn’t necessarily make the stock good value. In fact, BHP may be the biggest value trap of them all.

We’ve been warning about lower commodity prices, (see Iron ore: it’s (not) different this time on 15 Nov 10), and mounting imbalances in China (see The coming China crash) for quite some time. Investors in commodity businesses have long faced down these risks but now there are two more reasons to fret; pigs and shale gas.

Ore, steel and pigs

Imagine one morning Bluescope Steel declaring it was moving into pig farming. The decision would be met with equal parts mirth and disbelief. Yet this is exactly what Wuhan Steel, the fourth biggest steel producer in China, is doing.

Wuhan has announced plans to build a 10,000-head pig farm. As the price of pork (26 yuan/kg) is many times that of steel (less than 5 yuan/kg), it’s not entirely senseless and is in fact part of a broader trend.

Wuhan’s chairman describes the move as the first wave of diversification. More than US$6bn—10 times last year’s profit—will be spent developing new businesses in the areas of real estate, manufacturing and a service that replaces light bulbs for busy households. It will be followed by Wuhan Steel-branded vegetables.

Baosteel, the largest steel producer in China, is following a similar path. The company already makes about half its profits from real estate, retail and telecommunications. Ansteel, another local giant, is diverting money into coal mining and tyre manufacturing.

So the question is this: If the biggest steel mills in China are finding it more profitable to change light bulbs and rear pigs than to make steel, the Chinese steel industry must be in strife. What effects will that have on BHP and other iron ore miners?

Chinese steel

Throughout its modern history, steel in China has been more than just another industry; it’s an instrument of the state.

Following a period of civil war in the 1940s, Chinese steel production was decimated. In 1949, there were just seven blast furnaces and 19 mills in the entire country. Steel output was just 150,000 tonnes. Then came the Great Leap Forward. Steel production rocketed, but at a huge cost.

Today, the state is just as involved in the industry as ever. Production is far more sophisticated and output is a colossal 680m tonnes—about 45% of the world’s total—but there are reasons to doubt the sustainability of production at this scale.

With average returns on equity from the sector of just 3.5%, Chinese steel making is a woeful business. Operating margins are half that of other industrial sectors. Low profitability is matched with huge debts; the industry carries about US$400bn of debt but last year made profits of just $13bn.

Ordinarily, such low returns would force production cuts and businesses bleeding cash would exit the industry. Supply would then fall and prices rise. That’s not happening because decisions about production are made by the state, not by producers.

China’s abundance of people seeking work and cheap capital merge in the steel industry. To flatter unemployment targets, local governments encourage overproduction. Steel producers, terrified of being absorbed by a larger producer by government fiat, comply.

For example, in order to protect itself from consolidation, between 2003 and 2010 Rizhao Steel, a Shandong steelmaker, expanded output tenfold. In other cases, production cuts are simply forbidden. Under such circumstances, pig farming looks quite rational.

An oversupply of steel, as much as 15% of annual supply, swamps world markets, but ensures the demand for iron ore remains strong. The iron ore miners have been a chief beneficiary of irrational production decisions in China.

The madness

Irrationality can last a long time but it can’t last forever. There’s a good chance that global steel production is being artificially elevated and will fall as rationality returns. The implications for iron ore producers, which have based gargantuan expansions on booming steel output, are huge.

All up, about 700m tonnes of new iron ore supply will hit the market by 2015. That’s two new Pilbaras joining global supply. When soaring supply meets softening demand, lower prices tend to follow.

Remember, too, that lower prices aren’t contingent on a slowdown in Chinese growth. Even if the Chinese economy continued to grow at its current pace, additional supply and producer rationality could devastate iron ore producers’ margins.

We examined the financial impacts of lower commodity prices in BHP: On the horns of a dilemma on 13 Sep 11 (Hold - $36.59). For the lowest cost producers, iron ore will still be a terrific business but the last few years of hyper-profitability are over.

This means BHP’s largest profit engine won’t generate returns on capital at anywhere the rates it has in the past. The share price, having fallen 23% this year, reflects this new reality.

Gas dilution

Iron ore isn’t the only problem. BHP Petroleum, long the pride of the company, also risks lower profitability. Last year, the petroleum division generated US$7bn in earnings before interest and tax (EBIT), 20% of BHP’s total, and return on assets of 45%. Capital expenditure requirements for the division typically average about US$2bn a year. This is a splendid business that’s about to be transformed for the worse.

As explained in BHP Billiton’s new gambit on 21 Nov 11 (Hold - $35.89), the US$20bn purchase of Petrohawk and other shale gas assets in the US will change this division from being liquids to gas rich. Capital expenditure will rise and returns on capital will dramatically fall.

The plunging US gas price will probably mean a writedown on acquired assets. BHP Petroleum has long been a financial fortress but its walls are showing the first sign of cracks. It won't risk the company this time but BHP's new 'Magma copper' moment will cost shareholders tens of billions of dollars.

Between China’s steel sector, iron ore supply and the US gas price, this already complex business creates a host of anxieties. Is it time to sell BHP?

Reasons to hang on

For some investors, perhaps. The amazing annual returns from the business may be gone for now but, at today’s price, there’s a powerful case to hang on.

The giant $100bn capital expenditure program has been widely criticised. Blackrock, one of BHP’s largest shareholders has also been one of its loudest critics. In response, the company has made conciliatory noises, suggesting it could stagger, delay or even curtail altogether some of its expenditure in favour of higher dividends. The company retains substantial firepower with which to reward shareholders.

If we assume commodity prices fall to reflect marginal production costs (an exercise carried out in BHP: On the horns of a dilemma), profits will fall and BHP might trade on an EV/EBITDA multiple closer to 10. That isn't astoundingly cheap. But imagine the billions currently locked into dubious capital expenditure was instead diverted to shareholders; the potential free cashflow from this business, even with lower commodity prices, is enticing.  Of course, that's only possible if the wild-eyed desire to expand is replaced by a more conservative approach and if China isn't the disaster some fear it may be.

The share price today reflects lower profits and disapproval of colossal capital expenditures. Both concerns are valid but, as BHP may yet alter its capex,  the decision to hold or sell isn't clear cut. Yes, Jim Chanos is long BHP, but only as a hedge for another short position.

Portfolio risk management is the key. If BHP constitutes a big chunk of your portfolio, consider lightening your holding. The company is exposed not just to commodities but to the development of a country with looming imbalances that is chronically capricious. The downside remains large and unpredictable, which is why we recommend a portfolio limit of no more than 5%.

BHP’s share price is down 7% since BHP turns up the volume on 10 Feb 12 (Hold - $37.16). With signs the company may change capital expenditure plans, diverting cash for shareholders, it’s enough to HOLD.