Biting into BHP Billiton: Pt 1

The commodities boom is over. From gold, iron ore and oil, to graphite, lithium, and lime, commodity prices of every description have suffered calamitous falls. Reason enough, you might think, to avoid buying the world's largest miner. Yet that is just what we are recommending you do.

Upgrading BHP Billiton isn't the act of a blind contrarian. We're upgrading because this is not the business it appears to be. Falling prices, so often the death of miners, will not doom BHP. Mostly, this is because the Big Fella holds the best mining assets in the world – an unmatched collection of the lowest-cost, largest, irreplaceable mines.

Less obvious, but just as important, is the change BHP is undergoing right now. An aggressive, acquisitive miner, intent on domination through relentless expansion, is being replaced by a more humble beast interested in the dull virtues of prudence, profitability and shareholder returns.

Although we expect modest commodity prices in the future, a combination of asset quality and management change should result in higher free cash flow and a decent return on assets.

In part one of this two parts series we'll look at how the boom has, and will, change BHP. In part 2, we'll estimate how those changes will impact earnings and cash flow.  

Financial scars

Although miners are thought to be captives of the commodity price cycle, BHP shows few scars from cyclicality.

Over the past 25 years, a time that covers a variety of manias, panics and crashes, BHP has not made a single operating loss. When incurred, losses have come from errors in capital allocation rather than as a consequence of low prices.

The resilience of the business comes from the quality of its assets.  BHP boasts the second most profitable iron ore business in the world; its Bowen Basin coal mines have no equal; the petroleum business is among the world's top dozen oil producers and it operates the world's largest copper mine, the largest uranium deposit, the largest silver mine and is the largest manganese producer.

BHP's weakness has always been management, not mines. After wasting the greatest resources boom in history, management now shows signs of penance.

Splitting up

If previous management was expected to expand the empire, new chief executive Andrew McKenzie has been tasked with consolidating value.  He recently announced plans to demerge the business, splitting the high return, high cash flow businesses from the more cyclical, capital intensive ones.

The new BHP will keep iron ore, petroleum, copper, coal and some nickel and aluminium mines. The spin-off, to be called South32, will house the unfashionable manganese, silver and nickel assets as well as some aluminium, alumina and coal mines.

South32 will still be a formidable miner with an expected market capitalisation of about $12bn, but the best assets will stay with BHP. The demerger is awaiting shareholder approval and hasn't been popular so far. We are excited about a slimmed down BHP and an unpopular, underappreciated South32.

For now, however, we'll treat BHP as if the split weren't imminent. The idea has been proposed to allow management to return a higher portion of cash to shareholders. The outcome from the proposal is uncertain but the intention is clear. Just as the company's ambitions swelled during the boom, humility has followed the bust. BHP is now focused on cost and profit.

Asset change

The change is not just to appease investors. The long boom has changed BHP. Ten years ago, BHP was the epitome of a diversified miner. As Table 1 illustrates, the profit contribution from its various businesses was roughly equal: each division earned about a fifth of profit. Over time, diversity has diminished and BHP's earnings have become concentrated on iron ore and petroleum.

In 2004, iron ore and petroleum combined generated 40% of group profits. Last year, they were responsible for 75% of profit. This isn't simply because of a price boom. BHP has consciously invested more money into these divisions.

Over the past decade, BHP has spent $32bn in capital expenditure on its petroleum business, a sum that doesn't include about US$25bn in additional acquisitions. Over the decade, it has spent over $27bn on iron ore while spending just half that sum on copper and coal and just a third on aluminium and manganese.

Iron ore and petroleum accounted for 30% of BHP's asset base in 2004; last year it was 55% (see Table 2). BHP's past capital expenditure – as well as its future spending plans – are concentrated in these two commodities. It is here where the case for the Big Fella will be made or unmade. Price weakness in these commodities is also why an opportunity exists today.

Iron ore

BHP's return on assets from iron ore has averaged 54% over the past decade. Even though iron ore prices have halved in 12 months, BHP should still generate a return on assets of more than 30% and it has never generated a return of less than 25%. With or without a resources boom, this is a wonderful business.

The basis of this splendor are hundreds of kilometres of railway connecting four colossal mining hubs in the Pilbara. This intricate network of rail, ports and dirt has been finely tuned over decades to deliver iron ore from the middle of nowhere to China and Japan. A combination of accomplished logistics and high grade make this business hard to replicate.

Despite iron ore prices crashing over the year, generous returns are still likely. At US$60 a tonne, prices are back to where they were in 2005. In that year, BHP produced 100m tonnes of iron ore and generated a return on assets of 37%. This year it will produce 240m tonnes of iron ore, so even though prices have fallen, profits will soar.

Costs that had risen over the decade are falling again. By spreading infrastructure costs over more output, BHP can reduce unit costs while tweaks to logistics – debottlenecking in the parlance – will lower them again. Iron ore is a logistics business where small cost savings accumulate over time. BHP suggests it can lower costs from about $40 a tonne to $25 a tonne over the long term. We believe it.

The enlarged iron ore business should continue to generate stunning returns even if prices never recover to boom levels. Only BHP and Rio can make this claim. The pessimism surrounding iron ore returns is unjustified.

Petroleum

No commodity has attracted more pessimism of late than oil. Posting one of the swiftest declines on record, the oil price collapse has stunned producers and will be painful, even for BHP.

BHP's oil business can be split between legacy production, which encompasses production from the Bass Strait, offshore Western Australia, the Gulf of Mexico and elsewhere, and newly acquired shale oil and gas assets.

The legacy assets are hugely profitable, able to produce oil for less than US$10 a barrel. They continue to generate stunning returns. The shale business, however, which now accounts for the bulk of capital expenditure and output, faces lower returns.

In BHP's favour is that it commands a huge land holding and can switch drilling strategies depending on the oil price. When prices were above $100, for example, the company moved drill rigs to oil rich shales and drilled ferociously to expand output. Now that prices have slumped, it has cut rig numbers by 40% and will focus only on the highest yielding shales.

This flexibility is possible because of the geological properties of shales. Output from a single well begins strongly but falls by 50–80% in the first year, tailing off after that. To maintain or grow output, producers must continue to drill, which is why so much capital expenditure is allocated to this division.

As prices have fallen, however, BHP can move its fleet of rigs to shales that suit the oil price or it can cull them altogether. Using this flexible approach means that returns from the oil division will fall less sharply than the price. Capital expenditure and output will absorb the impact of lower prices. 

BHP is almost certain to announce big asset writedowns on its shale business but it is almost certain to cut capital expenditures, too. Output will fall but more cash will be available to lower debt or pay dividends.

Lower prices in the short term aren't the disaster that many are suggesting. On an asset base of over US$50bn, we expect returns to average 10–12% over the course of the cycle, implying earnings from petroleum of US$5–6bn.

If oil prices remain at $50 a barrel or below, however, more lasting damage will be done and production growth will stall permanently. As we explained in What now for the oil price, we don't think that's the most likely outcome but it is possible.

Buying BHP

BHP isn't glaringly cheap today. Yet it's hard to recognise cheapness in a resources business because prices can always be justified by commodity prices. Low prices today, especially for iron ore and oil, justify today's lower share price but, as we have suggested, we expect costs and expenditures to fall, propping up returns even with lower commodity prices. That's true for iron ore.

Oil is a more difficult case. We expect prices to return to $70–80 a barrel, at which point BHP can generate reasonable returns. We are relying on an improving oil price to realise our investment case.

Below $30, it's time to bite on BHP. We recommend starting with a 2% position and increasing it to around 6% if the price fell to around $26. At $24 – all things being equal – we'd be enthusiastic buyers. In Part 2 of this series, we'll look at earnings and cash flow for the business. For the first time in a decade, we're upgrading BHP to BUY.