Recent Buy: BHP Billiton PLC

| About: BHP Billiton (BBL)
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Well, my pockets are flush with fresh capital that I neither planned for nor wanted. This is due to the closing out of my position with American Realty Capital Properties Inc. (ARCP) after an accounting scandal that led to the elimination of almost the entire upper level of management, including the CEO, CFO, and COO, and then a credit downgrade that could negatively affect their cost of capital.

As usually happens, I tend to make a list and check it twice when I have some cash. I'm in no hurry to buy stocks, but I won't shy away from deploying capital in rather quick fashion if I feel that there are attractive investments out there when looking through the lens of a long-term perspective.

I decided to take some of the capital from the ARCP sale to average down on one stock that I've been busy accumulating over the last few months. I liked it at $52, so I certainly love it near $42.

I purchased 25 shares of BHP Billiton PLC (NYSE:BBL) on 12/17/14 for $42.20 per share.

Overview

BHP Billiton Plc is the world's largest diversified resources company. They're engaged in the exploration, development, processing, and production of a number of minerals. They also have a substantial oil & gas business.

The company operates in five segments: Iron Ore (32% of fiscal year 2014 revenue); Petroleum and Potash (22%); Copper (21%); Coal (14%); and Aluminum, Manganese, and Nickel (13%).

Their production operations are located primarily in Australia, the Americas, and southern Africa. They have a workforce of approximately 123,800 employees and contractors at 130 locations in 21 countries.

This is a dual-listed company structure. They have two parent companies -- BHP Billiton Limited and BHP Billiton PLC -- that operate as a single economic entity, run by a unified management team. The company is headquartered in Australia. This article is referencing the BBL shares that trade on the London Stock Exchange and are offered as ADR (American Depository Receipt) shares on the New York Stock Exchange for US investors. One can also purchase the BHP shares, which trade on the Australian Securities Exchange, which are also offered as ADRs. Since the BBL shares trade in the UK, the dividends they pay are not taxed by a foreign government due to a tax treaty between the US and the UK.

Averaging Down

I won't go back over the fundamentals and qualitative analysis on the company, as I did so back in early October. Needless to say, the company is fundamentally sound.

But if you're looking for a case study in averaging down on a stock that you're confident in over the long term, my history with BBL should prove useful.

I initiated a position in the company back in April of 2013 for $55.32 per share. The stock had a pretty spectacular rise until the summer of 2014, peaking above $71 per share. It then seemed to drop just as spectacularly due to concerns over demand for some of the resources they explore for and develop. Iron ore and oil have both been extremely volatile since the summer, mostly to the downside. And since BBL has substantial exposure to both of these commodities, its share price has suffered.

But whereas a short-term investor would be totally bummed out over the stock's performance over the last 18 months, I, as a long-term investor, am thrilled to be able to buy even more equity for a cheaper price. Now, that's assuming the fundamentals of the company haven't changed. BBL only releases results twice per year, so we won't know what fiscal year 2015 H1 operational results will look like until February 2015. That said, I look at BBL like a long-term investment. And looking at their resources, I think demand will remain for decades to come. Supply and demand is cyclical for many commodities, but these market forces tend to work themselves out over the long haul. In the meantime, BBL's stock price has corrected substantially.

So I've since averaged down on BBL stock four times. In early October, I basically doubled my position at $52.95 per share. I then added additional shares for $50.20 in mid-November. Not long thereafter, I averaged down yet again for $47.33 per share. Finishing the process is the purchase I'm writing about today. This last purchase allowed me to buy in with a yield of 5.88%. That seems almost silly next to the 3% yield this stock has averaged over the last five years.

Now, you could look at this activity and ask why I wouldn't have just waited for BBL shares to drop all the way down to $40 and load up then. Well, that's because I cannot predict the future any more than anyone else. I value a company with all known data in front of me. If I had future data available, I'd probably own my own private island and declare myself King. But it appears that Freedom Isle will have to wait.

BBL could have just as easily bounced back above $50 after my last purchase in late November. I cannot predict the stock market's behavior. I often cannot rationalize it either. Rather, I attempt to invest when I think equity in a high-quality company is priced below what it's worth. It's really as simple as that. The bigger the spread, the more enthusiastic I am. And that's why I enjoy averaging down.

I believe that BBL will be worth (and priced) far more than $42 10 years from now. And I'm confident it will be earning more and paying more in dividends, or I wouldn't be investing. When Mr. Market is depressed about a certain high-quality dividend growth stock and practically giving it away, you can bet that I'll make every attempt to be there with open arms and a fistful of cash.

New Company

One interesting piece of news that has come out since I last added to my stake in the company is that BHP Billiton has named the new company that will be formed by way of a demerger involving the Aluminum, Magnesium, and Nickel segment, as well as certain coal and petroleum assets. The new company will be called South32. I've been a part of a few spin-offs now as a shareholder, which is essentially what this is. And each one of them has done well for me. This action appears to be in the best interests of the shareholders, which will allow the streamlined BBL to focus on its largest and most profitable segments of the company. Meanwhile, shareholders will be receiving shares in the smaller company as well. Based on the stock's stunning fall over the course of the last six months (down 33.75%), it almost seems like the market is pricing this new company with a value of $0. I propose it'll be worth more than that.

With the potential of increased focus and profitability on the major businesses combined with reduced capital expenditures, BBL seems self-aware and well-placed in the current environment. BBL has also released an interesting fact sheet on South32.

Risks

I've pointed out BBL's risks in prior recent posts and they remain no different here. I believe BBL is a medium-risk stock that happens to offer a high degree of potential reward for those willing to wait it out. Its primary risk includes the fact that its primary business is in mining for and providing the market a number of commodities and natural resources, of which are exposed to large swings in pricing. These swings can have potentially dramatic effects on BBL's profitability. Its business is also cyclical, which means its operational results can vary from year to year and cycle to cycle. Finally, there is some measure of geopolitical risk.

I will make a quick note here about risk. Risk can be defined in many different ways. But one risk is valuation. Pay too much for a stock, and you're placing undue risk upon yourself. Counterintuitively, the market fears stocks after steep drops like what we've witnessed with BBL. But the cheaper the stock becomes, the less risky it is (as long as the fundamentals remain sound). It remains to be seen how its profitability will be impacted by the drop in oil and iron ore prices, but the stock is certainly less of a long-term risk at $42 than it was at $52. And I say that because BBL has a longstanding track record of operational excellence and maintains solid fundamentals across the board.

Valuation

In my mind, BBL's short-term profitability will probably be impacted by the severe drop in the prices for both oil and iron ore. But I always value stocks for the long term. As such, nothing has changed for me in regards to the valuation on BBL's stock over the last few months. Furthermore, I valued BBL rather conservatively from the start, which allowed a margin of safety.

The stock's P/E ratio is 8.06 right now. That's low even for a cyclical stock at the supposed top of a cycle. The five-year average P/E ratio is 14.

I valued shares using a dividend discount model analysis with a 10% discount rate and a 5.5% long-term growth rate. I used what I feel is a conservative rate, as that is about half of BBL's growth rate for both EPS and dividends over the last decade. The DDM analysis gives me a fair value of $58.14. I think that builds in a margin of safety, considering that even if BBL's growth is cut in half permanently, the stock is still trading at a discount of more than 25%.

Conclusion

So this concludes the averaging down on BBL for me. I now have 115 shares in the mining giant, which is probably about as large as I ever want to go. I see this as a smaller, ancillary position over the long haul. So I'm targeting a 1% to 1.5% weighting, which means that, unless shares become ridiculously cheaper, this is the last time I'll purchase shares in the company.

I've done well with averaging down in the past. Notably, I chased Target Corporation (NYSE:TGT) down to $55. It's since bounced back to above $73. I also averaged down on Digital Realty Trust, Inc. (NYSE:DLR) twice, with my last purchase occurring below $47. It has since rebounded to above $65. I have no idea if this will happen to BBL over the next year or two, and neither do I care. However, I am confident that this is a rather cheap valuation on a high-quality company. I can't predict the future, but being confident in your original analysis allows you to direct additional capital toward cheaper equity in a fantastic business, thus reducing your cost basis and increasing the potential of your future returns.

I think BHP Billiton is well-placed as one of the most conservatively run and profitable natural resource companies in the entire world. The proposed demerger and reduced capital expenditures allow them increased focus at the perfect time.

I'm going to include a couple of other valuation opinions below, as I use these to concentrate my reasonable valuation estimate:

Morningstar rates BBL as a 5/5 star value, with a fair value estimate of $70.00.

S&P Capital IQ rates BBL as a 4/5 star "buy", with a 12-month target price of $59.00.

This purchase adds $62.00 to my annual dividend income, based on the semi-annual dividend of $1.24.

I'll update my Freedom Fund in early January to reflect this recent purchase.

Full Disclosure: Long BBL, TGT, and DLR.