BHP Billiton this morning reported record production in the fiscal first half of 2010. Read this article for our initial response to the miner's numbers. For our outlook on natural resources industries, watch this video.
Fair value estimate: 2,150p ¦ Fair value uncertainty: Medium ¦ Economic moat: Narrow
Thesis
(Last updated 21/10/09)
As the world's largest publicly traded mining conglomerate, BHP Billiton has the financial wherewithal to weather the boom and bust cycles of the inherently volatile commodity markets. Geographic and product diversification give BHP more-stable cash flows and lower operating risk than most of its mining peers. Most revenue comes from the relative safe havens of Australia/New Zealand, North America, and Europe.
This narrow-moat company has several key advantages. It produces a range of commodities from oil and gas to diamonds, and it is a major producer of iron ore, copper, nickel, energy coal, metallurgical coal, and manganese. It offers a full suite of conventional energy products, as well. The company can benefit from a rally in any of its product lines. BHP is a major Australian commodity producer in close proximity to the Asian markets.
A geographically diversified customer base allows BHP to benefit from economic growth and development in any part of the world. When all major world economies are growing strongly, BHP's revenue and profits can benefit significantly. With most of its products in an upswing recently--because of the growing Asian economies and worldwide economic recovery--BHP reported stellar results in fiscal 2005-08. Earnings diversification will limit volatility during the current downturn.
The good times have fortified the balance sheet. Some cash has been returned to shareholders, but the bulk of the windfall is financing growth. Since the $8 billion acquisition of WMC in 2005, BHP has approved billions in expansion projects. The development pipeline is strong. With modest net debt of $4.2 billion at the end of 2008, there is plenty of room for further development projects or acquisitions.
It is difficult to create and protect competitive advantages while focusing on multiple commodities. With the exception of iron ore, we think BHP lacks pricing power in its products. There is a risk that expanding at near-peak market conditions will result in lower-than-optimal returns on investment. However, with its impressive portfolio of businesses in terms of size and scale, BHP has a narrow economic moat, in our opinion.
Valuation
We've increased our fair value estimate to 2,150p from 2,104p, based on
an exchange rate of 0.61p per US dollar as of October 20, 2009.
Underpinning longer-term profitability is ongoing growth in Chinese
metal consumption followed by India demand, mining industry input cost
inflation, industry consolidation, infrastructure bottlenecks, a
scarcity of quality resources because of years of exploration neglect,
and sovereign risk. Much of the new demand has been satisfied by
substantially higher-cost mines. The structural decline in the US
dollar--the currency in which commodities are denominated--continues.
Risk
We believe BHP carries a medium fair value uncertainty rating, given the
volatility in underlying commodity price assumptions. The firm has good
diversification and a relatively robust balance sheet. This does not
imply a lack of risks, however. BHP faces all the environmental and
operational risks associated with mining as well as the country-specific
risks associated with some of its assets.
Management & Stewardship
CEO Marius Kloppers took the reins from Chip Goodyear in October 2007.
He was expected to be more aggressive on the acquisition and development
front while retaining adherence to the Tier 1 asset-only policy.
Confirmation came with the 2008 Rio
Tinto bid.
Overview
Growth: An increase in production, along with rising commodity
prices, has resulted in strong revenue growth. We expect moderating
commodity prices to result in softening revenue and earnings during the
next five years.
Profitability: BHP's profits are inherently tied to commodity prices. Margins expand and contract with each turn in commodity markets. The company's progressive dividend policy underwrites a minimum payout but also limits dividend growth in boom times.
Financial Health: The company is on a strong financial footing. EBITDA has covered interest expenses an average of 14 times, and long-term debt/capitalisation has averaged around 21% for the last three years. Tax-effective buybacks have been a feature of recent years.
Profile: BHP Billiton is a diversified miner that supplies aluminium, coal, copper, iron ore, mineral sands, oil, gas, nickel, diamonds, uranium, and silver. A 2001 dual-listed merger of BHP Limited (now BHP Billiton Ltd.) and Billiton PLC (now BHP Billiton PLC) created the present-day BHP Billiton. The two still operate as separate firms but are overseen by the same board and management team. Shareholders in each company have equivalent economic and voting rights in BHP as a whole.
Strategy: BHP wants to be the supplier of choice to its end-use customers. Its strategy is three-pronged: build on its diverse reserves base and ensure that best practices are shared quickly across its operations; maintain a steady pipeline of greenfield projects for internal growth; and help increase its pipeline by staying close to customers.
Bulls Say
1. BHP is a beneficiary of continued global economic growth and
increased demand for the commodities it produces.
2. BHP's cash-flow base is diversified, and the company is less susceptible to the vagaries of the market than single-commodity producers are.
3. The company has an attractive, low-cost, long-life portfolio of operations.
Bears Say
1. Diversified miners' stocks always trade at discount valuations to
pure plays. Investors interested in gaining exposure to a specific
commodity would be better off investing in pure plays.
2. BHP is subject to the long-term supply-and-demand balance for metals, a major factor in determining the company's profitability.
