Why BHP Should Be Bracing Itself For a China Slowdown

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There’s trouble brewing over at the Big Australian – BHP. Investors are now starting to turn on the once impregnable company. Blackrock, BHP’s single biggest shareholder, recently sold a third of its holding.

Blackrock’s worried that BHP is investing too much money, from which returns won’t surface for many years. According to today’s Financial Review, BHP plans to invest around $100 billion between now and 2020. This is more than the company has invested in the past 20 years.

BHP currently generates a ‘return on capital employed’ of around 25 per cent. To maintain this rate of profitability, the company must add $25 billion in operational earnings by 2020. Given the long lead times between making investments and seeing return on them, this is not going to happen.

And that’s what investors are nervous about. It is likely that BHP’s profitability will drop in the years to come as it invests capital and patiently awaits returns. But just what those returns will turn out to be in a post-China boom world is also a source of concern.

For a capital-intensive resource company, BHP’s returns on capital and equity over the past five years or so have been exceptional. That’s largely thanks to the iron ore division. In the six months to 31 December, BHP’s iron ore operations produced an EBIT (earnings before interest and tax) margin of 65 per cent. And according to the 2011 annual report, the division generated a return on capital of nearly 100 per cent!

Remember, this is a bulk commodity. Granted, it’s some of the highest quality iron ore in the world. But is such a high return on its production sustainable?

No way. And as we’ve said many times before it’s all a result of China’s fixed-asset investment boom. The lending boom in China created a profitability boom in Australian iron ore production. In the coming decade those returns will revert to the mean.

Part of the reason China’s slowdown has not yet hit the iron ore price in a big way is because China doesn’t act like a capitalist economy. That is, it doesn’t respond to price signals the way private entrepreneurs do.

We’ll give you an example. China’s steel factories are churning out an excessive amount of steel. There’s excess production. Angang Steel, the country’s second largest steel producer made a loss of around US$340 million in 2011. In 2010, a boom year for production, it managed to generate a miserable return on equity (equity is another word for shareholders’ funds) of just 3.5 per cent.

The country’s largest steel producer, Baosteel, is struggling too. Its parent company, concerned at the lack of profits in the steel industry has diversified into other industries in recent years. Now, around 50 per cent of its profits come from non-steel activities.

The state is the majority owner of both of these companies. The state owns and runs most of China’s output. The state’s focus is not on profit and profitability…it’s on social stability. Keeping people employed and subservient is the number one priority of China’s ruling class. That way they can go on gaming the system.

As one steel mill manager recently told China’s business magazine, Caijing:

“We’re under a lot of operating pressure right now. Because it’s related to employment, we cannot just cut production. We’re now in a situation where we lose several hundred yuan on a ton of steel.”

That’s right, China produces steel at a loss to maintain employment. Hardly a sustainable state of affairs…although, to be fair, China’s ‘system’ can sustain abnormal economic behaviour probably longer than any other.

But this has important implications for Australia’s resources industry – and especially the bulk commodity producers of iron ore and coal. If demand and prices are the result of uneconomic decisions, then they are unsustainable. When the price structure finally reflects this, expect share prices to fall.

To some extent, investors have anticipated this. Check out BHP’s share price performance since mid-2009. It’s virtually gone nowhere. We asked Slipstream Trader Murray Dawes what he thought of the price action…and the reply wasn’t reassuring.

BHP is teetering on the edge of a massive support level. The last time BHP broke under $34 in a long-term downtrend was in late 2008. Back then it fell around $14 in a matter of months. Also, it must be remembered that at $34 there is about three years’ worth of buying in BHP that is out of the money. When they capitulate you will see a mass exodus out of BHP, which could cause a similar move to the one we saw in 2008.

Thanks for the cheerful prognosis Muz!

BHP Billiton – Teetering on the Edge

BHP Billiton - Teetering on the Edge

Yet it looks ‘cheap’…which we suspect is the reason why so many investors stick to the story. Based on 2013 earnings forecasts, BHP trades on a price-to-earnings ratio of around 7.6 times. Clearly the market does not believe BHP will meet the earnings forecasts. And we don’t blame it. Betting on continued 100 per cent returns on investment in iron ore is not one we’d like to make.

Here’s another interesting chart related to China. It shows the performance of the Shanghai Stock Exchange (red line) versus the All Ordinaries Index over the last year. There’s been a marked divergence in recent days. Shanghai has gone south, while Sydney has turned north.

Sydney and Shanghai – Going Separate Ways

Sydney and Shanghai - Going Separate Ways

Source: Stockcharts

We don’t know what it means, but rarely have the two exchanges parted company for an extended period of time.

Regards,

Greg Canavan
for The Daily Reckoning Australia

From the Archives…

Gold Money: A Once-in-a-Generation Buying Opportunity
2012-03-23 – Greg Canavan

A Question Australia Might Have to Answer
2012-03-22 – Joel Bowman

Australian Tax: Running Government at a Profit
2012-03-21 – Nick Hubble

China: Why All Feasts Must Come to An End
2012-03-20 – Satyajit Das

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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Garry
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Interesting call, however it’s about a year behind the reality, given that the share price trend has been reinforcing such a downturn since April of 2011. Note also, RIO has been saying much the same thing. Also, since Kloppers mentioned a slow down to the market just a few weeks ago, then it’s no surprise to him either. Added to this, there’s some leading indicators coming from China which suggest Kloppers had to say what he said, when he did. Indeed his timing matched the China data a few weeks ago. Then there’s the Aust$, a global proxy for the… Read more »
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