Why I am averaging down on BHP (7/28/2015)

(I tried to make this review less bias in BHP in contrast to other similar companies being mentioned)

BHP was one of my purchase since I opened my brokerage account January this year. Reason being is that the company had shown stable margins and returns over a decade. Only recently I applied my quantitative and qualitative analysis on this company.

To start with, I used Morningstar and Value Line’s list of competitors identified in the same industry. Overall, I selected only the top five mining companies in terms of market share returns over the past decade. With arranging the list from highest return to lowest, I came up with Compass Minerals International (CMP), Rio Tinto (RIO), BHP Billiton Limited (BHP), Materion Corp (MTRN), and Southern Copper Corp (SCCO).

I easily eliminated SCCO because of its below average market price return among the five.

I then assessed the remaining four’s book value and free cash flow (FCF) return. This gave me the following arrangement in terms of best to least combined return: BHP, CMP, and RIO. MTRN provided a negative FCF return thus being eliminated in the list.

In addition, BHP is the only active company buying its shares back in contrast to CMP and RIO whom otherwise increased their shares over the past eleven years (2005-2015).

CMP won the >10% criteria for the Buffett ratio. CMP had a 23.47% compared to BHP’s 9.19% and RIO’s -1.26. This eliminates RIO in the list.

Next on the checklist is whether either CMP or BHP can support their dividends if present. As of 7/28/2015, BHP has 6.63% dividend yield versus CMP’s 2.97%.

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As seen in the charts above, BHP tend to perform wildly during cyclical downturn-the 2009 Great Recession and the recent 2014-2015 commodity bear market. According to this data from Morningstar, BHP’s payout and coverage ratio has some more room to fall into in case there would be a longer duration of this commodity bear market. On the other hand, CMP appears to be more conservative and stable in terms of giving out dividends. CMP>BHP.

On the other hand, BHP’s FCFE ratio is off 78% from its median over the past 11 years while CMP is off 64%. It is also important to note here that this is first time (2015) that BHP’s ratio dropped below 0.5 in the past 11 years, while CMP’s FCFE went to 0 during the recent Great Recession. This just means that BHP may encounter difficulty maintaining its dividend policy if it were to continue with it during this cyclical down turn. CMP>BHP.

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Current EV/EBITDA valuation revealed that BHP is much cheaper than CMP. Using sources from Yahoo Finance! and Marketwatch, BHP had an average of 4.93 while CMP had 9.33. I assume that companies who have their EV/EBITDA ratio <10 cheap, treating the ratio similar as the PE ratio. BHP>CMP.

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Sustainable growth rate (SGR) shows that CMP is on an uptrend, showing that its TTM SGR of 25.23 is higher than the 11-year median of 24.92. On the other hand, BHP has shown a down trend since 2012. BHP’s SGR TTM is at 4.21compared to its median of 18.72. CMP>BHP.

CEO performance. BHP has Andrew Mackenzie (age 58) since May 2013. BHP’s share price had underperformed by 20% (including dividends) since his reign. CMP, on the other hand, has Francis J. Malecha (age 50), whereby CMP’s share price improved by 9.49% since his appointment on January 2013. CMP>BHP.

 

Brief comparison on the two CEOs and their companies. Market capitalization, Mr. Mackenzie is in charge of a $102 Billion company while a $2.8 Billion industrial metals company for Mr. Malecha. According to Value Line, BHP produces a variety of commodities, including crude oil, natural gas, iron ore, nickel, copper, diamonds, coal, minerals, and steel. On the other hand, CMP engages in the production and marketing of inorganic mineral products concerned with salt and plant nutrition. CMP produces and markets rock, evaporated, and solar salt and sulfate of potash and premium micronutrient products. (I am thinking of comparing CMP with Potash Corp./Saskatchewan Inc (POT) soon as it is more similar in its products).

According to Wilson (2015), Mr. Mackenzie has the following experiences:

1983: Joins BP’s research arm. Involved in discovering oil and gasfields in Norway and Indonesia. Moves to BP Finance, later BP head of capital markets; also chief reservoir engineer and chief technology officer. Ends BP career in US as group vice-president, petrochemicals.

2004: Joins Rio Tinto as chief executive of industrial minerals division.

2007: Decides to join BHP. Joins in 2008 as chief executive, non ferrous division.

2013: Appointed CEO of BHP.

On the other hand, Business Wire (2013) has the following description on Francis J. Malecha of CMP:

-More than 25 years of experience in agri-business.

-Most recently he had been chief operating officer-grain of Viterra Inc., the $7.0 billion global agri-business company. He joined Viterra in 2000, where his responsibilities included global grain merchandising, transportation, operations, commodity risk management, and international merger and acquisition activity. Viterra was acquired by Glencore International plc December 2012

-was named head of agricultural products for North America of the acquired Viterra.

-January 2013, CEO of CMP

Interesting quotes I gathered from Morningstar for both companies are as follows:

BHP:

“Positioned in the centre, BHP Billiton is the world’s largest publicly traded mining conglomerate, with the wherewithal to weather the boom-and-bust cycles of the volatile commodity markets. Geographic and product diversification give BHP Billiton more stable cash flow and lower operating risk than most of its mining peers. Most revenue comes from the relative safe havens of Australia/New Zealand, North America, and Europe.

BHP Billiton owns a very substantial proportion of the planet’s long-life, low-cost, export-oriented, expandable mining assets. Many of these are effectively irreplaceable, with low sovereign risk and proximity to key Asian markets. The assets can grow to meet the world’s long-term increase in demand for natural resources.”

CMP:

“About 60% of Compass’ salt sales are to highway deicing customers. Salt is the most economical method to clear snowy and icy roadways during winter, and with mines close to waterways like the Great Lakes and Mississippi River, Compass can competitively deliver deicing salt to local governments and municipalities. Salt’s low value/weight ratio makes location very important to a company’s cost structure.

Pricing for deicing salt has been historically stable, especially compared with prices for other commodities. Prices are determined annually by a government-directed bid process, in which prices are set during the summer for the following winter season. A snowy winter generally leads to higher prices in the following summer bid season.

The company’s rock salt mine in Goderich, Ontario, is the world’s largest active salt mine.”

 

Recent downfalls of BHP. BHP has written off more than $4 Billion of its assets since 2011 because of its attempts to have oil and gas as one of its pillars (The Wall Street Journal, 2015). According to Mr. Mackenzie, there are “four pillars” of BHP’s business; these are iron ore, oil and gas, copper, and coal. BHP aims to become one of the biggest petroleum producers after the major integrated oil companies such as Exxon Mobil. Oil and gas is the second biggest division of BHP’s business in terms of revenue.

On the other hand, iron ore price fell to $56.94 a ton on March 2015. A 70% retreat from its all-time high of $190 a ton in 2011 (IndexMundi, n.d.; see chart). This is far worse than the 50% decline in oil price.

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BHP’s recent strategy, along with other “big miners” such as RIO and Vale, involves producing more iron in the market through its lesser-cost operations to seek profitability. This would lead into squeezing higher-cost suppliers out of the market (Thomas, 2015).

 

[On a personal note, my portfolio currently has 3.97% weighting in Kumba Iron Ore ADR (KIROY) shares. KIROY share performance declined 36% since I purchased it early January 2015 (along with BHP). I was buying companies early this year based only in their margin and return performance over a period of ten years. Analyzing companies, with just ocular inspection, during early January led me to investing in KIROY as it was and still is a very affordable investment giving an attractive >5% dividend yield that time with margins and return on invested capital hovering in the 70’s. However, further understanding how to evaluate companies qualitatively and not only relying on quantitative measures gave me more peace of mind when deciding to purchase any additional shares of any company.

Checking again KIROY’s numbers quickly revealed that its gross profit margin has a median of 76 since 2008 with a compound annual growth rate (CAGR) of -7.6%, return on invested capital median of 69 since 2005 with CAGR of -7.9%, and debt to equity ratio median of 0.22 with a (sadly) CAGR of 25.72% including a recent 226.32% growth from 2014 to TTM alone.

This research led me to realization that the “big miners” strategy has been inflicting serious injury to these west-African miners. Only recently that KIROY completely eliminated its dividend after seven successive years of dividend growth (Vuuren, 2015). Not only that, “capex has been cut and phased and 133 permanent positions eliminated at the head office involving a 61% employee reduction” (Creamer, 2015a; para. 22). On the bright side, KIROY CEO “Mbazima sees the company being able to manage an iron-ore market price of $45/t by year-end” (Creamer, 2015b; para. 16).

West-African miners are not the only ones who are affected by the “big miners” decision to increase output despite weak commodity prices. Coal miners in the United States are also being affected. Six coal miners located in the U.S. have filed for bankruptcy just this year (Krauss, 2015). According to this author, 5,000 jobs annually have been cut in the last four years and further job losses are anticipated.]

 

Given the aforementioned quantitative comparisons between CMP and BHP, I would easily select CMP over BHP. However, there are five reasons why I am biased in BHP shares before and now. First, I bought it in January thinking that it has a strong margin and returns compared to its peers. Second, these cyclical times provided BHP with a much cheaper price than CMP. Third, management is prudent that they’ve decided to focus more on core business after the South32 (S32) spinoff. According to Value Line, BHP’s spinoff of S32 minimally affects BHP as S32 only represented a small portion of then BHP’s top line. Fourth, BHP provided the most service to its shareholders in terms of book value and FCF growth, along with share buyback program within the past 11 years. Fifth, BHP is more oriented with the metal business compared to CMP whereby the metal industry is experiencing a significant downturn recently and I am assuming that it is probably a good time to buy shares in the most neglected companies.

In addition, CAGR-ly speaking, CMP easily defeated BHP (see below table). However, identifying an eleven-year median in most of the quantitative markers identified below gave BHP more stronger financial standing when compared to CMP.

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According to Value Line, “this issue (BHP) is now ranked 4 (Below Average) for the year ahead. However, our projections indicate that these ADRs shares offer decent total return potential for the next three to five years. The stock’s attractive dividend yield provides some reward for patient investors” (July 10, 2015).

 

Valuation:

BHP current market price (7/29/2015): $38.3/share

Morningstar: $45/share

Value Line: low price target of $50/share; high price target of $70/share

My target price (using averages of owner’s earnings, Hagstrom discounted cash flow (DCF model), earnings yield, PE-PBV-PS average, ordinary DCF model with 7% discount rate, and the revised Graham formula) gave me: low price target of $69.70/share; high price target of $91.32/share

**Do not consider an expert advice. Do not consider a buy advice**

Thank you for reading! J

Mark Yu

References

Business Wire. (2013). ADDING MULTIMEDIA Francis J. Malecha to Become President and CEO of Compass Minerals. Retrieved from http://www.fool.com/investing/businesswire/2013/01/07/adding-multimedia-francis-j-malecha-to-become-pres.aspx

Creamer, M. (2015a). Kumba Iron Ore earnings plunge, dividend dumped, mines rejigged. Retrieved from http://www.miningweekly.com/article/kumba-iron-ore-earnings-plunge-dividend-dumped-mines-rejigged-2015-07-21

Creamer, M. (2015b). Low iron-ore price killing jobs at Kumba. Retrieved from

http://www.miningweekly.com/article/heads-roll-as-low-iron-ore-price-cuts-swathe-through-kumba-2015-07-21

Krauss, C. (2015). Coal Miners Struggle to Survive in an Industry Battered by Layoffs and Bankruptcy. Retrieved from http://www.nytimes.com/2015/07/18/business/energy-environment/coal-miners-struggle-to-survive-in-an-industry-battered-by-layoffs-and-bankruptcy.html?_r=0

IndexMundi. (n.d.). Iron Ore Monthly Price. Retrieved from http://www.indexmundi.com/commodities/?commodity=iron-ore&months=360

The Wall Street Journal. (2015). BHP Billiton Slips on U.S. Oil Patch. Retrieved from http://blogs.wsj.com/briefly/2015/07/15/bhp-billiton-slips-on-u-s-oil-patch-at-a-glance/

Thomas, H. (2015). Iron Ore Hopes Tarnish Quickly. Retrieved from http://blogs.wsj.com/moneybeat/2015/07/14/iron-ore-hopes-tarnish-quickly/

Vuuren, A. (2015). Kumba Iron Ore Axes Dividend as First-Half Profit Falls 61%. Retrieved from http://www.bloomberg.com/news/articles/2015-07-21/kumba-iron-ore-axes-dividend-as-first-half-profit-declines-61-

Wilson, J. (2015). Monday interview: Andrew Mackenzie, BHP Billiton CEO. Retrieved from http://www.ft.com/intl/cms/s/0/51b2a4e0-ce4e-11e4-86fc-00144feab7de.html#axzz3hKRi2Rm3