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BHP Might Be a Mess, But It’s a ‘Buy,’ Too

Wall Street has somehow baked in worse prospects than the company's already troubled waters

   

To read the headlines, you’d think now’s the exact wrong time to own a stake in miner BHP Billiton (BHP). China’s growth is expected to slow to its lowest pace in over a decade, metal and coal prices have fallen by double digits during the past 12 months, and the company’s per-share earnings are projected to fall 7% over the next 12.

All in all, it’s the kind of thing shareholders cringe at when they hear it.

Yet, when all of that bad news is already priced into the stock — and then some — could it be a “darkest before dawn” situation that merits a new position?

It depends.

The Bad News

BHP Billiton is not only one of Australia’s biggest coal and iron mining companies, it’s also one of the world’s biggest. Also important, it’s one of China’s biggest suppliers of coal and iron ore. But that’s a problem, too, since China’s likely to need a lot less of the stuff in the foreseeable future.

The number in and of itself seems just fine. A recent poll of economists suggested China’s economy would grow “only” by 7.8% in 2013. It’s a number the United States or the EU would be envious of, but by Chinese standards — where growth rates closer to 10% have been the norm for more than a decade — weakening growth is going to usher in a period of weaker demand for coking coal (used to forge steel) and iron ore (used to make numerous products).

Perhaps there’s no greater evidence for tapering demand and/or more supply than the fact that the prices of coal and iron ore are still broadly falling. Coking coal has lost 7% of its value since the end of the first quarter, when it reached a multiyear low; the modest Q2 rebound in coal doesn’t appear to be getting traction. At the same time, iron ore prices are also tumbling, from the 2011 peak of $218 per metric ton to the current value of $165 per ton … a downtrend that’s still underway.

Oh, and shares of BHP are currently valued at 13% less than their February peak, and are down to the tune of 31% for the past two years. That doesn’t exactly paint an encouraging picture for would-be shareholders.

Of course, why should it? Not only is BHP Billiton likely to sell less iron ore and coal in the foreseeable future … it’s going to sell it for less of a profit.

The Good News

The bad news is clearly … well, bad. But, what if that news was already as bad as it could possibly be? For that matter, what if the market had priced in a future that was far more grim than necessary?

It would translate into an opportunity.

To put it bluntly, the stock’s 31% pullback since early 2011 was deserved. During the first half of that year, BHP Billiton generated $37.5 billion in sales, and turned $13.1 billion of it into a profit thanks to ultra-strong metal and coal prices. Both numbers have fallen ever since then, mirroring the deterioration of the iron ore and coal markets. During the last half of 2012, the Australian miner generated only $32.2 billion in revenue — a 14% decline in the early-2011 total. But profits plunged to $4.2 billion for the last six months of 2012. That’s 68% less than the big profits the company was putting up less than two years earlier.

So how is that good news? Because it’s unlikely coal and iron ore prices could get any worse. There are structural and psychological limits for any market, and we’ve reached them on these commodities. Should prices tiptoe any lower, odds are good that some miners would mothball their projects, thus stabilizing supply.

Even if iron and coal prices don’t start meaningful recoveries in the near future, however, it’s still entirely possible BHP’s bottom line could start to grow again.

Few questioned the company’s heavy capital expenditure commitments when they were made in 2010 and 2011, as commodity prices were rallying, and expansion projects would more than pay for themselves. As the 68% dip in income illustrates, though, weak margins on low-priced commodities, in addition to heavy capital spending, have taken too big of a toll. Shareholders can expect at least some profit growth heading into next year, however, as many of those planned capital expenditures are being cut.

New CEO Andrew Mackenzie has a different philosophy than his predecessor — he’s not spending money left and right to develop new source mines that might or might not be profitable ventures. For perspective, his capital spending budget for fiscal 2014 is 18% less than 2013’s budget, and he’s aiming to further cut capital spending in the years beyond that.

Won’t that put the brakes on any potential sales growth? Yes, but by cutting the 2014 capex budget by $4 billion, Mackenzie is actually going to make the company’s bottom line bigger, even with today’s tepid commodity prices (which, as was noted, are apt to be at or near their ultimate lows).

Bottom Line

It’s tough to step into a stock that seems to have little going for it. Just bear in mind that nothing lasts forever. BHP Billiton might not be the hottest stock out there right now, but with little risk and a decent reward built into the stock’s price — and maybe even a decent rebound in commodity prices in the works — the potential reward could be bigger than anybody’s giving the company credit for.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2013/05/bhp-might-be-a-mess-but-its-a-buy-too/.

©2014 InvestorPlace Media, LLC

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