Iron ore prices have fallen by around 21% since August 2011 to around $140 per metric ton (PMT) currently, and it is likely that we will see increased pressure on the revenue and net income of global iron ore miners such as BHP Billiton (BHP), Rio Tinto (RIO), Vale (VALE) and Anglo American (AAUKY.PK).
This is likely to be exacerbated by the view that China is headed for an economic hard landing, which will have an even greater effect on the revenues of basic materials and energy companies that depend on Chinese demand to drive a significant portion of their revenues. I believe that given BHP has dropped by 4% since the start of 2012 to trade at around $72 currently, it is time to analyze the company in order to determine whether it is capable of offering solid investor value through 2012.
As BHP is an Australia-based miner that is dual listed on the NYSE, it does not issue quarterly reports and all financial and production results are issued on a biannual basis. For the first half of the 2011/2012 financial year BHP reported a 0.2% fall in revenue to $18.7 billion and a 24% fall in net income to $5 billion. In addition, for the same period, its balance sheet weakened with cash and cash equivalents falling 64% to $3.6 billion, while long-term debt rose 47% to $18.7 billion. However, despite the negative financial results there are a number of positive takeouts regarding BHP's position in the first half of 2011/2012, including that:
- The company has developed a uniquely diversified product portfolio consisting of 60% in ferrous assets, 29% in energy assets and 11% in non-ferrous metal assets, all of which reduces product concentration and risk.
- The company has $27 billion of growth projects underway across the entire product portfolio, which bodes well for future growth prospects.
In addition, BHP's key performance indicators point to its performing well when compared to its competitors as the table below shows, and this bodes well for its future performance.
Company | PEG | Profit Margin | ROE | Debt to Equity Ratio | Credit Rating |
BHP Billiton | 0.82 | 31% | 38% | 0.28 | A+ |
Rio | 0.39 | 10% | 11% | 0.26 | A- |
Anglo American | 1.58 | 20% | 20% | 0.49 | BBB+ |
Vale | 0.06 | 37% | 28% | 0.32 | A- |
Based on the PEG ratio, BHP has reasonably strong growth prospects, which, while lower than Vale's and Rio's, are superior to Anglo American's. The company is also delivering a solid profit margin of 31%, which is lower than Vale's, but higher than Anglo American's and Rio's. When this is combined with its solid return on equity of 38%, which is more than triple Rio's, almost double Anglo American's, and 10% higher than Vale's, it indicates that the company is well positioned to continue generating solid financial results. In fact, BHP's return on equity is indicative of the quality of BHP's management team, which is widely recognized in the mining industry. It is the quality of the management team which, in my view, makes BHP such a compelling buy.
I really like BHP's conservative debt to equity ratio of 0.28, which is only marginally higher than either BHP's or RIO's. This bodes well for net income and dividend stability, and is also a good indicator of the overall degree of risk investors undertake when investing in BHP. A conservative debt to equity ratio like BHP's demonstrates that the company has a strong balance sheet, where operations are predominantly funded by equity. Overall, this reduces the risk of cash flow disruptions from events such as rising interest rates or substantial drops in the stock price due to a market collapse.
BHP also has a superior credit rating to the other companies of A+, which is well ahead of Anglo American's BBB+, Vale's A- and Rio's A-. This I believe also recognizes BHP's strong performance, solid financial position and exemplary management.
BHP pays a handy dividend yield of around 3%, which is lower than Vale's 5%, but higher than Rio's 3% and Anglo American's 0%. The company also has quite a low dividend payout ratio of 24%, which bodes well for dividend sustainability and indicates that BHP should have no problems in maintaining its dividend yield. Over the last five years, BHP's dividend has grown in value by 22%, and this figure is low in comparison to companies in other sectors, primarily as the company has retained much of its income to use for exploration of new resources and acquisitions. BHP has a solid balance sheet and at this time is sitting on $1.3 billion dollars in cash.
Despite the strength of BHP's fundamental indicators, it is important to get a feel for the company's forward valuation to determine whether it is a worthwhile investment. Its forward valuation will also allow us to determine whether it is cheaper than its competitors at its current trading price. BHP is trading at around $72 and analysts expect 2012 EPS of $7.40, giving it a forward PE of 10 and BHP's revenues are expected to grow by 4% during 2012. Vale is currently trading at around $23 and analysts have forecast 2012 EPS of $3.79, giving the company a forward PE of 6. Furthermore, Vale's 2012 revenues are expected to fall by 2%.
Rio is currently trading at around $53, with analysts forecasting 2012 EPS of $34.83, which gives Rio a forward PE of 1.5. For 2012, Rio's revenues are projected to grow by 7.7%, which is almost double BHP's forecast revenue growth. Finally, Anglo American is trading at around $20 and has consensus forecast EPS of $4.70, giving it a forward PE of 4.2. It is estimated in 2012 that Anglo American's revenues will fall by 2%.
From this analysis, BHP at its current price appears to be expensive in comparison to Vale, Rio and Anglo American, with its forward PE of 10. However, it is forecast to have superior revenue growth to all of these companies other than Rio.
It is also important to get a feel of BHP's cost of production and how this compares to its competitors. For 2011, BHP's cost of goods was $14.6 billion, which is 20% of total revenue, whereas Vale's cost of goods for 2011 was $23.6 billion, which as a percentage of total revenue is 39%. Rio's cost of goods for 2011 was $36 billion, which is 60% of total revenue and Anglo American's cost of goods for 2011 was $21 billion, which is 69% of total revenue. It is clear that in 2011 BHP had a firm control of costs and has the lowest cost of goods when compared to Vale, Rio and Anglo American. This indicates that of the big miners, it is one of the lowest cost producers. This is supported by BHP's exceptional return on equity of 38%.
My only concern regarding BHP's future financial performance arises from its dependence upon Chinese demand for its key products of iron ore and coal, particularly as it is predicted that China will experience an economic hard landing this year. In fact JPMorgan's chief Asian and emerging-market strategist Adrian Mowat, has recently stated that; "China is in a hard landing. Car sales are down, cement production is down, steel production is down, and construction stocks are down. It's not a debate anymore, it's a fact." Furthermore, the IMF has forecast that China's GDP growth rate for 2012 will be 9%, which is lower than the 9.4% GDP growth average for the first 3 quarters of 2011 and China's 20.3% GDP growth of 2010.
A slowdown in Chinese growth will have an impact both on the price and volume of iron ore globally, affecting the revenue and income of BHP and its competitors. However, I do believe, with the price of iron ore having already dropped by 21% since August 2011 to $140.40 per metric ton at the end of February 2012, this drop in demand has already been factored into iron ore miners' stock prices. It would also appear that iron ore prices will level at out at around $140 pmt, which is supported by the views of another Australian iron ore miner Fortescue Metals Group Ltd (FSUMF.PK). Fortescue recently stated that iron ore prices should find support at around $140 to $145 pmt in the short term, despite slower Chinese economic growth.
Another key advantage that investors have when investing in BHP, Rio or Anglo American in contrast to Vale is that they are taking less risk when investing in these companies. This lower degree of investment risk arises as Vale is a Brazilian-based company and any investment in Brazil or a Brazilian company is subject to a degree of country risk that doesn't exist when investing in a U.S, Australian or United Kingdom based company such as BHP, Rio or Anglo American. Recently, the OECD gave Brazil a country risk rating of 3 on a scale of 0 to 7, with 0 being the least risky and 7 the most risky. As a point of comparison, the U.S, Australia and the United Kingdom all have an OECD country risk rating of 0.
Finally, I believe that BHP is undervalued by the market at its current trading price as it has an earnings yield of 12%, which is five times more than the risk free rate of return. When allowing for the accepted risk premium sought when investing in equities of around 4%, the company is still undervalued by the market at its current price.
BHP is the largest global diversified miner with a range of high quality and diverse operations across four continents with operations in iron ore and coal mining, oil drilling and gas extraction, and aluminum production. In my opinion, this diversification of assets assists in reducing any investment risk inherent in BHP. I also believe that the company at its current price is significantly undervalued and, in combination with its dividend yield, the company will continue to deliver solid investor returns through 2012, despite the anticipated hard economic landing in China.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
