Iron minors have enjoyed a bubble-like rally in the last few months. The rally was not driven by fundamentals, however, but by hype. With iron prices moving down again, iron miners have started giving back the gains and I expect the bearishness to continue.
BHP Billiton (BHP, Financial) is one such stock, and investors should use the recent surge to sell the stock.
Debt situation
Samarco was a joint venture of Vale (VALE, Financial) and BHP Billition that ended in a disaster, literally as well as figuratively for both the companies. The maximum penalty that BHP may have to recompense should be about 50% of the overall penalty, as that is the amount held in stock in the Samarco joint venture by the company. Therefore, the overall amount that the company would probably be accountable for is $21.775 billion.
Moving onward, if this lawsuit is endorsed in court, then 7.7 billion reals must be paid. That figure will account for almost $2.18 billion at the existing market rate.
Apart from this, the company's debt situation is becoming worse with time. At present, debt holders are now possibly bothered regarding BHP’s capability to come across interest and principal compensations. The company now has long-term debt of $32.48 billion.
BHP Billiton formerly had a $750 million maturity on Nov. 21, with the total amount remaining. This is the most significant problem this year along with the semi-yearly interest payments of $374 million. Therefore, an additional $1.02 billion will be gone in 2016 to pay their short term debt.
It is highly likely that the penalty will take more than a year to pay off. Furthermore, in 2017, a total of approximately $2.75 billion is scheduled to be repaid, excluding the interest. As a result, these substantial maturities could possibly generate a liquidity crisis for the company.
Cost enhancements are not enough
The company’s unit costs have been declining swiftly and for now have been reduced by 47% during the prior two years. Simultaneously, BHP Billiton is providing a progressively greater margin at small prices. The company's existing EBITDA margin is 50%, which throws light on substantial enhancements though the company's cost has reduced substantially.
These cost enhancements is the reason why the company has managed to stay profitable in the prevailing market condition. As a consequence, BHP will have its earnings be substantial enough to cover its dividend yield of only above 5%.
Apart from this, BHP also anticipates that steel demand will continue to grow until 2020 mainly due to the biggest consumer, China, which should support keep prices strong.
Conclusion
BHP Billiton, due to its debt concerns, is a very risky investment. The company can potentially run into a liquidity crisis due to the Samarco disaster, whereas the falling commodity prices pose another threat to the company. Reducing costs isn’t going to be enough, which is why I think investors should sell the stock.
Disclosure: The author doesn’t have any position in the stock mentioned in the article.
Start a free 7-day trial of Premium Membership to GuruFocus.
