Rudi's View | Jul 25 2012
By Rudi Filapek-Vandyck, Editor FNArena
Something happened last week that has yet to attract wider attention across the Australian investment community. Something that hasn't been seen for ten years.
The world's largest and healthiest commodities producer BHP Billiton ((BHP)) is expected to see its profits for shareholders fall over two consecutive years. Next month, the company's FY12 earnings report is expected to reveal that earnings per share for the full year have fallen by circa 19% from the all-time peak delivered exactly one year prior.
To make things worse: consensus forecasts as measured by FNArena are now also anticipating FY13 will not bring much relief for loyal shareholders either, with projected EPS to decline further by some 3% for the coming full year.
Some optimists may see a positive story of "it's getting less bad" behind these expectations, but if maintained, and met by the company in August next year, this implies the company won't grow its earnings for two years in a row. Something that has not happened since the FY02-03 years.
Before we delve deeper into this matter, I know some of the critics amongst you will have already responded with "those are forecasts, not facts". Which is true. While it is also true that forecasts tend to be further off the mark the further they go into the future, it remains a fact of life that forecasts count for a lot more than facts in any share market, at any time.
Let's have a look at the turnaround that has occurred between early 2011 and today. In a period of only some 18 months the share price first appeared to be on its way to a new all-time high then subsequently reversed direction heading south. The price is down a very un-cool 37% and is again threatening the $30-mark, a level not seen since early 2009, before global markets embarked on their US Fed stimulus-inspired recovery rallies.
In early 2011, securities analysts projected BHP would effectively double its earnings per share over a two year period. After a stellar recovery to the tune of some 75% in FY11 (to a new record high), the projected follow-up for FY12 was for additional growth of around 22%. Gradually, however, those forecasts started melting away and by late last year it should have been obvious to everyone (though it still wasn't) that BHP wasn't going to grow any further in fiscal 2012.
Things have only kept getting worse since and over the past few months the decline in overall expectations has simply gone through another downward spiral. In an earlier analysis on BHP, I wrote that simply because the share price had fallen so much, this did not automatically imply the stock was now an absolute must-have bargain.
Look at what has happened in the background since: projected EPS growth has reversed from a positive +22% to a negative -19%. If current consensus projections are correct, there won't be any meaningful rebound during the year ahead either. The latter, from a general psychological perspective, is best not to be underestimated.
Investors have by now witnessed plenty of examples of resources companies' highly cyclical swings in profits: up by the missile one year, down like a rock the next. I suspect most investors have yet to get their head around the fact that a fall of 19% as likely to be reported by BHP in August is no longer to be automatically followed by a rise the following year.
And it's not that we can now assume that only worst case scenarios are left on the table either. The latest poll conducted by Thomson-Reuters still shows analysts continue to project rising prices for many natural resources, including crude oil and industrial metals, in the years ahead. So it's not that BHP's earnings outlook instantly changes at the next rally in commodities. Any rally will have to be stronger and longer than is currently anticipated.
Most importantly, while forecasts for many others in the resources space look rosier, I do believe the change in fortune for BHP shareholders is having broader, sector-wide implications, across the globe. It brings home the message that even if demand still rises and prices follow suit, investors (as opposed to traders) are not necessarily going to enjoy stellar returns from their commodities-leveraged investment assets.
As things stand right now, BHP shares trading around $30.40 are still on implied Price-Earnings Ratios of circa 10x for this year and next, depending on what currency values we use, which looks far from exceptionally cheap. Implied annual dividend returns of 3%-something are too low for my personal liking, especially if one takes into account additional risks and volatility.
As far as the discount goes that currently explains the gap between share price and analysts' Net Present Value (NPV) calculations, I think it's only fair to assume this gap will close somewhat from the moment the world becomes less risk adverse (impossible to predict when, but I suspect not imminent). However, investing in the share market is all about tapping into growth in earnings and as long as that remains absent, a large chunk of the implied valuation gap is poised to remain in place.
Note that most rosy projections of mid-$40s price targets/NPVs for BHP have fallen too over the past 18 months and recent updates by stockbrokers such as BA-Merrill Lynch and Credit Suisse put new price targets in the vicinity of $35. That still represents a healthy return from today's price, but given BHP is part of the generally assumed "must have" investment staples in Australia, many a shareholder today will be heavily disappointed by these new targets, as shares would have been bought at higher prices (than today's) post March 2009.
The average price target, by the way, is currently $40 (in a downward trend).
Next month, after the release of the FY12 financial results, FNArena will start updating market forecasts for FY14. I predict the starting point will be for high single digit growth projections only, let's say 8 or 9% for the year. The implication here is that not only have times changed, dramatically so, and both investors and analysts are finally starting to catch up, but also that BHP's profits won't be approaching last year's peak anytime soon.
That's why the pressure will only increase on the board and on operational management to allocate funds wisely, to shed or to shut down underperforming assets and to focus on extra-measures to enhance shareholder benefits.
(This story was originally written on Monday, July 23, 2012. It was published on that day in the form of an email to paying subscribers at FNArena).
P.S. In case anyone wondered: back in FY02 BHP's EPS pre-write downs fell by 32.5% and again by close to 13% in the following year. Those were much heavier falls from much lower profit numbers. Another characteristic of the so-called "Commodities Super Cycle"?
Related stories that might be of interest:
– The Next Revolution Is Already Here (25 June)
– Value Is In The Eye Of The Beholder (12 June)
– Resources Stocks: And Now What? (21 May)
