Fair Value Estimate: 2445p | Uncertainty Rating: Medium | Economic Moat: Narrow
Thesis (Last updated 13/10/10)
As the world's largest publicly traded mining conglomerate, BHP Billiton (BLT) 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, thermal coal, metallurgical coal, and manganese. It also offers a full suite of conventional energy products. The company can benefit from a rally in any of its product lines. Finally, 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--because of the growing Asian economies and worldwide economic expansion--BHP reported stellar results in fiscal 2005-08. Fiscal 2009 softened with the global financial crisis, but the company's diversified earnings stream dampened the overall volatility associated with the 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 $3.3 billion at the end of fiscal year 2010, 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 2,445p from 2,433p. Upgrades to medium-term iron ore, copper, and coal prices are the driver. The Australian government looks to have substantially softened its stance on a previously proposed 40% Resource Super Profits Tax, or RSPT. As a company with limited capital shield, BHP's Australian tax rate could have risen to 57% under RSPT. We now expect that the maximum it would rise to would be around 44%. The issue brought down a Prime Minister, but has resulted in a new replacement Mineral Resource Rent Tax, or MRRT, proposal with a headline rate of 30% after a 25% extraction allowance in the miners' favour. This makes it in effect a 22.5% rent. Carried forward MRRT losses are indexed at the long-term bond rate plus a new 7%. MRRT is income tax deductible.
The new proposal addresses key industry concerns over retrospectivity, competitiveness, and resource differentiation. The new tax applies only to iron ore and coal.
Risk
We believe BHP merits a medium fair value uncertainty rating, as individual commodity price volatility is offset by mineral 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 unsuccessful 2008 Rio Tinto bid.
Overview
Financial Health: The company is on a strong financial footing. Net interest coverage has averaged 30 times over the last five years, and debt/capitalisation has averaged 30%. 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.
Bulls Say
-- BHP is a beneficiary of continued global economic growth and increased demand for the commodities it produces.
-- BHP's cash flow base is diversified, and the company is less susceptible to the vagaries of the market than single-commodity producers are.
-- The company has an attractive, low-cost, long-life portfolio of operations.
Bears Say
-- Sovereign risk heightened following the Australian government's intended Resource Super Profits Tax. The softer replacement Mineral Resource Rent Tax has reduced but not erased this risk.
-- The global economy is cooling off. Demand for commodities will follow suit.
-- 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.
-- BHP is subject to the long-term supply-and-demand balance for metals, a major factor in determining the company's profitability.
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