Stock: BHP Billiton Ltd
Code: BHPMarket Cap: $155.5bnRecommendation: Hold
As the benchmark ASX200 index falls to the brink of new bear market depths, it is no surprise to see half of our 50 largest companies trading within 10% of their bear market lows. But it’s a little scary to think that while this fresh wave of worry washes ashore, the ASX200’s largest single component, BHP Billiton, is still hovering over 45% above its November nadir. BHP’s 13% weighting in the ASX200 index is double that of the next biggest member, Westpac. So without this relative muscle flexing from the ‘Big Australian’, where would our market be?
The simple answer is – much lower. But don’t get me wrong. 40% down from its 2008 all time high, BHP’s share price has not been spared punishment as commodity market’s turned upside down. Therefore the ‘strength’ we refer to is the stock’s relative resilience to both its resource sector peers and the broader market.
So what is holding BHP up? And is this strength sustainable?
BHP is benefiting from two key trends to evolve out the credit crisis – industry consolidation and de leveraging. BHP is the world’s largest mining company. While it did very well during the boom years, so did many other smaller players and start ups that sought to get a slice of what was a very warm pie in the resources sector. But with boom having turned to bust, many rivals (regardless of size) are struggling to survive. The result is less competition and increased market power for BHP. In an industry where there is little difference between your product and what your rivals dig up, a tightened market structure bodes well for the remaining players like BHP over the long term.
The reason why BHP is has not fallen into a pure battle for survival relates to debt. Used to fuel growth in the boom years, debt has now become poisonous in an environment of declining earnings and asset prices. Mining, a particularly cyclical industry, is one of the worst places to house debt when a downturn hits. High fixed costs mean earnings fall sharply, but debt remains the same. BHP entered the 2008 credit crisis with its lowest gearing levels since 2001, and cash flows that could repay its modest debts within the space of a year.
So already being the dominant player in the sector and boasting a balance sheet that was the envy of its peers, BHP has entered this downturn in a very lucrative position. As the cycle plays out, the company is best placed to not only survive, but to acquire distressed mining assets at depressed prices.
The company has been quiet on the corporate action front after withdrawing its bid for Rio Tinto. Understandably it has been busy shoring up internal operations. Despite its strong corporate position, BHP has not been immune from the pain of lower commodity prices. In its latest half yearly report, the company was forced to make big write downs on its underperforming nickel business, which resulted in mine closures and a 57% fall in reported profits. Excluding these ‘one off’ items, the 6 months to December saw ‘operational’ earnings hold up fairly well. The operating result of $6.1bn was actually slightly ahead on the previous corresponding period. Income from bulk commodities such as iron ore and coal, which are sold on an annual contract basis, helped offset immediate declines in base metal income, where prices are actively traded.
However the near term outlook is not so fortuitous. Contract prices for bulk commodities are set to fall, the magnitude of which is unclear. Therefore should base metal prices remain near current levels, the pressure on operating earnings is firmly downward. For this reason the outlook for the share price is less clear. Whether it holds near current levels rests on the magnitude of pending earnings declines. BHP’s current normalised PE is just under 9 times. A further 30% fall in earnings (a real possibility) would see this multiple expand to over 12 times.
Overall we view the stock as fairly valued in the absence of a rebound in commodity markets. With near term upside appearing limited, but long term fundamentals intact, we rate the stock a ‘hold’. Share price weakness could provide a buying opportunity, but it must be assessed in the context of earnings declines. Members will be advised accordingly.
Tim Morris is an analyst at wise-owl.com, one of Australia’s leading independent stockmarket research houses. Click here for your complimentary report.
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