I’m starting this month off a bit busier than usual, putting capital to work pretty much right away. Buying stocks is just extremely exciting for me, so the moment cash hits my hand I’m usually already thinking of which equities I might want to buy. Who needs a shopping mall when the greatest store in the world – the stock market – is available?
As was the case with my recent addition to my position in American Realty Capital Properties Inc. (ARCP, Financial), this purchase involved buying a stock after fairly substantial recent weakness. It also involved adding to an existing position. I first initiated a position in the company discussed below in April 2013 and it’s been sitting there ever since. I saw a chance 18 months later to average down on my position, and I took it.
I purchased 20 shares of BHP Billiton Plc (BBL, Financial) on 10/3/14 for $52.95 per share.
Overview
BHP Billiton Plc is the world’s largest diversified resources company. They’re engaged in the exploration, development, processing, and production of a number of minerals. They also have a substantial oil & gas business.
The company operates in five segments: Iron Ore (32% of fiscal year 2014 revenue); Petroleum and Potash (22%); Copper (21%); Coal (14%); and Aluminum, Manganese, and Nickel (13%).
Their production operations are located primarily in Australia, the Americas, and southern Africa. They have a workforce of approximately 123,800 employees and contractors at 130 locations in 21 countries.
This is a dual listed company structure. They have two parent companies – BHP Billiton Limited and BHP Billiton PLC – that operate as a single economic entity, run by a unified management team. The company is headquartered in Australia. This article is referencing the BBL shares that trade on the London Stock Exchange and are offered as ADR (American Depository Receipt) shares on the New York Stock Exchange for US investors. One can also purchase the BHP shares which trade on the Australian Securities Exchange, which are also offered as ADRs. Since the BBL shares trade in the UK, the dividends they pay are not taxed by a foreign government due to a tax treaty between the US and the UK.
Fundamentals
BHP Billiton experiences cyclical demand for their products, as commodities vary in demand and price based on a large number of outside factors. As such, some of their financial metrics can be a bit bumpy from year to year; however, the long-term trend is up. I believe it’s natural to expect short-term volatility in the pricing of many of the natural resources the miner explores for and processes, but long-term demand should drive increasing prices.
Their fiscal year ends June 30.
Revenue grew from $29.587 billion in FY 2005 to $68.730 billion in FY 2014. That’s a compound annual growth rate of 9.82% over that time frame, which is fairly solid. Revenue oscillated a bit during the Great Recession as well as more recently, but the long-term growth rate appears healthy.
Earnings per share increased from $2.08 to $5.18 during this time period, which is a CAGR of 10.67%. Overall, that’s a great result, though EPS does fluctuate quite a bit from year to year. S&P Capital IQ predicts EPS will grow at a compound annual rate of 3% over the next three years, citing volume growth and productivity gains being offset by falling commodity prices (they predict supply growth to outpace demand growth).
What’s really wonderful here is that BBL has a rather impressive dividend growth record. They’re the only major miner that has been able to regularly and reliably increase dividends to shareholders over the last decade. You might not expect that from a company that’s exposed to such volatile commodity pricing, but I think that speaks well to both management’s desire to reward shareholders as well as their conservative and consistent operational history.
This stock pays semi-annual dividends, like most European stocks. It pays an interim dividend in March and a final dividend in September. The final dividend is typically the larger of the two.
BBL has increased dividends for the last 12 consecutive years. Over the past five years, they’ve increased the dividend at an annual rate of 10.6%.
The most recent dividend raise came in time for the final dividend paid in September, and was a 5.08% increase. This brought the yield up to 4.68% based on my purchase price. Meanwhile, the payout ratio remains low, at 47.9%, which should ensure future dividend raises even while earnings fluctuate.
One area BBL particularly shines in is their lack of leverage, as their balance sheet is better than any of their peers. The long-term debt/equity ratio ended at 0.38 at the end of FY 2014, while the interest coverage ratio is 38.4. Fairly impressive numbers, and allows BBL flexibility to take on large projects.
BBL’s profitability metrics are also substantially better than major peers. Net margin has averaged 23.43%over the last five years, while return on equity has averaged 27.22% over the same time frame. Competition, like Rio Tinto Plc (RIO), isn’t even close.
Capital expenditures have been falling heavily lately, and BBL expects this trend to continue as it allows internal businesses to compete heavily for resources and spending, which should increase profitability. This also bodes well for free cash flow generation and overall shareholder returns.
Qualitative Aspects
Commodities don’t offer the growth visibility that, say, food or shampoo does over the long haul. Therefore, I don’t plan to have a significant portion of my net worth exposed to BBL. However, like oil supermajors, there is definitely attractive aspects of investing here.
BHP Billiton has broad diversification across many commodities, which gives them some insulation from a massive change in any one commodity’s price. And they stretch the economic gamut: Iron ore is used in steel manufacturing, and emerging markets that are still building cities and expanding infrastructure need steel. Copper is used in building applications, as well as in consumer products, which would be used as these economies mature. Of course, agricultural needs change and grow as middle classes rise up and as the global population increases, which increases demand for potash. And then you have energy, which is a long-term growth story, which bodes well for their O&G exposure – they are the largest overseas investor in onshore US shale.
They own long-life, low-cost, expendable, upstream assets. These resources are finite, meaning when they are completely expended that’s it. You can’t go and just manufacture copper out of thin air – you mine for it. While there is substantial recycling available for some of these natural resources, the supply slowly dwindles over time. As demand increases from not only developed economies that are still using these resources, but also from emerging economies that continue to grow and expand, the law of supply and demand takes over. That should bode well for long-term pricing.
The pricing power for BBL isn’t quite the same as a consumer products company, but there has been consolidation in the industry over the last 20 years which results in increasing pricing power and stability for those players still left. BBL is the largest such resources company in the world, and well-diversified by product, market, and geography.
Furthermore, their size and scale gives them an economic moat and competitive advantage. They already own substantial long-life assets around the world, and it’s not like any company can go out there and buy land and start mining it. It takes substantial resources to do this, and expertise in how to cost-effectively extract and process these resources. This naturally limits competition since the barriers to entry are quite high, which is probably why you only see a few companies really doing this. And BBL is the largest and most profitable of all of them.
One interesting aspect of BBL is that most of their sales are denominated in the US dollar. They also report their results in the USD and declare dividends in dollars. So this makes it a bit easier to track the investment and maintain some reliability/visibility in its dividend. It trades on the NYSE, reports in USD, and pays dividends in USD. And, as aforementioned, the dividend isn’t taxed by a foreign government. So this is really just like owning a domestic company, but it gives you substantial foreign exposure. The only aspect that might ruffle some feathers is the semi-annual dividend, though that doesn’t really bother me.
A potential catalyst for near-term shareholder returns is the proposed demerger of a selection of high-quality aluminum, coal, manganese nickel, and silver assets. This would allow BBL to focus on their large, long-life, ore, coal, copper, petroleum, and potash basins. They believe this renewed focus on these assets would allow them to increase productivity and reduce costs on the larger businesses, generating even greater returns on investment and free cash flow. The assets that would be jettisoned constitute a very small portion of BBL’s profit.
The demerger, if finalized, would result in two independent companies, and BHP Billiton shareholders would receive shares in the new business. A potential issue is that these shares may trade solely on foreign exchanges.
Risks
Of course, one should consider the risks of investing in this company (as with any company).
There is exposure to highly cyclical commodity markets, which means BBL’s results can swing from year to year. Commodity price swings can have a material impact on BBL’s profitability. In addition, it’s quite capital-intensive to extract resources and get them ready for market. And while competition is somewhat limited, BBL still faces a strong competitive marketplace across all of their commodities, especially petroleum. I would also consider geopolitical risk, although BBL primarily operates in stable economies with governments that are highly unlikely to start nationalizing resources.
Valuation
Shares in BBL trade hands for a P/E ratio of 10.22, which is far below the broader market. Furthermore, it’s also well below BBL’s own five-year average of 14. Mining stocks, including BBL, have been weak lately due to concerns over growth in China. And BBL specifically has seen its stock fall lately after the proposed demerger was announced, as there has been some concern over the lack of a new buyback program – the stock is down over 22% since the demerger was announced on August 19.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 5.5% long-term growth rate. I used a much lower growth rate than what BBL’s dividend and EPS has grown at over the last decade, which compensates for potential lower growth moving forward and the cyclical nature of commodities. So I’m attempting to build in a margin of safety here by using a rather conservative growth trajectory. The DDM analysis gives me a fair value on shares of $58.14, which implies a ~10% discount based on what I paid. So a margin of safety definitely seems present, as I valued shares rather conservatively, which still resulted in a price over and above where shares are trading at right now. There’s potential that BBL shares are significantly undervalued here.
Conclusion
BHP Billiton is the largest diversified natural resource company in the world. They have broad exposure to a number of resources that the world needs to build, thrive, and grow. These resources are finite by their very nature, which should mean they become more valuable as time passes and supply slowly dwindles. And the competitive advantages are already built-in based on the immense cost and expertise necessary to take on leases and mine for resources in a cost-effective manner.
A proposed demerger could provide a catalyst for further shareholder return, as it will not only allow BBL to focus all of their capital and attention on the assets that provide the vast bulk of their profits, but may also allow the new, independent company to potentially provide additional upside all by itself.
This purchase adds $49.60 to my annual dividend income, based on the semi-annual dividend of $1.24.
I’m going to include current analyst valuation opinions below, as I use these to concentrate my reasonable valuation estimate:
Morningstar rates BBL as a 4/5 star value, with a fair value estimate of $76.00.
S&P Capital IQ rates BBL as a 4/5 star “buy” with a 12-month target price of $74.00.
I’ll update my Freedom Fund in early November to reflect this recent purchase.
Full Disclosure: Long ARCP and BBL.
