What Will It Take To Turn BHP Around?

This story features BHP GROUP LIMITED. For more info SHARE ANALYSIS: BHP

-Yield elevated, even if div cut
-First half result could be positive
-Industry discipline improving
 

By Eva Brocklehurst

The Big Australian, BHP Billiton ((BHP)) is in a state of flux. The diversified miner is under pressure following continued weakness in its chief commodities, coupled with the effects of a disaster at the Samarco joint venture in Brazil.

Morgan Stanley, on upgrading to Overweight on the stock, received a number of surprised responses from investors suggesting its decision may be premature. The broker is not the only one with a positive rating. There are five Buy ratings on FNArena's database, with two Hold and one Sell.

Essentially, the questions centre on just how long the current downturn will last and whether there will be another step down in commodity prices. Also, what is required to induce a turnaround?

The broker does not back away from its view on the stock, assessing it would still trade on an elevated yield even after the dividend is cut by 40%, while the shares are already pricing in the the US$8-9bn in lost value related to Samarco.

Moreover, BHP does not have a problem with its balance sheet, Morgan Stanley maintains, and investments are likely to be reduced to fit in with the available cash. The broker suggests that, while its view may appear contrarian in light of the potential for downgrades to earnings forecasts, the heightened discussion surrounding the stock signals that value is becoming apparent.

The broker anticipates the first half result in February could be a positive event if it confirms that operating costs and capex are being reduced and there is a strategy to address the shortfall in free cash flow relative to the existing dividend.

Most brokers expect the dividend will be cut and re-based. UBS expects a 50% reduction and observes the company is encouraging internal competition for capital to ensure the best returns on investments are made. The broker maintains the initiatives to reduce costs and capex in 2016 are positive aspects for shareholders.

Macquarie accepts the company's commitment to protecting its balance sheet and assumes the progressive dividend is re-based by 50%, but at the FY16 results, sticking with a Neutral rating.

Credit Suisse maintains an Outperform rating and notes that with US capex under review and to be updated at the interim results, reductions are likely to be primarily in the petroleum division where there is current capex guidance of $2.9bn, including $1.4bn in shale spending allocated for FY16.

In terms of the industry outlook, UBS expects prices for key commodities will remain subdued over the next few years but finds some evidence the mining industry is starting to operate in a more disciplined way, which bodes well for the longer-term supply/demand outlook.

The broker's upside case for BHP assumes a 10% increase to commodity price forecasts and a 10% decrease to the Australian dollar/US dollar rate into perpetuity. The downside case assumes a 10% decrease to commodity price forecasts and a 10% increase to the FX rate into perpetuity.

Morgan Stanley sets its price target at $22.50, as a weighted average of its bull, base and bear cases. The bull case, with a $36.00 target, implies 50% of free cash flow is reinvested at a 20% return for five years, with Jansen potash valued using a discounted cash flow model rather than at book, and Samarco re-starts, receiving US$1bn in fines.

The bear case, with a $13.20 target, implies the market loses even more faith in the stock, the Jansen potash project proves worthless, Samarco does not re-start and BHP incurs a share of fines amounting to US$5bn. FNArena's database has a consensus target of $19.98, signalling 29.4% upside to the last share price.

See also Prepare For The BHP Billiton Dividend Cut on January 21 2016.
 

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