Value In BHP’s Mega Projects?

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This story features RIO TINTO LIMITED.
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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

 – BHP continues to divest non-core assets
 – Move highlights focus on large projects
 – Deutsche expects long-term valuation upside from mega projects
 

By Chris Shaw

Yesterday BHP Billiton ((BHP)) announced the divestment of its 37% stake in South African titanium play Richards Bay Minerals to fellow 37% stakeholder Rio Tinto ((RIO)). The sale was accompanied by the announcement BHP intends to exit the titanium minerals sector entirely.

As Macquarie notes, the sale is a continuation of BHP's strategy to sell out of smaller businesses to better focus on large, scaleable and self-operated assets. The move out of titanium follows last year's announcement of the intention to exit the diamond business through a sale of the Ekati assets.

The move to focus on large, "mega projects" offers some risk, as Deutsche Bank suggests a key challenge facing management at BHP at present is convincing shareholders long-term acceptable returns can be achieved by investing in capital intensive projects over an extended period of time.

As Deutsche notes, BHP currently has four mega projects – US onshore oil and gas, the Olympic Dam expansion, Jansen Potash and the Outer Harbour iron ore project – that will require about US$120 billion in capex over the next 15 years.

While all of these projects are expected to beat BHP's cost of capital, Deutsche notes it will only be from FY23 that the projects should really offer a boost to the company's return on assets. Returns from that time should be enough to outweigh concerns of depressed returns in the nearer-term.

One advantage of the mega projects being pursued in Deutsche's view is the company will by 2030 have a well balanced commodity mix. BHP should then be generating equal one-third contributions from ferrous, non-ferrous and energy commodity groups.

The major risks associated with the mega projects are long-term pricing assumptions and capex overruns. Deutsche suggests this is particularly the case for projects such as Olympic Dam, where the investment program will be an extended one. A positive for all four projects for Deutsche is they are in developed economies, which mitigates the associated geographical risks. 

On Deutsche's numbers, the mega project contribute around 24% to its unleveraged valuation for BHP. This implies the market at present is factoring in little value for the projects. Without the projects going ahead, Deutsche estimates BHP could deliver around 40% less in earnings before interest and tax by 2030, while earnings growth in copper equivalent terms would likely fall below that of global peers.

This makes the go-ahead of these projects important for the long-run earnings outlook for BHP. All four mega projects are expected to deliver returns above group returns, with the Outer Harbour project forecast to achieve an internal rate of return (IRR) of 14% at a long-term iron ore price of US$80 per tonne.

Olympic Dam's expansion should not be far behind with an expected IRR of 13.7% at a long-run copper price of US$2.77 per pound, while the Jansen Potash project is expected to achieve an IRR of 12% at a long-term potash price of US$480 per tonne.

Assuming a 20% capex overrun relative to current expectations and 20% lower commodity prices, Deutsche estimates the Jansen and Olympic Dam projects would be value destructive. 

The upside potential from these projects supports Deutsche's view BHP offers value at current levels. The broker retains a Buy rating with a price target of $55.00. This compares to a consensus price target according to the FNArena of $47.35. BHP is rated as Buy by six brokers in the database and Neutral twice.

Shares in BHP today are higher and as at 12.30pm the stock was up 54c at $37.45. Over the past year the stock has traded in a range of $33.68 to $49.81, the current share price implying upside of 26% relative to the consensus price target in the FNArena database.

 
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