At Valuentum, we like to cut to the chase. Commodity-producers such as BHP Billiton (NYSE:BHP) may be solid companies that generate lofty operating margins and high returns on capital, but their end-market product is largely undifferentiated. That means that changes in their equity values and prices are driven mostly by changes in the long-term expected prices of the underlying commodities they produce.
This may sound obvious, but the reality is that investors in commodity-producing stocks pay the most attention to the cost side in evaluating business quality (a potential source of competitive advantage), and simply overlook (or de-emphasize) the fact that the delta of economic profit (valuation) is driven more by top line pricing dynamics, which remain largely out of the constituents' control. In evaluating what investors care most about (changes in the magnitude of economic value creation), commodity prices are much more important to the analysis than any cost assessment. With this in mind, let's take a look at BHP Billiton's stock.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. BHP Billiton posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. A 6 is not a terrible score on the index, but it is not a 9 or 10 either (a "we'd consider buying" rating). If a company passes muster with our analyst team, highly-rated equities are then included in the actively-managed portfolios.
Mining Industry Overview
The diversified mining industry is highly cyclical and almost entirely commoditized, with little differentiation from one firm to the next. Rising input costs can only be passed on to consumers if industry-wide prices increase. Exploration and development require large capital investments, which could pressure cash flows during weak economic times. A miner's position on the cost curve for each respective resource is a critical investment consideration, given the volatility of commodity prices. Though participants boast hefty operating margins, the industry experiences fairly significant (economic) profit swings. We continue to be huge fans of the largest miners' decisions to strengthen their respective balance sheets by enhancing cash flows and reducing capital spending. A focus on debt repayment is also welcome, particularly as concerns about global growth (especially China) remain.
BHP Billiton's Investment Considerations
- BHP Billiton earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 41.2% during the past three years. We think BHP Billiton has an Economic Castle, but it is growing less attractive.
- BHP is a leading global resources company operating in the following groups: Petroleum, Aluminium, Base Metals (including uranium), Diamonds and Specialty Products, Stainless Steel Materials, Iron Ore, Manganese, Metallurgical Coal, and Energy Coal.
- BHP Billiton has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 10.7% in coming years. Total debt-to-EBITDA was 1.3 last year, while debt-to-book capitalization stood at 33.2%.
- BHP Billiton's success will be largely tied to growth in the Chinese market, which has become a significant source of global demand for commodities. Sales to China represent roughly one-third of its business. China's GDP growth remains robust, but it is slowing.
- The firm's operations are characterized by very high operating margins, and its production execution continues to be excellent. Though the firm boasts a diversified portfolio, BHP's performance still remains tied to commodity price swings.
- Iron ore generates ~50% of BHP's operating profit. Iron ore prices have slipped below $100 ton, and BHP thinks they will continue to slide for the next few years. This means that economic profit creation may continue to shrink, albeit it may be partially offset by expected capital spending reductions at the firm.
Moats and Castles: In an economic moat assessment, evaluating the cost structure, which is a source of a competitive advantage, will suggest that the lowest-cost producer for any given commodity will still be able to generate economic profit even under dire pricing conditions, and therefore, the lowest-cost producer will have a sustainable and durable competitive advantage. However, a more relevant and pertinent understanding to business analysis is the Economic Castle™ rating, which considers the magnitude of any ROIC-less-WACC spread. BHP's economic moat may be as strong as ever (and it can continue to widen it through more cost-cutting relative to peers), but its Economic Castle is growing less attractive due to the main driver behind its share price changes (commodity price movements). The Economic Castle is much more pertinent (relevant) to stock analysis than any moat consideration in this respect. Investors care about the magnitude of economic profit and value.
In February, BHP Billiton reported solid financial results for the December 2013 half year, with underlying EBIT advancing by 15% to $12.4 billion, and underlying attributable profit jumping by 31% to $7.8 billion. The company noted that substantial improvements in productivity and volume from lower-risk projects drove a material improvement in its underlying EBIT margin and underlying return on capital for the period. BHP Billiton's net operating cash flow increased 65% and investing cash outflows dropped 25%, resulting in a $7.8 billion increase in free cash flow from the comparable six-month period last year. We like that both measures are moving in the correct direction to drive free cash flow expansion. The firm is wisely using its expected strong free cash flow to pay down its debt load to $25 billion by the end of the 2014 financial year (from $27.1 billion).
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. BHP Billiton's 3-year historical return on invested capital (without goodwill) is 41.2%, which is above the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. BHP Billiton's free cash flow margin has averaged about 29.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At BHP Billiton, cash flow from operations decreased about 46% from levels registered two years ago, while capital expenditures expanded about 92% over the same time period.
Our discounted cash flow model indicates that BHP Billiton's shares are worth between $51-$85 each. Shares of BHP Billiton are trading at $68 per share at the time of this writing (roughly in line with the midpoint of the valuation range). The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $68 per share represents a price-to-earnings (P/E) ratio of about 16.7 times last year's earnings and an implied EV/EBITDA multiple of about 7.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 6.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 7.7%. Our model reflects a 5-year projected average operating margin of 32%, which is below BHP Billiton's trailing 3-year average. To view our Excel-based valuation model, please contact us for more information. Beyond year 5, we assume free cash flow will grow at an annual rate of 6.1% for the next 15 years, and 3% in perpetuity. For BHP Billiton, we use a 10.5% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare BHP Billiton to peers Cliffs Natural (NYSE:CLF) and Rio Tinto (NYSE:RIO), among others.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $68 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for BHP Billiton. We think the firm is attractive below $51 per share (the green line), but quite expensive above $85 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate BHP Billiton's fair value at this point in time to be about $68 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of BHP Billiton's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $87 per share in Year 3 represents our existing fair value per share of $68 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.