Fly on WallStreet

For those who might be considering diversifying out of the US markets into the emerging markets, and specifically China and or commodities, BHP has always been touted as a "Blue Chip" investment.

While I would not disagree on the ability of BHP to survive any cyclical downturns in the future, currently you are paying quite over the odds for the shares.

For my second, out of three posts for the weekend slot, I thought we could take a quick look at this iconic Aussie resouce business as it has been in the news recently being touted as a possible acquirer of Alcoa, and currently involved in a large share repurchase program.




INDUSTRY STATISTICS

Market Capitalization: 360B
Price / Earnings: 15.6
Price / Book: 5.2
Net Profit Margin 16.7%
Price To Free Cash Flow -87.0
Return on Equity: 32.6%
Total Debt / Equity: 0.5
Dividend Yield: 1.5%


Resources, commodity prices have been at historic highs just recently. With prices for the producers of commodities currently so high we must take into account the “cyclical” nature of the businesses involved.

We must ascertain whether the P/E ratio is derived from high earnings due to high prices received for production, or, a low purchase price available for the aggregate earnings over a number of business cycles.

To date the earnings have risen on high prices, and this has already more than been reflected within the prices asked for within the industry. This can further be illustrated within the low current dividend yield.

Purchasing this industry implies continued growth within China & other developing nations.
Is this current growth rate sustainable?

There will be many opinions upon that crucial question, but, the answers are all speculative, and if wrong, could find a very nasty correction in the prices of resource stocks. This has already happened in May, and currently the question remains, after the correction, have the prices become cheap, or undervalued?

The unequivocal answer is no. They are still as a sector overvalued.


CAPITALIZATION

The Capitalization structure of BHP is an unqualified good.
The debt, constituting both funded debt & Bank debt is a very small component of the Capitalization.
Further, the Pension & Operating Leases component is currently showing a surplus from my estimations.

Income Statement
Revenue 32.20B
Revenue Per Share 10.64
Qtrly Revenue Growth 9.70%
Gross Profit 10.09B
EBITDA 13.08B
Net Income to Common 7.80B
Diluted EPS 2.56
Qtrly Earnings Growth 55.10%


The coverage of Interest payments is excellent, and poses little risk to holders of debt, or of equity.
We can see the result of the current high prices of commodities reflected within the two ratios of “revenue growth” and “earnings growth”.

A 9.70% growth in Revenue, contrasted with a 55.1% growth in Earnings. Should commodity prices weaken, and commodity prices are very cyclical, we would see a significant shrinkage within earnings as a result, with a concurrent shrinkage in Revenues.

Due to the lack of leverage within the Balance Sheet, and the high percentage of Common, the expectation would be for a low volatility within the share price. This until just recently was the case. It has not been the case over the past two years.

There has also been a significant improvement to net profit due to a reduction in production costs, quite possibly due to economies of scale. There has additionally been a significant improvement within Selling General & Administration, costs falling. These are both positives, but sustainability is a concern.

Balance Sheet
Total Cash 1.65B
Total Cash Per Share 0.546
Total Debt 10.47B
Total Debt/Equity 0.495
Current Ratio 1.092
Book Value Per Share 6.98


Cash is lower currently than one would like to see. This in of itself is not a major problem, as of course the ability to borrow cash would be forthcoming, and undoubtedly, BHP, would have a credit revolver available.
The Current Ratio however is not high enough to qualify BHP as “Investment Grade” currently.

Inventory & Receivables display no red flags, and pass muster.
The collections of Receivables is possibly a little low, but is consistent, this would need to be monitored.

BHP however does not pass muster on the return generated on assets. With the current high prices that are being paid for commodities, a return of $0.97 on each invested $1.00 is indicative of a low return business.


Cash Flow Statement
Operating Cash Flow 10.04B
Levered Free Cash Flow 8.27B


Cash-flow analysis throws up some interesting areas.
Depreciation is the problem child. As a percentage of Revenues, Depreciation has fallen from an aggregate of 8.9% to 6.6%. This will after Tax, flow to the bottom line, improving net profit growth, this is some $0.13 cents per share.

Capital Expenditures have fallen quite significantly, some $0.77 per share from the aggregate.
Depreciation compared to Capital Expenditures has also decreased.
Depreciation to Cash from Operations……..fallen.
Depreciation as a percentage of Net Assets………..fallen

What we are left with does not look confidence inspiring currently, especially as we are not even purchasing a bargain, thus we have no margin of safety.

We have reduced Capital Expenditures, thus pumping up net profits.
We have reduced Depreciation being charged against Net Assets, pumping up profits.
In short, there may very well be reduced investment, or more importantly reduced, or inadequate spending on maintenance to pump up earnings.

Examination from a different perspective reveals nothing that allays any concerns.
%growth in Capital Expenditures = 30.7%
%growth in Plant Property & Equipment = 24.3%
%growth in Depreciation = 9.8%

When we compare this to the following;

%growth in Revenues = 22.8%
%growth in Gross Profits = 34.3%

It would seem that the Depreciation charge is being inappropriately rated. This is always a red flag, and may pose problems further down the road. At current prices, it is certainly enough of a question to apply prudence to the investment decision.

The Depreciation or Depletion charge carries an extra importance within the purchase of the common stock of a resources business. The Depreciation charged by the business cannot be the depreciation charge utilized by the individual investor, as of course, the business charges depletion at purchase price, and so must the investor.

Utilizing a pessimistic outlook, and diminishing productive capacity after seven years, the investors return would calculate to 4.5%. This is inadequate, and provides no margin of safety at all.

Utilizing a generous twenty years on productive capacity, we still have only a 6.7% return. For this return, a lot of things would need to move in the investors favor.

MANAGEMENT

Looking at hidden Cash-flows we can identify a discretionary Cash-flow of $295.9 million, or $0.09 per share within Selling General & Administration. This in of itself is generally a positive, as these cash-flows may well be available to the business in harder business cycles.

There is however a discretionary Cash-flow within Capital Expenditures also, calculated to be approximately $593.8 million, or $0.19 per share. Under the present question marks present regarding the Depreciation charge, I am not willing to look at this as a positive, if; in point of fact maintenance spending has suffered.

SUMMARY

BHP is considered a “Blue Chip” business, or share. In my opinion, the business is profitable, but has a very low return. It has some serious question marks in regards to the Depreciation charges and related questions regarding the outcome of Capital Expenditure spending.

At the current price, it is too expensive, and returns accruing to the investor, purchased at these prices will reside almost entirely on speculative outcomes. Will commodity prices remain at 25 year highs? Will China & other developing nations continue their extreme growth rates?

jog on chaps