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Questions for BHP Biliton investors
Posted by: Chandan Dubey (IP Logged)
Date: June 11, 2013 10:32AM

BHP Billiton (LSE:BLT) as well as Rio Tinto (LSE:RIO) are touching their 52-week lows today. I read an article which made an excellent case for BHP, the largest multi-commodity miner in the world by market cap. One of the arguments for BHP as opposed to Rio and Vale was the favorable product mix of BHP which is well diversified across commodity segments. Following is a picture taken from the article.



The mining industry is facing several headwind, e.g. higher labor costs, and lower commodity prices. BHP has in turn responded by cutting capital expenditures. Its new CEO Andrew Mackenzie promised to scale back expenditure which touched as high as $22 billion in 2012 (Morningstar claims $19 billion capex).

Given that Andrew is new on the job (appointed May 2013 as the CEO after Marius Kloppers), it makes sense to look at how the management has spent the copious amount of cash BHP has generated over the last decade.



BHP has bought back copious amount of shares (nearly 866 million shares). In spite of this the dividend has gone up substantially — [size=13px; line-height: 1.22]from $0.08 to $1.11, a compounded 30% annual growth. They yield 4% at the moment. All this paints a picture of good shareholder friendly management.[/size]



As always, the case is not so simple. The previous CEO Marius Kloppers resigned because of significant write downs BHP faced under his management. BHP wrote down $3 billion in its Aluminium and Nickel business, after writing down $2.8 billion in 2012 in U.S. Shale gas assets which cost Mr. Kloppers his bonus. The share buyback of nearly $10 billion in 2010 to 2011 was also ill-timed because of the inflated share price of BHP stock due to the boom in commodity prices. These are evidence of bad capital allocation by BHP management.

The mistake in capital allocation has been industry wide. Due to similar circumstances the CEOs of Rio Tinto, Xstrata and Anglo-American have also fallen. The boom in commodity prices had led to a lot of cash in their coffers and instead of spending them wisely they chased ambitious takeovers at inflated prices. A management which mindlessly follows the crowd and makes the “easy” decisions is not going to lead to good shareholder returns.

Discounting the management mis-steps it is still not clear if BHP is a good investment at current prices. Following are the margins of BHP over the last decade.



We observe that net margin was almost 2.5 times in 2011 vs 2003. It is still around twice as much in 2012 as compared to 2003. The easy answer is to be found in the graph below (price of iron ore).



The price of iron ore is more than 10 times now, compared to 2003. A similar situation exists with copper (nearly 6 times), coal (3 times) and petroleum (4 times). It is hence clear that the performance that the stock is enjoying is due to significant rise in commodity prices and an absence of commensurate rise in its expenses — [size=13px; line-height: 1.22] increasing its revenue and the bottom line. [/size]

Given that the book value of BHP stock is $25 (might be understated), I don’t see BHP as a “value” in this sense either as opposed to ArcelorMittal (MT).

An “investor” has to ask himself the following questions before investing in BHP. Do you expect the status quo to remain or you think prices are likely to come down? Why do you think your particular view of the future is the correct one? Are you willing to put real money on the line on such a prediction?

Unfortunately, answering these questions is hard for me. I can ignore them and buy BHP stock based solely for the dividend. An argument can be made about the dividend track record of BHP and why a 4% yield is likely to go up -- if we extend the current trend into the future. I find this argument to be quite simplistic. Without confronting the questions above, it is not clear if you are an “investor” or a “speculator” according to Graham’s definition.


Stocks Discussed: BHP, RIO, MT, LSE:AA,
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