Why The Market Has Misread BHP

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

– Demerger implies capital discipline
– NewCo offers earnings upside
– Iron ore expansion a positive surprise
– Escondida set for copper expansion

By Greg Peel

Long suffering BHP Billiton ((BHP)) shareholders were convinced August was the month in which their patience would be rewarded. Stock analysts had been uncertain up until the prior February result season, when an upbeat report appeared to confirm capital management would be announced at the full-year result.

Having abandoned grandiose tier one acquisition plans, BHP has been concentrating on expanding its existing iron ore production, selling off non-core assets, improving efficiencies across remaining assets and reducing debt. In February it appeared all was on track as the cash flowed freely from Western Australia, while assets in North and South America continued their contributions. BHP had gradually increased its dividend payout profile but while shareholders would have preferred a cash-in-hand special dividend on top, they were quite prepared to settle for a share buyback instead.

Indeed a share buyback, which would increase earnings per share and thus dividends per share, seemed inevitable.

Then came the clanger. Four days out from its result release, BHP announced it was planning to de-merge its remaining non-core assets into a new company, dubbed, for the time being, NewCo. The share buyback, it seemed, was off. Once again, BHP shareholders would be left high and dry.

BHP shareholders would instead receive shares in NewCo, on demerger. The remaining BHP would retain the core assets of iron ore, petroleum, copper and coking coal production, while NewCo would carry the rump of alumina/aluminium, manganese, silver/lead and thermal coal assets. Shareholders were outraged. Stock analysts were surprised, but forced to admit that irrespective of market disappointment, it is a good idea.

Between February and August the iron ore price collapsed. Oil prices retreated, while copper and coal prices wallowed. All along management’s target, and the supposed trigger for capital management, has been a reduction in its debt to below a US$25bn threshold. Six months ago everything was travelling nicely. Six months later BHP’s free cash flow had declined sufficiently to ensure net debt had begun to creep back up above that threshold.

The decision BHP has made is thus a disciplined one, stock analysts suggest. For a long time commodities analysts have been forecasting lower longer term iron ore prices based on increased global supply, particularly from Australia, and lower oil prices based on increased global supply, particularly from North America. For other commodities, the outlook is brighter, including the belief the likes of copper and aluminium are trading at bottom-of-the-cycle prices.

As a low-cost legacy producer, BHP is by no means threatened by lower commodity prices, as is the case for many a junior pure-play miner of respective commodities. But with cash flow falling and debt once again rising, now is not the time to be handing out cash rewards to shareholders, in whatever form. Given management will have been watching so many companies around them doing exactly that, from banks to major gas producers, the decision was always going to be a tough one, requiring aforementioned discipline and greater longer term vision than that which yield-hungry investors have been prepared to apply.

BHP could have sold off its rump assets rather than spin them off, allowing debt to be paid down and shareholders to enjoy capital returns. But this would mean selling into a potentially reluctant market at bottom-of-the-cycle prices. Today’s shareholder candy would represent tomorrow’s lost value. As Macquarie suggests:

“With these assets sitting on their lowest EBIT margins in a decade, BHP is spinning-off its most leveraged assets at the bottom of the cycle, leaving NewCo well positioned for an anticipated recovery in many of its commodity exposures.”

Assessing valuation, Macquarie estimates NewCo would be initially valued at around US$15bn which would slot the stock straight into the ASX Top 20. On commodity price forecasts, the broker assumes NewCo could achieve around 9% earnings growth over its first five years. With little in the way of debt to repay or investment to be made, the company could adopt a 75% payout ratio a dividend yield of around 5.4%, partially franked, to the end of the decade.

The remaining BHP would lose 9.7% in value, which shareholders would balance with NewCo shares. Iron ore and petroleum alone would provide some 70% of value and 80% of earnings. Given management has promised not to re-base the BHP dividend following the demerger, Macquarie estimates the stock’s progressive payout rises to 54% from 49%.

When all said and done, and despite shareholder anger in being stuck with rump asset shares instead of cash, Macquarie believes the NewCo portfolio will offer unrivalled scale, diversity and quality, and greater simplification should support management’s targeted margin and return improvements.

UBS was another broker expecting a buyback announcement last month, but believes BHP should be commended for remaining disciplined in the face of declining free cash flow. This in itself should be enough to appease shareholders, but UBS also points out something all the buyback noise post result caused shareholders to miss.

BHP announced its Western Australia iron ore production will expand from 225mtpa to 290mtpa instead of the 270mtpa previously targeted. What’s more, the capex required to reach this new target will represent something less than US$50/t, rather than US$100/t as previously assumed. This reduction in capital intensity alone adds around US$3bn in value, calculates UBS, while the additional 20mtpa of production adds a further US$6bn based on the broker’s forecast iron ore prices.

JP Morgan suggests this new production target looks “highly achievable”. Productivity gains to date have lifted production to around 250mtpa, and Jimblebar will be the primary driver of the additional 40mtpa. The broker estimates an internal rate of return on the expansion to 290mtpa of 21%, assuming a long term iron ore price of US$80/t, adding around $1.30 to share price value. Given BHP’s breakeven cost of iron ore production is around US$54/t, weakness in the iron ore price is unlikely to hold up expansion.

But wait, there’s more.

BHP’s copper production in Chile is also set for production expansion. The company’s 57.5% owned Escondida mine, which is 30% owned by rival Rio Tinto ((RIO)), will have three big operating plants running on 2015 when OGP1 boosts processing capacity from 245kt to 400ktpd.

At least that’s what Deutsche Bank is assuming. The current plan at Escondida is to tear down the Los Colorados plant to gain access to higher grade ore. But Deutsche’s analysis shows that running all three plants will increase copper production by around 200ktpa from FY18, which would create more value than running just two plants. The broker is assuming this three-plant strategy will be adopted in FY15.

Including this assumption in valuation models lifts Deutsche’s earnings forecasts for BHP and Rio by 2-3%. Implicit productivity gains would be in addition to the companies’ current cost reduction targets.

The broker does not believe an additional 200ktpa of copper will have a material impact on copper prices. Deutsche currently forecasts a 300kt global deficit in 2018 and 1000kt in 2019. Eventually it will prove more value accretive to build another concentrator, OGP2, the broker suggests, tear down Los Colorados and open up access to higher grade ore. But not until after 2020.

In summary, the poor share market reaction to BHP’s full-year result has been all about disappointment with regard capital management, and not about value, brokers attest. For the sake of longer term perspectives and capital discipline in the face of weaker commodity prices, the NewCo spin-off seems the best option. And in focusing on their disappointment, shareholders have missed the exciting news accompanying the result announcement.

And for the record, BHP’s full-year underlying result was broadly in line with expectations.

BHP Billiton currently attracts three Buy or equivalent ratings on the FNArena database, four Holds (following one post-result downgrade) and one Sell. The consensus target stands at $41.66, suggesting around 14.5% upside.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms