BHP Billiton: Is There Enough Blood In The Streets?

| About: BHP Billiton (BHP)

Summary

The outlook has worsened dramatically over the past two months.

A dividend cut in February is expected by most market participants.

Volatility will likely remain high.

There is a fair chance that the stock will appreciate after the HY report, no matter what happens to the dividend.

I was a strong believer that BHP Billiton (NYSE:BHP)(NYSE:BBL) would maintain its dividend, at least in 2016 even if it meant higher debt. However, I have to admit that the probability of a dividend cut has increased noticeably since my last article late November. BHP's situation has worsened dramatically over the past two months. Several negative developments came together, the most obvious one being commodity prices declining at an accelerated pace.

Over China worries, the price for iron ore dropped below $40 in December. Since then it has somewhat recovered, but still trades around this level. The second issue that negatively impacts BHP's cash flow and its ability to maintain its dividend is the oil price. To make things worse, copper also marked new multi-year lows, not to mention the worries about the financial consequences of the Samarco disaster.

Is A Dividend Cut unavoidable?

I still do not necessarily expect a dividend cut when BHP will announce its half-year result on February 23, but consider it a distinct possibility now. More important for the management than the progressive dividend policy is the group's credit rating. Therefore it comes down to the question of how much new debt BHP would have to issue to maintain the dividend, and which debt level is acceptable for the rating agencies in the current environment. BHP's rating was already put on review for possible downgrade by Moody's last December.

The fact that BHP pays bi-annual dividends is a certain disadvantage compared to quarterly payments, since each of these dividend installments leads to a large cash distribution. If BHP's interim dividend is kept constant, $3.3B will be distributed to shareholders in April - a large pile of money in times with very limited visibility.

I still believe that if BHP is confident enough that the combination of operational cash flow and a manageable amount of new debt will be sufficient to cover expenditures including the dividend, without triggering a downgrade, the dividend will be maintained, at least for now. The decisive question is how much operational cash flow BHP can generate in the low price commodity environment in the first half of CY16.

Regarding the factors that are under BHP's control, a likely response is further cuts to the capex budget and more layoffs. BHP forecasts capital and exploration expenditures of $8.5B in FY16 and $7.0B in FY17. To be meaningful, a reduction in capex would require that the budget was slashed by the $1.5B that is anticipated for next year already in FY16. The likeliest target for any capex reduction measure remains the petroleum segment, and also mothballing the Janssen Potash project could be a logical move. Going forward into 2016, lower tax and royalty payments as a result of lower earnings and weak commodity prices will liberate additional cash and bring some relief.

Possibly, BHP can gain enough breathing room to maintain the next dividend installment, but if market conditions do not improve, a cut will almost be unavoidable later in the year. If the dividend will be really slashed, either now or later, I expect a substantial reduction. Investors would be disappointed anyhow, and if BHP had to abandon its dividend commitment, it should at least bring meaningful relief for the balance sheet. Therefore, a 50% cut seems the most probable option, at least from today's perspective. Such a move would save $3.3B per year and bring BHP a significant step closer to cash flow neutrality. I do not expect a full dividend suspension near term, and one should not forget that BHP still is in much better shape than, for example, Glencore (OTCPK:GLNCY) or Anglo American (OTCPK:AAUKY).

This automatically leads to the question, what could happen to BHP shares if a dividend cut was announced in February? The stock has lost almost 50% in the past three months and appears to be in an oversold territory now. There is definitively blood on the streets, the question is if it is enough.

The market could respond positively to a dividend cut, similar to what happened to Glencore when it announced the dividend suspension. The positive effect of a cut is obvious: The financial flexibility increases, the balance sheet improves and so do the chances for maintaining the credit rating. Therefore a dividend cut could actually lift BHP shares, at least as a short-term reaction. On the other side if BHP reported better than expected results and maintained its dividend, it should as well trigger a positive market response.

Likely, the high volatility will continue over the next weeks. Furthermore, there is a good chance that the beaten stock will react positively to the HY report and any decision regarding the dividend. Short term, these developments can offer trading opportunities, and also loading up on BHP shares on weak days prior to the earnings release could be a viable strategy.

The long-term picture

Beyond the question of whether BHP's dividend will possibly be cut in February, in August, later, or never, I believe that it is worthwhile to take a closer look at the stock now. It is definitively too early to call for a bottom in the present environment, and BHP could still be a falling knife. On the other side, stocks are never cheap because they are liked by investors, but only when nobody is willing to touch them. The biggest gains always loom for bold investors who are willing to take a contrarian view (preferably at the right time). The mining industry is in a down cycle and the recovery will likely take longer than during previous crises. Only time will tell whether we are already close to the bottom today.

Nevertheless, I believe that BHP is a good opportunity for investors with a long-term horizon. Iron ore, copper, oil, and coal will be needed for decades to come, and BHP is one of the strongest players in the industry. Whenever the tide turns, the company is likely to emerge stronger. The only question is if today is already an appropriate entry point or if it will pay off to wait. I have already started accumulating BHP shares over the past year, and I will use the recent drop to buy more during phases of weakness, but keep some powder dry. Timing the market is difficult, and of course I'll wish that I had waited longer in the first place. Nevertheless, I stick to my original plan to accumulate shares over a longer period.

Speculating about the Yield

Coming back to the question of the dividend and the yield, from where we stand today, I estimate that the likelihood of BHP cutting the dividend is higher than for maintaining it. Based on the last two biannual installments of $0.62 (or $1.24 annually) for BHP's ordinary shares and $2.48 for the ADRs, BBL yields around 13%. Even assuming a 50% dividend cut, the yield would still stand at 6.5%. Surely, this calculation may be worthless if the dividend is reduced further or suspended entirely, but it is something to think about.

I do not know if we are already close to the bottom, but the market sentiment for mining stocks is very negative. My rationale for investing in BHP today is clearly not the dividend, but to buy one of the few leading mining companies that will survive whatever commodity crisis we are in. BHP shares trade lower today than during the financial crisis, and the stock is cheap. Of course cheap does not necessarily mean attractively valued, and I cannot rule out further declines, but I believe that the risk reward potential for long-term-oriented investors is already attractive today.

Conclusion

The last three months have been a disaster for BHP shares. The downturn in the commodity markets accelerated, and on top of that the Samarco dam burst worsened the outlook for BHP. The probability of a dividend cut with the next announcement in February has increased significantly. Nevertheless, I believe that ahead of the release of the HY results, there is more upside than downside potential, at least short term. Bold investors might want to have a look at the oversold stock at the present level.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation, any material in this article should be considered general information, and not relied on as a formal investment recommendation. Before making any investment decisions, investors should also use other sources of information, draw their own conclusions, and consider seeking advice from a broker or financial advisor.

Disclosure: I am/we are long BBL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.