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The Not So Big Australian

The Not So Big Australian

The half year result posted by BHP this week paints a grim tale of low commodity prices.  Earnings under pressure, book values  slashed and the biggest  dividend cut in the company’s history all reflect the current low in commodity prices. Is there an investment case?

The Broken Hill Proprietary Company. BHP. “The Big Australian”. “Hills”.

Australia’s largest listed mining stock’s moniker has evolved with its operations. Variously named and nicknamed, it was once the largest company by market value listed on the ASX. Now, with a capitalisation around $53 billion, it pales behind companies such as CBA  ($125 billion) and Telstra ($64.5 billion).  Nonetheless, the half year result against the backdrop of cyclical lows in commodities is an important investor event.

How is BHP operating?

Among all the red ink is an interesting number – BHP’s operating margin is 40%! This is possibly the most important number published today, because it tells investors what they need to know – even at current low metal and energy prices, BHP’s operations are profitable.

Looking at the half year, the underlying profit (before write downs) was US $412 million – down more than 90%.  The cause is clear – crude oil down 50%, gas and iron ore down 40%, copper down 30%, coal down 20-25%. The commodity cycle which drove BHP to share prices above $45 has now fully reversed. The key questions for investors are has the company prepared well for this down turn, and is the cycle likely to turn up from here?

Is the balance sheet OK?

This result suggests management are on top of their game.

BHP’s financial strength is also on display.  The write downs are enormous, and would cripple most of BHP’s competitors. The Brazilian mine disaster at Samarco has already cost more than $1 billion, and $858 million of the write offs is associated with these costs. However, the big drag on the balance sheet is the $7 billion plus write down associated with the US onshore energy assets.

The numbers here are eye-watering, but the net result is a cleaner balance sheet.

Most importantly, BHP has further reduced debt, bringing its gearing to historically low levels and leaving it well prepared to take advantage of any distress selling of mining assets. For many mining companies the next twelve months are a matter of survival. It’s very likely that many high cost producers will be forced to either sell or shutter operations. BHP is in a good position, with potential to selectively buy quality assets at cycle lows.

How are investors affected?

Many investors will focus on the change in dividend policy. As flagged by the Chair and the CEO, the progressive dividend policy is dropped to protect the balance sheet. The US 16 cents is not much of a dividend yield – but there are many who argue that resource companies should not be bought for dividend yields. Usually, buying mining stocks is about rising share prices. And in share price terms, there is a case:

20160223 bhp

BHP is trading at better than ten year lows. To recap, this is the world’s largest listed mining company, that is diversified geographically and across four different commodities. After touching a low at $14.06 recently, it has bounced to $17, but remains well below the longer term trading range between $28 and $36.

The drivers of lower commodity prices sit on both sides of the equation. Production in oil and some metals has not fallen away with commodity prices, as normally occurs, as dominant producers attempt to drive competition from the markets. The demand side is less clear cut, with much conjecture around China’s economy – the marginal buyer of metals and energy over the last decade. While these themes play out, it’s important to note the huge price  falls, which may mean the risks for commodity prices on the downside is limited.

In my view there is a strong case to add BHP to portfolios at current levels. Any post result weakness could be a long term buying opportunity, especially for investors who are underweight commodity or growth exposures.

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