By The Valuentum Team
BHP Billiton (NYSE:BHP) operates in the iron ore, copper, coal, petroleum and potash markets, among other commodity based end markets. Profits have remained under pressure for BHP Billiton as the Chinese economy, the largest consumer of iron ore in the world, remains in a transition phase while iron ore producers continue to increase production, with some producing at record levels. Though we cannot deny the slight bounce in iron ore prices, we aren't sure supply and demand rebalancing is right around the corner.
BHP reported its third quarter results for fiscal 2016 on April 20, and through the first nine months of the fiscal year, iron ore production was down a mere 1% on a year-over-year basis. The firm reduced its guidance for full-year production by 3% to approximately 229 million tonnes (Mt), but this is still a notable increase over fiscal 2015 production of 218 Mt.
This expected increase in production comes despite the disastrous failure of a dam in the firm's iron ore joint venture, Samarco, with Vale (NYSE:VALE) in Brazil that killed at least 17 people and resulted in the shutdown of production at the joint venture. Samarco is expected to pick up operations before the end of 2016, though the exact timing remains uncertain at this point.
BHP's decision to cut its interim dividend by 75% in February has not sat well with dividend-focused investors, but management felt it was necessary to preserve its balance sheet and credit rating in the midst of slumping commodity prices. We're most comfortable remaining on the sidelines, especially at this point in the economic cycle. BHP Billiton currently registers a 6 on the Valuentum Buying Index. We avoided this catastrophe. Did you?
BHP Billiton's Investment Considerations
• BHP is a leading global resources company operating in the following groups: Petroleum, Aluminum, Base Metals (including uranium), Diamonds and Specialty Products, Stainless Steel Materials, Iron Ore, Manganese, Metallurgical Coal, and Energy Coal. The company was founded in 1851 and is headquartered in Melbourne, Australia.
• BHP Billiton's success is tied to growth in China, which has become a significant source of global demand for commodities. Sales to China represent roughly one third of its business. China GDP growth is robust but it is slowing, and the country's housing market is worth watching closely.
• Falling iron ore prices have been a thorn in BHP's side. Iron ore prices tumbled nearly 50% in 2014, and the supply/demand make-up for 2016 may not spell relief. We may never see $100/ton iron ore prices again. Profits have remained under pressure, and the company was forced to cut its dividend by 75% in February 2016 in order to protect its balance sheet and credit ratings.
• BHP's operations are characterized by very high operating margins, and its production execution continues to be excellent. The firm boasts a diversified portfolio, but BHP's performance still remains tied to commodity price swings, which are often unpredictable.
• BHP breaks the variance in its EBIT performance into controllable and uncontrollable factors, and the firm attributes all of the $7 billion decline in EBIT in the first half of fiscal 2016 to uncontrollable factors, such as price and exchange rates.
Economic Profit Analysis
In our opinion, 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 29.2%, which is above the estimate of its cost of capital of 8.5%. 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.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. BHP Billiton's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 0.4 (anything above 1 is considered strong).
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 21.1% 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. At BHP Billiton, cash flow from operations increased about 23% from levels registered two years ago, while capital expenditures fell about 22% over the same time period.
In the first six months of fiscal 2016, BHP Billiton reported net operating cash flow of ~$5.3 billion and capital expenditures of ~$4 billion, resulting in free cash flow of ~$1.3 billion. This represents a ~68% decrease from the first half of fiscal 2015.
This is the most important portion of our analysis. Below we outline our fair value assumptions as well as derive a fair value estimate for shares.
We think BHP Billiton is worth $33 per share with a fair value range of $25-$41. Shares are currently trading at ~$28 per share, towards the low end of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
We're expecting a significant decline in both revenue and earnings for BHP in fiscal 2016, ending June 2016, due to the continued pressure on commodity prices, namely iron ore, across the globe. Though we are expecting a slight rebound in fiscal 2017, it will be some time before the firm returns to historical levels of performance. We're also anticipating ongoing capital spending reductions as the company works to maintain its financial flexibility in the current operating environment.
Our model reflects a compound annual revenue growth rate of -10.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of -1.9%. Our model reflects a 5-year projected average operating margin of 17.9%, which is below BHP Billiton's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.9% for the next 15 years and 3% in perpetuity. For BHP Billiton, we use a 8.5% weighted average cost of capital to discount future free cash flows.
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 $33 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 were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for BHP Billiton. We think the firm is attractive below $25 per share (the green line), but quite expensive above $41 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 $33 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $38 per share in Year 3 represents our existing fair value per share of $33 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.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.