Equities Spotlight: BHP

This is the first of a regular equities analysis post we’ll be introducing to MacroBusiness.  In the posts we’ll be taking a single company and analysing its business and financials from the perspective of a fundamental/value investor.
 
In a continuation of this week’s earlier post on BHP and the AUD, today we  look at BHP Billiton.

The Business

BHP Billiton (BHP) is the world’s largest resource company.  It mines and processes a diverse range of materials including iron ore, coal, base metals, petroleum and aluminium.

The bulk of BHP’s non-current assets reside in Australia (55% as of June 2010), with 14% in South America and 11% in North America.

BHP Billiton came into existence in 2001 when Australian Broke Hill Proprietary Company merged with Anglo-Dutch Billiton.  BHP is listed on both the ASX and the London Stock Exchange and is the largest company on the ASX by market capitalisation.

Financials

BHP’s return on equity (ROE) has averaged an impressive 48% over the last 5 years.  ROE dropped to 22% during the GFC, but is now forecast to rise to 49% for FY11.  Intangibles assets are very low at $0.14 compared to $10.53 of tangible assets, which is expected given the large capital investment required for a resource company.

BHP’s net debt is zero, with $16B in interest-bearing debt offset by $16.2B in cash and equivalents – another impressive statistic for a mining company.  Equity per share has grown consistently from $5.23 at the start of 2006 to $10.65 in 2011 as a result of acquisitions and organic growth.  After several failed merger and joint venture deals, BHP instituted a share buy back program in 2010 in order to return surplus cash to shareholders.

In terms of earnings streams, BHP revenue totalled $52.8B in FY10.  Of this, 25% was from Chinese customers, 19% from the rest of Asia (excl Japan), 16% from Europe, 11% from North America and 10% from Japan.

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Return on Equity

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Equity per Share

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Management

BHP is currently lead by CEO Marius Kloppers, who took the helm in October 2007.  Holding a degree in chemical engineering, he has both technical and corporate experience in the industry, especially within the BHP/Billiton organisations.  The remaining top-level management consists of a mix of industry, finance and corporate expertise with a heavy emphasis on resource backgrounds.

BHP management has tried to expand BHP’s reach through several acquisitions and JV opportunities over the last few years.  Some of these have been successful; however those that would have significantly increased BHP’s market power were stopped by regulatory authorities.  BHP is still looking to diversify into soft commodities like potash.  The use of surplus cash to buy-back shares in 2010 (after the failure of the Rio Tinto joint venture) indicates a good grasp of capital management.

Management remuneration is based on a complex combination of base salary, short term incentives ,cash incentives and long term share-based incentives.  Cash incentives are typically at the same level as base salary, whilst the long term incentives appear to be the largest of the renumeration components.

Opportunities

  • BHP will continue to benefit from high commodity prices as long as China continues to grow,
  • BHP has a well-diversified portfolio,
  • The balance sheet of BHP is very good, with low debt and high ROE,
  • Management have pursued sensible acquisition targets, whilst also returning cash to shareholders where appropriate.

Risks

  • BHP’s earnings are tied to the strength of commodity prices and the US dollar (the currency in which its commodities are sold), both of which can be volatile,
  • BHP’s increasing reliance on China to generate revenue growth,
  • Regulatory attempts to increase BHP’s tax burden (especially in Australia),
  • The increase in supply being brought online around the world (due to new mining projects) may see commodity prices decrease in the medium to long term.

Summary

BHP is the world’s largest resource company, with a healthy balance sheet and impressive ROE.  It is well positioned in the midst of a commodities boom, with a variety of established, low-cost operations spread around the globe.

Management appear to consider the allocation of capital seriously, choosing acquisition targets well whilst also returning surplus cash to shareholders at appropriate times.

At Empire Investing we consider BHP Billiton to be a “Good” company due to a lack of competitive advantage and its exposure to commodity price and exchange rate volatility.

Valuation

Using a forecast ROE of 36% (dropping to 28% over 5 years) with an equity per share of $10.65, Empire values BHP at $46.00 per share.

Using a 50% Margin of Safety, our maximum buy price is ~ $30.70.

Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has no interest in the businesses mentioned in this article.  The article is not to be taken as investment advice and the views expressed are opinions only.  Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.

Comments

  1. Top work, from a fundamental/value investor point of view.

    Quick glance at a long term chart of BHP could be of additional value. Wish I had a nice chart on my own blog, but right now yahoo will have to do:

    http://au.finance.yahoo.com/q/bc?s=BHP.AX&t=5y

    Last month BHP tested the price zone just below $50. It also tested that same price zone in 2007, and 2008.

    To state the obvious, three failures to break $50 means there is big resistance in the market to such a move.

    This raises the odds that we will see a contuation of the big trading range between $50 and $25 that has held for the past 4 years.

    So, unless BHP breaks through $50 soon, price is likely to head back toward $25.

    The flipside is, any break up through $50 would be “have legs”.

    This is not investment advice, just my observations.

  2. Thanks Avid

    I’m a fundamentalist fundamental investor, so I basically ignore price charts. The Prince and I often trade blows on investing vs trading. That said, I always enjoy hearing the chartist viewpoint, so thanks for the insight.

    Hey Prince – what do the tea leaves tell you about BHP at the mo?

    • Good points Avid.

      “investing hat on” – the only price charts we look at Empire are how value tracks price over the very long term. Obviously you want to buy below value and sell at or above, but we don’t use price charts to find entry/exit points – only price action vs valuation.

      “trading hat on” – I’m bullish BHP in the very short term as a trader – its made a temporary bottom at $43.50 or so. In the medium term, it like the ASX200 index needs to get past $50 (or 5000 points) to return to a bullish market phase.

      Strip away the effect of QE and its pretty clear that the technical price point of control on BHP is around $40. For an investor, that’s not low enough to mitigate the risk of commodity bubble bursting regardless of the diversification of the business.

      Just to clarify a point – when you hear “bearish/bullish” quoted, it doesn’t mean anything unless you know the timeframe you’re operating in – and again this delineates the traders from the investors and the optimists.

  3. “This is the first in a regular equities analysis post that we’ll be introducing to MacroBusiness. ”

    Excellent. This blog keeps going from strength to strength. Thankyou.

      • wouldn’t mind an analysis on WES. It’s one of the more difficult ones to value given the conglomerate type nature of the business, and you guys have already done WOW a few times.

      • We have analysed WES – the major problem is the level of intangibles on their books after paying WAY too much for Coles.

        Having said that, you are quite correct – its a difficult one.

        I will add it to the list for a public valuation to be made however – it may come out as one of our spotlights for next week’s theme.

        Thanks for the request JC.

  4. Using ROE to value BHP? I think thats very misguided. The E for a mining company is not the same in my view as an industrial as you dont build your business the same way. Book value for a mining company can and does bear little to no resemblance to the future potenial cashflow. You can spend $10m’s in drilling and studies to firm up a deposit that has $bn’s of theoretical NPV. BHP’s E is effectively a mixture of assets developed themselves (WA iron ore) and assets purchased through M&A (Escondida, Olympic Dam). The real value of the assets developed themselves will be higher than the book value while the assets they bought through M&A will be closer to real value. To illustrate, look at WA Iron ore within BHP, it earnt US$6bn of EBITDA in 1H FY11, compared to US$13bn of net operating assets on the balance sheet, thats close to 100% ROA. Whereas Olympic Dam earnt US$330m in EBITDA, vs $6bn in net operating assets (they purchased this through acquisition of WMC).

  5. Using a 50% Margin of Safety, our maximum buy price is ~ $30.70.

    Well I thought my target price of below $35 is already quite conservative …but not quite according to your valuation. Quite frustrating though to wait Mr. Market realizes the “value” of any share.

    Anybody finding the recent surge in Big4 Banks share prices a bit fishy considering recent bad news from rating agencies ? Possible insider’s work to prop-up price to make impression that market ignores the bad-news ?

    • Hi Deo

      We are quite conservative in the margin of safety we use for companies we consider “Good”.

      As an explanation for everyone else, our buy price and our valuation are two different things. We think BHP’s value is about $46 given our ROE assumptions and using a 15% required rate of return. However, we’d only buy BHP below $30.70 because we like a big margin of safety for the companies we consider “good”. This allows for errors in our valuation because GFC mk 2 may happen tomorrow and tank all commodity prices, or the AUD may hit $2.00 in October.

      The better quality the company (very good, wonderful) then the lower the margin of safety we use. I’d rather take a punt on WOW’s ROE in 5 years time than BHP’s.

      No idea what’s going on with the banks. Mr Market in an exuberant mood again?

  6. I’d agree with you Mining Man for small to medium size miners (Fortesque for example) and the start ups/explorers. For this reason we stay away from the miners because you can’t value them using ROE. FMG didn’t actually turn a profit until last year. How do you determine a ROE for a company that raises capital and makes losses for 5 years?? As value investors, we consign them to the “non-investment” grade bin because taking a punt on their limited reserves and the price they’ll get for the commodity is speculation rather than value estimation.

    However, the giants like BHP, Rio and Vale have such large capital bases and diverse portfolios that we believe a ROE analysis is justified. They can sink $10M into exploration and it’d be smaller than their accounting errors. With such a large capital base their equity levels are real and measurable. They have also been around long enough to demonstrate their ability to put that equity to use. BHP may find a new iron ore reserve tomorrow, but because of the size of its current known reserves it wouldn’t have the impact that it might have on a smaller miner.

    • Can see your point. As an aside, I also have a beef with ROE analysis in general and P/B multiples because I dont beleive the E anyway. The balance sheet has a large multitude of different valuation techniques for assets and liabilities and the E is thereofre like the remainder on long division. Inventories can be held at lower of cost and net realisable value. Buy vs build for assets has a very different outcome on the B/S. Accounting for leases. The decision to capitalise or expense various items etc. Writedowns on acquired assets etc.

      • True, there’s always creative accounting. But over a long time frame you’ll see whether tricks are being used to hide things. That’s why we look for at least 5 years worth of financial data. There’s also other metrics to use specific to each industry – inventory turnover figures in retail for example – that are used as further checks of integrity.

        However, we believe ROE is the most important measure of company value because it tells you what the company is doing with shareholders capital. I’d rather own a company generating $1m in NPAT from a $1m (%100) ROE than a company that generates $2m in NPAT from $20M in equity (10% ROE).

        What sort of analysis you do consider valid Mining Man?

        • Haha,

          Interesting and justified question. I am getting disheartened with a lot of things lately, and have become more of a trader post GFC than before. I have also been relying on intuition a lot more, going with my gut. I dont use technical analysis though as I have never understood how that could work. Having said that, I think I should study up on it to question my view that it is of no worth.

          I look at earnings and cashflow primarily, and have a value investor bias. I like to invest in a 10x P/E company with growth. This is I guess in some ways an inverse of your ROE, but on the basis that ROE looks at book value, P/E looks at the market value. I also look for good management and sustainable competitive advantage. Look at what market expects and ask where could it be different. What is the market missing?

          I think you have to get the thesis and drivers really simple. I like to model companies in as little lines as possible. I look at mining stocks mostly and build a 10-20 line model. Then look at what the long term commodity price is using consensus and build an NPV. Then i go with my gut and ask, is consensus too low on long term commodity price or too high? Surprisingly I have found a 10 line BHP model is almost as accurate at picking earnings as a 5000 line model.

          NPV is great for mining because of the finite life of a project. It doesnt work so well in industrials because you end up with a terminal growth factor which is a multiple anyway.

    • “As value investors, we consign them to the “non-investment” grade bin because taking a punt on their limited reserves and the price they’ll get for the commodity is speculation rather than value estimation.”

      My advice to you is to get better at speculating, because it leads to much much greater returns than the 9% you’re getting now.

      • Thanks for the constructive tip Juk. It’s good to see you’re checking out our website and performance figures.

        We look for long-term, low volatility, absolute returns over all market conditions. Given that the average super fund has returned 5% over the last 10 years (http://www.superratings.com.au/latestreturns) we’re not unhappy with our current performance, but we’re always aiming for better.

        As for speculation, I am sure there’s a fair bit going on amongst the fund managers returning 5% p.a over the long term, whilst the market did over 8% p.a in the same period.

  7. Thanks for a succinct and apt analysis Q!

    I am somewhat biased to the view that miners (junior or mammoths like BHP) have their biggest asset as contingent claim upon the commodity prices. With the economies of scale these guys have they either are doing very little (underusing their assets) or going to the moon with multiple zeros being added to operational cash flows. And I humbly believe that forecasting the value of this asset can only be an educated guess as to what the commodity prices will be on AVERAGE that they receive.

    As an aside, IMHO, an inactive hedging strategy against commodity prices makes sense for them as investors in these companies are largely looking for exposure to these prices and as such should factor in the downside risks in their discount rates or MOS as you accurately point out to.

    Thanks again for sharing insights at Empire!

  8. I think we have a significant problem with the management, in comparison to peers BHP is hamstrung by slow management. the example of failled M&A and now a belated capital management program. They still paid over $1b in fees for the failed Potash debarcle.

    I would be say if they had some of the xtrata boys at the helm they would be up over $65… I’ll leave for the moment

    As an aside I have little faith in many of our company managers who have “inherited” their jobs.

    Aside #2, agree Wes paid to much – wrong time of the cycle but I rate the management of Wes, they seemed to have turned coles around.
    Aside #3, I don’t (really) like WOW.

    • Ha! Sounds like you’re a BHP insider there Jack. I know from experience how slow-moving and bureaucratic BHP’s internal approvals process can be, so I wager you’re comment is apt fore the rest of their management processes. Disasters like the HBI plant in WA and Ravensthorpe have only added to their conservatism.
      That said, the companies fundamentals are still good and they still have a string of low-cost assets producing high profits at todays prices. High and risky capital investment for new projects are a need for all miners, which is why we’d never call the likes of Rio or BHOP a Very Good or Wonderful company.

    • Yup – in our opinion (and with our risk profile) buying at $30.70 ensures we are getting a better-than-value deal on a good company whose earnings can be volatile.