It is no secret that I rate BHP Billiton (BHP) (BBL) as an outstanding diversified mining company, and I have written as much over the last 12 months. It is a core stock within my overall investment portfolio, and yet over the last 12 months, I have often come to question myself "Is BHP still a good stock to hold"? I ask myself this question as the market changes on a daily basis, and I think long and hard on it when I see articles in the media that are bearish for the company and the sector overall. Over the course of the last week and the collapse in iron ore pricing, I found myself simplifying this question: Why BHP?
The most basic of investment principles suggests that in order to minimize risk to capital is to have a diverse investment profile, a broad spread across asset classes and securities. FINRA defines this theory with securities as follows:
Generally, over a long time, the prices of stocks tend to go up. However, not all stock prices move up and down together. What if you were to create a stock portfolio made up of stocks that tended to not move in lock step? The overall variation (volatility) of the return on your portfolio would be reduced because individual stock price changes would likely cancel each other out to some degree, leading to a more stable return on your portfolio. Your risk would be reduced via this diversification strategy. Diversification accomplishes risk reduction by forming a portfolio of stocks that are likely to move in a complementary fashion.
Therefore to reduce risk, we diversify our portfolio to avoid a negative loss or return in one sector affecting the entirety of our capital. FINRA again explains this with respect to securities:
So, stock price increases and receipt of dividends are the ways that an investor can earn a return on stock investments. On the other hand, if the stock price falls during the investment holding period, an investor would have lost money on the stock investment. This is the major downside risk to stock investing, and a typical investor will want to minimize exposure to this risk. The typical investor, therefore, is risk-averse -very much liking return but disliking risk. Diversification presents an opportunity to reduce risk.
It follows then that we should diversify our portfolios where ever possible, even to the extent of seeking diversification within specific sectors, and specific stocks can help us to achieve this. The extent to which we seek diversification will be balanced against our individual appetite for risk, size of capital to be invested against a particular position, and what exposure we have within a specific sector. We can look at how diversifying within a specific sector can impact a position, when only one or two fundamental variables change - in this case slowing demand from China and a reducing iron ore spot price.
Given all prices down trending, we can see that BHP has the least reduction in share price, the second least change in PE ratio, the send least change in EPS, and maintains the highest dividend per share. BHP seems to have a floor price of $60 per share, against RIO's floor price of $45 per share (when viewed against long term graphs). In terms of how the three miners performed against each other, the market and the sector, BHP maintained an outperform on all:
Market Comparison Earnings BHP 0.76 Market 0.72 RIO 0.72 Sector 0.47 FMG.AX 0.20 Source: Investsmart.com.au
Pricing Impact from the Iron Ore Sector
So even in a falling sector, BHP as the more diversified of the miners weathered the storm the most, while the pure iron ore miner Fortescue is suffering the effects the most. But as past performance is no guarantee of future returns, it is important to look again at the potential impact on the miners given slowing demand from China, and a new floor in iron ore spot pricing. In doing so I would direct readers to Paulo Santos' recent articles on BHP and RIO:
This makes for $22.601 billion in iron ore revenues, and $14.201 billion in EBIT. Given that WAIO iron ore tonnage during the latest fiscal year was 179 million tonnes, we have an average selling price of $126.3 per ton. Taking into account the 62.8% EBIT margin -- which is huge -- we come to an EBIT breakeven price for BHP's iron ore of $46.9 per tonne, quite low at that.
A $1 move per tonne in iron ore represents a $110 million change to net profit. With BHP's average for last year hovering around $126, if the market was to now stabilize around $100 per ton and after a while (while contracts rolled over), the negative impact from pricing alone would be -$2.86 billion. Some of this could be compensated by volume increases, but on the other hand several of the other minerals BHP sells, such as met coal, are under the same pressure as iron ore.
Anyway, an impact of -$2.86 billion would take earnings down to $14.24 billion, on 2.66 billion shares that's an EPS of $5.35, for a P/E of 12.8 right now. Not too excessive.
With a move towards $80 per ton, the impact on net profit would be -$5.06 billion, taking net profit to $12.04 billion, EPS to $4.53, and moving the P/E up to 15.1, which already seems a bit stretched in a scenario where earnings would be dropping fast.
RIO had $29.9 billion in 2011 iron ore revenues and $12.9 billion in iron ore underlying earnings. For an overall production of 245 million tons, this gives us an average selling price of $122.1 per ton. Taking into account that the underlying earnings represent a margin of 43%, this would mean the underlying earnings' breakeven point for RIO would be $69.6 per tonne. However, the underlying earnings are after tax. If we consider a 30% tax rate, then the margin becomes 61.4% and the breakeven point is $47.1, comparable to BHP's EBIT breakeven point ($46.9).
Iron ore at $100 per ton means a 19.7% hit to earnings, and at $80 means a 37.7% hit to RIO's earnings. It's important to take into account that this is just from iron ore, and many other minerals in RIO's book are be correlated to iron ore and dropping along with it.
So what then is the impact of these market changes and the reduced demand on a pure play iron ore company such as Fortescue? Decreased revenue, reduced cash flow, an inability to service interest liabilities once iron ore contracts fall below a certain price. In Fortescue's case:
The iron ore miner has cut $300 million from its costs and laid off 1000 staff in recent weeks in response to softer demand from Chinese steelmakers. Fortescue, with debts of $9 billion, requires iron ore to remain at $US110 per tonne or higher in order to cover repayments to its backers. If the iron ore price stays under $US100 per tonne in the mid-term or well below this company would still be in trouble.
This is troubling for Fortescue if the Bureau of Resources and Energy Economics view holds that "the recent plunge on spot markets would drag the average contract price for 2013 to $US101 a tonne", $19 per tonne below Fortescue's prediction that it will rebound to $120 per tonne.
Outlook for Iron Ore Pricing & Demand for Resources
The Bureau of Resources and Energy Economics also said that its "projection is based on the latest slump in prices dragging the value of Australia's most lucrative export down by 16 per cent in this financial year, despite higher volumes". Hurting the trade more is the continual bullish $AUD, which "if to fall by 10 per cent, would represent an additional $19 billion in iron ore exports this financial year".
In researching this article, I have not been able to define what will drive the iron ore spot price lower, and/or if it will establish a floor at $80 / $100 / $120 per tonne. This article from the Sydney Morning Herald offers a more upbeat perspective to the common consensus in the media, and may be the viewpoint which Fortescue Management holds. I also came across the attached graph on FT Alphaville that shows the iron ore cost curve, and the price level at which producers can and will continue to produce:
We can also take the five year spot price chart for iron ore and use this as a basis for a comparison of price on BHP's annual results. The five year spot price chart is shown below:
In terms of what impact this is likely to have on Iron Ore revenue to BHP's bottom line, we can look at historical performance versus forecast future production:
I think this helps to understand the impacts of the spot price on miners, and we have seen recently what effect this causes the miners with respect to ongoing operations, and on future capital expenditure for infrastructure and new operations. BHP, RIO and Fortescue have all cancelled or postponed infrastructure projects, and or sold off high operating cost and/or underperforming assets to raise capital and rein in costs. Viewed in conjunction with Paulo's assessment of the effects on each of the big miners, I would take the view point working off a lower iron ore spot price in a consensus margin of $100 to $120 per tonne. With this in mind, a best case scenario of $100 per tonne would put it in the same revenue spot price as 2009, however additional capacity would see revenue from iron ore operations remain relatively high (pending demand not being dramatically reduced). The company will take a hit on revenue, but it will still turn a profit.
So Why BHP?
So back to my original question, of why BHP? I want exposure within my portfolio to the natural resources sector, both globally but also in Australia. BHP is an established miner with a credible and consistent performance history. It pays a consistent dividend, and historically has done so, which is important as my preference is returns on both dividend and capital. It has established operations and infrastructure, has demonstrated it can control costs when required, and it has a low cost to profit break-even point compared with other miners. Like RIO it is diversified, but even more so within the sector that makes up its largest revenue stream. And it is more likely to survive market fluctuations for these reasons. BHP offers me exposure to natural resources and the iron ore market without the speculative upside that Fortescue presently has. Diversifying my portfolio means inclusion of a diversified miner, and BHP remains my inclusion for the long term, in my case a viewpoint of five years plus. I still think it is a good company, well run by management, and which will continue to deliver consistent returns in the future.
Disclosure: I am long BHP.
Additional disclosure: This advice is general advice only. You should seek independant financial advice before making any investments of your own.