BHP Can Produce, But Can It Profit?

This story features RIO TINTO LIMITED. For more info SHARE ANALYSIS: RIO

– BHP production in line with expectations
– Potential to exceed guidance
– Prices nevertheless a drag
– Cost reduction is vital

By Greg Peel

Having now shelved its more quixotic mega-project and expansion plans, BHP Billiton ((BHP)) is now back to doing what it does best – simply pulling stuff out of the ground. Over the December quarter the company was able to do this adeptly, largely matching analyst expectations of production levels and maintaining 2013 production guidance. Unusually however, no mention was made by management on the release of the production report regarding cost, pricing or sales volume – only amounts of “stuff”. This surprised Morgan Stanley, but as is the case with other brokers, MS expects BHP is currently working on cost-out plans which will be revealed at the February 20 full-year earnings release.

Focus for BHP production is on the “big three” of petroleum, iron ore and copper, with the “little three” of coal (met and thermal), aluminium and nickel making up the numbers.

All up, petroleum division production was down 2% from the September quarter, but this is mostly due to weaker gas production in the legacy Bass Strait field. The biggest offset was a 4% increase in US onshore production (land-based shale as opposed to Gulf of Mexico crude), about which analysts are happy. BHP's shale operations have already taken a big write-down hit, and five minutes after getting into shale gas the company was forced to escape the glut by shifting focus to more lucrative liquid shale drilling. The good news is the liquids ratio has improved from 1.6% to 17.6% over the quarter.

The bad news is that a total of US$2.1bn was spent on shale drilling in the quarter when the full FY13 budget is only US$4bn. Deutsche Bank assumes this implies a now higher rig count but BA-Merrill Lynch suggests BHP's onshore US energy assets are running at “break even at best”. Note that US shale oil becomes West Texas Intermediate, the price of which is heavily impacted by a production glut, lack of storage space and the (as yet) inability to ship crude from Oklahoma to the coast at a viable cost. Hence WTI is currently trading some US$17 below that of global export oils such as Brent, Tapis and even Gulf of Mexico crude. Meanwhile, US natural gas prices have still not recovered from the GFC, with shale-driven abundance again an issue.

At least, as Goldman Sachs notes, the petroleum division provided a positive surprise in that there were no negative surprises, which is usually the case.

The picture for iron ore is a bit rosier, and not just because of the Chinese spot price rebound from US$86/t last year to US$147/t today (albeit having been around US$10 higher in the new year). Pilbara iron ore production is running on track with guidance, and the last piece of infrastructure which will take BHP's production and export capacity to 220Mtpa – a fifth rail car dumper at Finucane Island – is now in place. It's now up to the mines to actually produce at that rate, and this won't happen until at least the March quarter FY14 when the new Jimblebar mine starts up. In the meantime, management has guided to 183Mtpa for FY13 although with Jimblebar apparently running three months ahead of schedule, Deutsche Bank is among those brokers tipping the potential for guidance to be exceeded in the next two years.

Indeed, UBS expects BHP to “sweat” the existing mines this year to try to utilise the added capacity now in place and, as suggested, exceed targets.

The picture is also a good one for BHP's copper operations, at least at Escondida. Other copper mines, such as Olympic Dam, have suffered from lower grades but over in Chile, an 8% increase in copper production in the quarter reflects the highest grades in two years, Macquarie notes. Escondida is thus on track to meet guidance of a 20% production increase over FY13, with new capacity due to come on line.

There was also good news for Queensland metallurgical coal (used for iron ore production). After suffering through strikes and a Big Wet in the same quarter last year, met coal production is back to full capacity and the hint from management is that the second half will see an improvement on the first. That's the good news.

The bad news is highlighted by the Merrills analysts who warn, “be aware that the unit is NOT making money at the moment”.

Which brings us to thermal coal (used for power generation), which is more of a sad and sorry tale. Unplanned outages meant production levels were down 11%, which can be reversed one assumes, but the coal being produced is now at such a high ash content that it attracts a 10% discount, UBS notes, to a price which is already in the doldrums.

And then there's the aluminium and nickel divisions. Suffice to say that, with prices for both metals remaining depressed, UBS and Macquarie are among those expecting a value write-down ahead while CIMB goes a step further to suggest BHP will be looking to divest of these divisions. Merrills suggests investors “watch this space”.

So the bottom line is that BHP's production is looking healthy, and has the potential to exceed guidance. The problem is, prices obtained for such production are not setting the world on fire and with global economic growth to remain net sluggish at best in the nearer term, no one much expects any marked improvement in 2013. Depending on where brokers had previously set their estimates, earnings forecasts have been rejigged either up or down in small moves, in some cases marking to fresh estimates for commodity prices and the Aussie dollar.

Citi's forecasts, for example, are sitting 10% below consensus and the analysts note that there would be little change in FY14 were they to mark to current spot pricing. On that basis, Citi believes consensus estimates are open to downside risk. The UBS analysts sum up the general feeling by reminding, “We have said before that 2013 will be a year of self help for the miners, with price not expected to assist earnings, so cost out is key”.

JP Morgan agrees that reducing costs is “an important focus for the diversified miners at the moment”. The analysts note that while rival Rio Tinto ((RIO)) has now specifically targeted at least US$5bn in cost reductions over 2013-14, BHP has so far only guided to “flat” costs in FY13 without specifying an actual savings plan. As noted earlier, brokers are assuming all will be revealed in February. Meanwhile, JP Morgan notes that if BHP follows Rio's lead and targets 10% cost reductions over the longer term, this would represent about a US$4bn per year.

So is BHP a value bet for investors at this point?

Well, the first problem is that the stock price has rallied 23% from the July 2012 low and, according to Citi's numbers, is trading at forward price/earnings of 14x in FY14 and 12x in FY15 which is the upper end of the recent range, and with no commodity price rally on the cards. Indeed, it's all enough for both Citi and CIMB to now downgrade to Hold (or equivalent), joining JP Morgan and Macquarie. The latter is keen to wait for next month's results but is also looking for a further pullback in iron ore prices in the meantime. CIMB and JPM both specifically prefer Rio.

Goldman Sachs and Morgan Stanley nevertheless prefer BHP over Rio, while UBS and Deutsche are also maintaining their Buy ratings for BHP. Merrills is sticking to its Sell (Underperform) rating, which is not a recommendation one often sees for the Big Fella. Citi is not expecting any further capital management initiatives in the near term, outside the new progressive dividend policy, given net debt is not expected to decline until FY15.

Turning to FNArena's Stock Analysis, we note BHP now only boasts two Buys out of the eight brokers in the database, one Sell and a balance of Holds. An average price target of $38.41 offers 3.7% upside from the current price, while a 3.1% FY13 dividend yield is not to be sniffed at for a miner. By contrast, Rio boasts only one Hold, with everyone else on Buy. An average target of $77.60 suggests 17.1% upside, although the yield on offer is 2.5% in Rio's case.

In earnings terms, we note the FNArena database brokers are forecasting 12% earnings growth for BHP in FY14, compared to 40% for Rio (in 2013). Both forecasts are at present AUD/USD value.
 

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