- BHP Billiton has reduced cost and improved production over the last couple years and generates lots of cash flow despite some high-profile mishaps.
- I recommended BHP last October, shares are slightly higher.
- I continue to recommend BHP for income investors. The dividend has significant cushion.
If you got into mining and resource giant BHP Billiton (NYSE:BHP) in early 2016, congratulations. Since then, shares have about doubled. Admittedly, I chickened out with BHP at the time, recommending 'staying on the sidelines' on January 21st of last year; right about at the bottom.
So, full disclosure, I missed out on that because I feared things could have gotten much worse for BHP. Since then, the company has muddled along through several headline-grabbing, multi-billion dollar mishaps which have shrouded the fantastic cost reduction program and advancing productivity in its bread and butter industry. The most important story, which many missed, was that BHP Billiton was increasing productivity, cutting costs and taking advantage of cost deflation to structurally improve margins and cash flow. This article takes a look at BHP's ongoing efforts and what income investors can expect going forward.
The big story
BHP Billiton has messed up a lot over the last five years. Let's go down the list because it bears repeating: The Samarco mine accident in Brazil which resulted in the flooding and displacement of entire towns, the fact that management went on a spending spree in shale oil and gas in the 2011 heyday, only to now try and exit the market entirely with commodity prices about half of what they were at that time. There's also the ambitious investments in both Olympic Dam and Jansen Mine, multi-billion dollar greenfield projects for iron ore and potash, respectively, which were started soon before collapses in commodity prices in both industries.
Each of those are significant setbacks, no doubt, but here is one thing that BHP Billiton did get right. Despite being overly ambitious with a few giant projects, BHP Billiton did foresee the general downturn in global commodities, particularly from the softening of demand from Asia. As a result, BHP started reacting in 2011 and 2012, focusing on cost cuts and capex reductions, even though some big projects were just getting in full swing. The end result was that by 2014, the other big mining companies were hurting, but BHP had already begun the turnaround process.
Courtesy of BHP Billiton Investor Relations.
This chart, above, shows the overarching story. As you can see, EBITDA margin dropped and dropped from 2011 through to early 2016. All the while, BHP Billiton had been working on costs, and now, BHP's underlying margins are every bit as high as they were in 2007 and 2011, which is quite incredible considering that iron ore spot prices are a little more than half of what they were in 2014.
Productivity gains since 2012 cumulatively have saved the company over $12 billion per year. Courtesy of BHP Billiton Investor Relations.
Ample cash flow
BHP now generates ample excess cash flow; more than enough to pay its dividend and downsized capital expenditure needs in 2018. So far in this fiscal year, BHP has generated $7.3 billion in cash flow from operations, $1.8 billion of which goes into maintenance capital expenditure and another $1.8 billion has gone into the dividend. 'Organic development' takes another $1.9 billion of capital expenditure, presumably to keep production flat. With all that out of the way, BHP has $1.7 billion in free cash flow left over, most of which it is applying to improve the balance sheet. In this environment, it is much better for BHP to delever than it is to plow capital into new projects. BHP remains in a financially strong position.
Pays you to wait
BHP pays you handsomely to wait, which is one of the reasons I continue to recommend the stock. Currently, BHP yields 5%, and as the chart for the above paragraph shows, there's plenty of cash flow by which to pay that dividend. Expect the dividend to track earnings per share, as BHP is committed to paying half of its earnings per share in the form of dividends. That's a rather loose commitment, but BHP has a long history of a progressive dividend, with the exception of 2016 when the company had no choice. I suspect BHP will at the very least continue to raise dividends by low single-digits.
BHP is a very cyclical company, and share price tends to track earnings tightly. The good news is, it appears the recovery in commodity prices is well underway. To give viewers some perspective, have a look at BHP's earnings over the last couple decades, courtesy of FAST Graphs.
This chart goes a long way to demonstrate just how gigantic the previous commodities supercycle was; fueled by an economic boom in the developing world, particularly China, which at the time had a seemingly insatiable appetite for commodities. The end of this 'supercycle' was fairly dramatic for the big mining companies, including BHP Billiton. The bottom is in, however, and the recovery appears to be underway, although I don't expect any return to the heydays of 2007 or 2011.
What you'll certainly get from BHP is a generous 5% yield that the company should be able to sustain in any cycle. The commodities BHP are in, copper, iron, and metallurgical coal, are both economically sensitive and volatile. However, BHP has situated itself to the point where it can make an impressive profit even at today's commodity prices. For this reason, I recommend BHP Billiton, particularly as this is a sector which income investors typically gloss over.
This article was written by
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