Is BHP Billiton a Buy?

BHP Billiton Ltd

Everyone’s talking about the future of BHP Billiton [ASX:BHP]. It recently closed at $17.20 per share. That’s almost 45% lower than its February high of $31.07 per share.

Unfortunately, many investors were caught on the wrong side of the trade.

Today, I’ll show you how you could have foreseen the crash in the world’s biggest miner.

I’ll also tell you whether it’s now a buying opportunity.

But before we get to that, a quick look at precious metals.

For the past 24 months, I’ve said gold will hit US$931 per ounce or below before the bear market ends. With the gold price falling to lower lows all year, I’m still confident in that call.

That said, I thought we’d see more destruction across the gold industry by now. While we have seen some carnage, there have been some absolute standouts in the industry. For example, St Barbara [ASX:SBM]. Since the start of this year, the company is up more than 1,200%!

Remember, this is in a falling gold price environment…

My colleague Greg Canavan over at Crisis and Opportunity has been on the hunt for the next St Barbara all year. He’s found an absolute ripper of a stock in the silver sector. This company has been on my own radar for a while.

If Greg’s thesis is correct, this company could deliver five or even 10 times your initial investment next year. You can check out Greg’s research here.

Could you have seen the crash coming?

Now…back to BHP. To be honest, its share price crash is hardly surprising. On 14 April, BHP Billiton was trading at $29.14 per share. At the time I provided the following update in Resource Speculator:

At the moment, there are almost zero gains to be made from buying iron ore stocks…

From the start of the resources super cycle back in 2003, prices have overwhelmingly been the major driver of earnings for BHP. From 2003 to 2014, 76% of the core earnings growth (EBIT) was driven by higher prices, with volumes contributing 24%.

It is no surprise that the major drag on earnings over this period were costs and foreign exchange fluctuations. The combined movements wiped out 46% of the price and volume benefit from BHP’s EBIT. 

‘[On this note], the Aussie dollar averaged 90 US cents over 2014. It now sits at roughly 76 cents. This should give a considerable earnings boost to [BHP]. However, the average spot price in 2014 was US$97 per tonne. It’s now roughly half that, at US$48.80 per tonne.

This price drop has more than wiped out any foreign exchange gain. Looking at the adjusted price numbers, the iron ore price was AU$107.77 per tonne in 2014 compared to AU$64.21 per tonne today.

Yet, the share prices barely moved…

This is soon to change – big time!

BHP has [a current] breakeven price of roughly US$37 per tonne. [But] I wouldn’t be surprised if this was closer to the US$42 per tonne level.

A falling iron ore price will crunch the big miner share prices…it’s just a matter of time. The iron ore price is already at US$48.80 per tonne.

This is where fundamentals can be a distraction.

We must be aware that BHP Billiton’s iron ore division generates 45.5% of earnings before interest and tax (core earnings), which is set to increase after the coming South 32 demerger.

Sadly, [with falling iron ore prices], the good days are over. In my view, BHP will head towards $20 per share or lower.

Is it time to buy BHP Billiton?

In the above note to my readers, I even suggested going short. If they took my advice, they should be up nearly 50%.

But now that BHP is trading well below $20 per share, has the time come to buy back in?

To answer this question, let’s look at the balance sheet.

Boasting an ‘A’ credit rating, BHP has a strong balance sheet for a miner. Considering the ongoing destruction in commodity prices, this is quite surprising. Nonetheless, BHP has only managed to cut its net debt (debt less cash) position by 5% this year. It stands at US$24.4 billion.

For BHP to survive, it has to convince bankers it can handle a US$24.4 billion net debt load. If it can’t, the share price could plummet much further. In the worst case scenario, BHP could go bankrupt.

However, BHP’s debt maturity profile looks good. It’s reasonably spread out over the longer term. You can check out the breakdown on the chart below.

Source: BHP Billiton

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It’s imperative to consider the immediate payments. BHP owes roughly US$3.5 billion next year. And another US$3.7 billion in 2017.

If these payments can’t be financed, expect the share price to get hit hard next year. Can they make these payments?

Their ‘free cash flow’ (FCF) gives us a good idea. Free cash flow is money that you can use towards debt payments and dividends. BHP generated US$6.3 billion in FCF this year. If it earns US$6.3 billion in FCF next year, you’d think it could meet its near term debt repayments easily.

But, there’s more to the story.

Thanks to lower commodity prices and large capital outlays, FCF this year was down 26% from 2014. If resource prices crash next year, FCF will likely be lower than US$6.3 billion.

And don’t forget about dividends. BHP pays generous dividends, which comes out of their FCF. BHP has hiked its dividends every year since 2000, even during the GFC — though this trend is likely to end next year.

According to Citi Research, BHP should generate negative FCF next year. The company should lose US$2.1 billion. And blow its net debt positon out to US$26.4 billion. You can see the numbers on the chart below in the red box.

Source: Citi Research

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Negative FCF means that BHP won’t be able to repay its debt next year. Let along maintain its generous dividends.

It all comes down to the iron ore price. UBS estimates BHP’s iron ore businesses can break even US$29 per tonne. That’s good news if the iron ore price jumps next year. It’s currently at US$37 per tonne, the lowest level in daily data since 2009 according to Metal Bulletin Ltd. But, with growing supply issues and a persisting strong US dollar, I wouldn’t be surprised if it hit US$35 per tonne next year, or below.

I should add, Citi’s Research assumes that iron ore will rise to US$47 per tonne next year. This means, if the iron ore price is any lower, BHP’s negative FCF number should be even worse than US$2.1 billion.

Is there any potential from the rest of the business?

BHP’s coal division is barely making a profit. In a deflationary world economy, coal prices are set to struggle for a couple more years.

Their crude oil department won’t help the company either. Thanks to US onshore rig count reductions, oil production is set to fall next year.

Lastly, BHP’s copper production is set to decrease by 12% next year. In the immediate term, the copper price is due for lower lows.

The bottom line: While it looks cheap on paper, I’d stay clear from BHP for now. With falling commodity prices and US$3.5 billion in debt due next year, there’s a good chance BHP’s dividend will be cut for the first time in decades. That means less income from your shares, and likely a lower share price as shareholders sell out to seek returns elsewhere.

I’m keeping a close eye on BHP and other mining companies for Resource Speculator readers. Many, though far from all, will become bargains in the months ahead. Just in time for the next phase of the resources bull market.

You can find out more here.

Jason Stevenson,

Resources Analyst, Resource Speculator

Ed note: The above article was originally published in Money Morning.

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