BHP Billiton (NYSE:BHP) is one of the huge companies that should have more coverage. The company produces great reports, but they may fall on deaf ears. I decided to cover BHP because they are expanding copper production and I regularly cover one of the major copper producers, Freeport-McMoRan (NYSE:FCX). I started my research by going over the investor presentation. For smaller companies, I often go straight to the SEC database to pull up statements, but large companies prepare some very useful reports.
I'd like to take readers on this journey with me. This piece is intended to serve two purposes. It should provide investors with an introduction to the company and an introduction to how an analyst begins researching the company. There won't be any buy or sell recommendations, because those should take time to develop.
The existing organizational design
The first thing to know about the company is the "what" and the "where." I wouldn't waste any concern on who is managing operations until I know more about the company. There are a few executives that can unlock additional value for shareholders, but it is a poor place to start.
All of the slides in this article are grabbed from the investor presentation I used to start my research. After I know more about the mining companies, then I swap to preparing my own charts on the relevant factors that I feel are not being sufficiently covered.
This slide is going to show what the company is doing and where they are doing it:
We can see the main functions in the chart, and we can see where the operations are located. The major area of operation currently is Australia, but there are a significant amount of operations in other parts of the world. The next largest area by number of locations is South America.
The next issue is to look at how that chart is going to change. The company is preparing for a demerger which could substantially impact operations. The next slide shows the proposed locations and operations after the demerger.
After the demerger the company will be easier to track. The exposure after the demerger is limited to only Australia, South America, and North America. Therefore, when we want to look at the long run performance of the company, those are the only areas we really need to watch.
Since I'm just opening up coverage, I won't go into analyzing the impacts of the demerger on the assets that will be separated from this portfolio.
How does management intend to drive value for shareholders?
The next thing I want to look into is the company's plan for delivering returns to shareholders. What do they think is important? This is a nice benefit of the presentations they prepare. It is much easier to see which areas they are trying to highlight. As an analyst, I might agree or disagree with their strategy.
The next slide shows a major part of the company strategy:
The company is preparing for the next few years by planning to reduce their capital expenditures. For any investors that haven't been following the mining industry, prices for some metals (like Iron and Copper) are pretty awful lately. Because those prices are low, the outlook for the mining sector is much weaker.
Exploration and development of assets can take a long time and prices can change significantly. Does that mean the company should ignore current prices and continue exploration? I don't think so. When the outlook gets worse it is more difficult for companies in the sector to get funding on attractive terms. The debt that is available would require higher yields and issuing shares at depressed prices is no recipe for success. Therefore, I like the reduction in capital expenditures. However, I also wish that fiscal year 2015 would be reduced a little more. The grey area at the top of the bar for FY15e (Fiscal Year 2015, expected) is "approved minerals projects."
Volume, volume, and more volume
BHP is growing their production substantially. While that may seem great for shareholders of BHP, it creates a major problem. Look at the chart below to see the growth in FY14 and FY15e.
The company is growing their production rapidly. If we were talking about a tiny company, this wouldn't matter. A tiny company in a big market can grow rapidly without any major concerns about changing the market. However, BHP is so massive that their production can trigger changes in global supply. When supply is increased and the demand curve does not change, the price has to be reduced.
In a very competitive market, the best method for each producer is to improve their own cost structure so they can survive the harsh environment. However, the mining market didn't have to be this competitive. Despite producing a commodity, it may have been possible to have a less competitive market.
If you're familiar with Porter's 5 forces, you'll remember that rivalry within the industry is the center force. The level of rivalry here is higher than it really needed to be and that is making the mining industry less attractive across the board.
How BHP is both handling and contributing to the rivalry
BHP has focused on the factor they can control, costs. Rather than trying to reduce the intensity of competition, BHP decided to focus on lowering their costs so they could produce massive amounts of the commodities and possibly drive competitors straight to bankruptcy. In a free market with perfect competition, this is precisely the right strategy. When the economy gets tough, the companies with the best outlook are the ones with the highest quality and lowest costs. All the other players are just lining up to feel the pain, as economic forces dictate which companies can survive.
It is great to see the company reducing costs, but reducing costs through higher production volume in markets that already have more than adequate supply may cause prices to continue falling. In the short term, that means weaker prices and profits for everyone. Companies that are not able to keep up with BHP in cost reductions may be eliminated from the market place. If BHP can buy up their assets at a discount because everyone is suffering from the competitive environment, then that is a very favorable development for BHP.
The way BHP is doing business feels weird. BHP keeps acting as if they are in perfect competition, but outside of the rivalry, I think the industry would resemble oligopoly or monopolistic competition. The real winner in this scenario is the person that needs to buy the commodities BHP is producing. However, if BHP is able to ruthlessly stomp out competitors, they may be able to acquire assets at low prices and allow prices to rise through reduced production when fewer companies are left standing.
Leave your thoughts in the comments section. Thoughts on taking a first look at a company with an analyst? Other parts of the operations you'd like to see covered in subsequent articles?
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.