Ride The Choppy Seas On The Good Ship BHP

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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The first thing one needs to do when assessing BHP Billiton’s ((BHP)) half-year result, released yesterday, is to get these numbers sorted. The headline on the television news last night screamed of a big fall in profits. The truth is that on first glance the numbers looked poor, until one removes the tax effect. Analysts were shocked to find that BHP was paying 43.7% tax. Take this, and other bottom line one-offs away, and BHP posted a profit that was actually 2% higher than the “previous corresponding period” and thus mostly in line with expectations.

That means 1H09 produced 2% more profit than 1H08. In 1H08, oil, metals and bulk mineral prices hadn’t quite taken off yet. The difference between 1H09 and 2H08 (the previous two quarters) was a profit drop of 34% – there’s your headline.

Nevertheless, an onerous element of the Big Australian’s result was that some 72% of the profit came from steel-making bulk inputs (iron ore, coal, manganese) and that the contribution was more than the analysts expected. It was the base metals divisions which suffered the most (aluminium, copper, nickel) and thus disappointed compared to forecasts. One presumes oil responded as one might have expected under the circumstances.

The problem here is that the bulks trade on an annual contract basis while base metals are more beholden to the spot market. In other words, the drop in bulk material profits is yet to be felt. While analysts have come around to believing the 2009 negotiated iron ore price may not be quite as bad as the doomsayers have been suggesting, they still see a drop of around 30% coming. Coal will be worse.

None of any of this is a surprise, however. There is nobody out there who got a shock when Marius Kloppers declared FY09 will be tough. Analysts are largely expecting another 40%-odd fall in profits in 2H09. Kloppers also apologised for not appreciating the magnitude of the upcoming downturn when he provided guidance six months ago, but there would have been a few knowing nods at the press conference – there but for the grace of God go I.

The problem with commodities, any resource analyst will admit, and with base metals in particular, is that their prices are subject to extreme volatility. So trying to successfully forecast profits a year ahead is like trying to balance on a beach ball in a swimming pool. And that’s at the best of times. There will be no crying foul if Kloppers latest guidance proves to be a tad astray again. The brokers, as a whole, are preparing for the worst and warning of further potential downside in prices ahead.

On that basis, then, why invest in BHP?

Well before we get into any reasons, note that there are only two Buy ratings currently among the FNArena database brokers and there have been no changes post the result. Everyone else is on Hold. But were there such a thing as a “Strong Hold” then BHP would no doubt boast several such ratings. The resource industry outlook is bleak, but everyone loves BHP.

Macquarie, for example, would like us to know that cashflow “cannot be dismissed”. This result came with a record cashflow increase of 74%. There are companies in every sector of every stock market in every country in the world who would give their right arms to get hold of that sort of cashflow right now. Within just Australia’s resource sector alone, there are miners burning cash so fast they are under threat of combusting. The idea is to keep a mine going even if metal prices are less than production costs per pound, and then hope like hell prices will recover sooner rather than later.

For BHP, there is no cash problem to worry about at all. Gearing has now fallen to below 10%. All BHP has to worry about is that the opportunities for profit growth have pretty much evaporated and that the next two-three years are simply all about consolidation. If it’s marginal, shut it down. If it’s risky, abandon it. If it’s a greenfield project (starting a project from scratch) put it on the backburner. If it’s a brownfield project (expanding an existing project) then consider the numbers carefully. Batten down the hatches, we’re going to ride this out.

But while all about are selling assets in desperation to reduce gearing levels and prevent cash-burn, BHP is one global mining giant in the enviable position of being ready to snap up bargains. Kloppers could turn up at any far flung post with several attache cases in hand, and likely be welcomed as a saviour.

The truth is, this is how the resource industry has always worked. Since about the Bronze Age, commodities prices have moved over lengthy cycles of a decade or more. The longstanding operators have seen it all before. Prices go up big time and then prices collapse. Hay must be made while the sun shines, but also stored away for the winter. Mining operations cannot just be opened and closed like retail outlets – they take years to develop and years to re-start if abandoned. Core operations must keep chugging along. Opportunities are best exploited in the bad times, rather than the good.

Having said that, there are plenty of old hands of the mining game who have been caught out by this latest downturn just as if it were the first cycle turn they’ve ever encountered. So much for hay. BHP, clearly is not in that predicament. (Except that Kloppers has declared he didn’t quite see this coming and don’t forget that BHP guidance might look very different had it included a recently acquired and debt-laden Rio Tinto ((RIO)). Kloppers must light a candle every night for Tom Albanese in honour of the Rio CEO’s rejection of BHP’s advances.)

The bottom line is that while BHP is in for a quiet couple of years, it’s still a must in every portfolio as far as most brokers believe. There will no longer be a share buyback or any extraordinary capital returns but the company’s policy of progressive dividends has been maintained. There are better yields about, but not much higher quality. When the inevitable cycle bottom comes – whenever that may be – and commodity prices begin a cyclical upswing, BHP will be in the box seat to reap the spoils once more.

Only one broker – UBS – which has a Neutral rating on BHP, has pointed out that it prefers an investment in Rio given Rio’s 30% discount in enterprise value terms as provided by its current share price.

The average target in the FNArena database for BHP is $33.80, which is only a tick down from the pre-result level. That’s only 8% above the current price and thus hardly the stuff of blue sky, but in BHP’s case we’re talking solid, if not spectacular, earnings, buckets of cash, minimal debt, and simple longevity.

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