Rudi On Thursday

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

(This weekly editorial was originally published on Wednesday, February 11, 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).

Think about it: the difference between perceiving a glass as half full or half empty is simply a difference in state of mind. Nothing changes the glass nor its content. It’s all about our perception of reality, how we look into the future and whether we’re zooming in on the fact that half the glass is filled with a substance, or whether one half is not.

One only has to observe the share price of BHP Billiton ((BHP)) to see that the state of mind of investors has gradually shifted into “glass half full” mode since the beginning of the year. Coming from a trading range between $20 and $32 -at its most extreme moments- the shares have gradually settled in a $27-$33 range, while spending most of their time above $30 in February.

By anyone’s account: this is a major uplift.

Sure, there are more complicated indicators to gauge overall investor sentiment, or global risk appetite, but I think we can keep our analysis very simple, and still accurate, by simply using BHP’s share price as a proxy.

Other commentators will tell you the technical picture has changed for commodities, or that risk appetite has picked up as governments across the globe are putting together stimulus package after stimulus package to unfreeze credit markets and support their economies. Others will say it’s the constant rise in the Baltic Freight Index, combined with a continuous optimistic news flow about China’s iron ore demand – or the fact that every hedge fund and its neighbour had gone short commodities and commodity stocks last year and is now forced to rewind those positions.

All of these elements have contributed to the overall rise in investor optimism, and thus to the rise of the share price of BHP Billiton. None of these elements, however, tells you whether this rise is justified, and whether the share price is likely to rise further.

So, is the rise justified and will it keep rising? I will try to answer these two questions through my analysis below.

Firstly, and to get the main conclusion out in the open right away, the gradual rise in BHP’s trading range seems fully justified. Underneath the rise lies in essence the result of renewed optimism that net profits may not have to fall as deeply this year, and next, as previously feared. The effect of this on investor optimism in general has been further strengthened by the fact that some experts in the market now believe contract prices for iron ore may only fall by 10%, or less, for the year between April this year and March 2010.

Add all the other elements I mentioned above and what you get is a powerful cocktail of positive factors that, combined, have supported the BHP share price on its way to higher price levels. But will it be sustained?

Allow me to throw in another conclusion: BHP shares are expensive.

The Australian share market at present is trading on a Price-Earnings multiple of 10-11 if one takes earnings per share (EPS) estimates for FY09 as the benchmark, and at a multiple of 9 only if we look at FY10 estimates. (Some of the banks are trading at multiples of 8). FNArena consensus forecasts (see Stock Analysis on the website) will tell you BHP shares are trading at multiples of 15.8 and 15.6 respectively. Yesterday, those multiples were above 16.

I don’t think BHP shares have ever traded at such lofty multiples during the four years prior to August 2008, when the Big Correction Most Of You Would Like To Forget set in. On this basis, I’d be inclined to say: further upside appears limited, in the absence of a major positive change in perception or in underlying market fundamentals. The risks are thus skewed to the downside from here on.

I have dug deeper.

Currently, FNArena consensus estimates are skewed towards stockbrokers who take the effort to translate their USD estimates into Australian dollars. We are currently working on improving our data by including foreign currency estimates. I hope we can add this improvement to our website in the not too distant future. For now, however, I have done the old fashioned manual thing: sifting through analyst reports with a note bloc and calculator in hand.

As such, I think I have found the true adjusted market consensus estimates: US$1.876 per share for FY09 and US$1.633 for FY10.

Playing around with these numbers, in combination with the AUD/USD cross, has pulled back the PE ratio for BHP Billiton shares to 12-12.5 for FY09 and to 14-14.5 for FY10. At face value, this makes the shares a lot less expensive on this year’s estimates. However, as I have stated in past analyses, with many companies facing two years of declining EPS forecasts (and BHP is at present no exception), it is but logical that investors will be looking at FY10 more than at the FY09 numbers. One does not want to overpay for something that will automatically fall in value later. (I’d like to add to this: especially not for resources stocks).

In essence, all this has only slightly changed the conclusion I drew earlier: BHP shares are trading at a sizeable premium to the market as a whole.

This premium can be easily explained. BHP is not only by far the largest player in the global resources sector, it also boasts by far the largest market capitalisation and the largest annual profits in the Australian share market. Add gigantic cash flows, a healthy balance sheet, potential for favourable acquisitions, or a share buy-back, and it is easy to see why. Despite an outlook for declining profits, investors are willing to price the shares at a higher valuation relative to most other companies in the market.

Mind you, an oft forgotten element is that, even at a share price of around $32, the shares offer prospective dividend yields of 3.2% (FY09) and 3.7% (FY10). The exact size of BHP’s premium is a matter of conjecture, but I would think that at 14.5 against 9, the relative premium is at a stretch already.

It is easy to see why stockbrokers have started to switch in their preferences, advocating investors should consider Rio Tinto ((RIO)) shares instead. Current pre-FY08 results release estimates place Rio Tinto shares on a forward looking PE of 5-something. Even if these forecasts change dramatically post the result, it is only fair to assume that if Rio Tinto manages to address market concerns about its nasty debt problem, the shares have a lot of catching up to do vis-a-vis its former suitor.

Placing Rio Tinto shares on a comparable PER of 14.5 would take their price to $138 compared with $51.60 now. Of course, Rio Tinto doesn’t deserve a similar premium. But even at the light market multiple of 9, its share price still has upside potential of 68%!

Underneath all this lies a newfound market optimism based on the fact that several indications for iron ore trade and Chinese demand for natural resources might be on the rise again. The Baltic Freight Index, for instance, has now risen 16 days in a row. Even though many a sceptical expert has pointed out that a bounce was to be expected after a fall of around 94%. I can only acknowledge that as long as this index continues to rise, it will continue to inject extra optimism into the market. Sixteen days of uninterrupted growth seems a lot to get excited about, low starting levels or not.

Morgan Stanley analysts have pointed out the Baltic Freight Index still has some 60% to go before it returns to what they believe is a sustainable long term trend level for the index. At that point we can all safely assume global trade is back at healthy levels. So, is current market optimism justified?

Never say never. If anything, insights and information about China are sketchy and opaque at best and simply unreliable in all other instances. But it would appear that investor optimism has once again ran too high too soon. As such, BHP’s share price may have proved its value as barometer for global investor appetite.

The reason I say this is because every day, leading forward looking indicators are still trending downwards, indicating the global economy is not getting better. In fact, it is still getting worse. And all those positive indications, such as a gradually climbing iron ore spot price instantly made sense to me when I read that producers such as Rio Tinto have given their customers carte blanche to purchase product on the spot market (it’s cheaper than purchasing it under last year’s negotiated contract prices). Combine this with some restocking and it is easy to see why a market that had come to a virtual standstill late last year, is now showing signs of life.

It doesn’t mean, however, that the pressure will be off any time soon. In fact, this week’s economic data from China should have worried investors about the underlying trends in the Chinese economy instead of fuelling more optimism. Some economists are now questioning whether the reported 6.9% GDP growth for the December quarter wasn’t adjusted to the upside (imagine, it was already so far below previous trend levels). If anything, I tend to agree with those who believe the scene remains set for more horrible data and figures from China in the weeks and months ahead.

Expect another rate cut in the country soon.

Having said all of the above, I also agree with those experts who believe that “times are a’changing”. One only has to look at price charts for most commodities over the past weeks to see that a gradual lift to a higher price range has taken place, similar to what has happened to the BHP share price (see earlier).

Again, this was always going to happen at some stage. Just like prices cannot indefinitely rise, they also cannot continuously fall. I have a suspicion that too many investors have interpreted this as a sign that the next upturn is commencing right here and now. If so, I cannot but think they have set themselves up for disappointment.

Sooner or later the economic realities will hit home. As I don’t have a crystal ball, I cannot say when exactly this is going to happen, or what will cause it, but it seems only logical to assume that present investor optimism will have to endure some serious tests in the coming weeks.

Finishing off this week’s story, I believe BHP Billiton’s new trading range has moved up to a likely $26.50-$34. Unless something fundamentally changes in the company’s outlook, or to forecasts that support this new valuation range, I don’t think trading outside this range is justified for the shares.

At $26.50 the shares would still be on a prospective PE ratio of 12 compared with 9 for the rest of the market and 5-something for Rio Tinto.

With these thoughts I leave you all this week.

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by the Ab Fab team of Andrew, George, Greg, Chris, Joyce, Pat and Grahame)

P.S. From October last year onwards I have been predicting BHP Billiton shares would likely trade between $20 and $32 for the foreseeable future. They have done so until this week. Similar to today’s analysis, I explained the previous trading range in detail in a document titled “2009 Outlook”. This document is for paying subscribers only. If you are a subscriber and you missed out on this document let us know and we happily send you another copy via email.

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