BHP Billiton: Priced for the apocalypse

BHP Billiton's share price is down over 25 per cent from its 52-week high. Rather than being fearful, potential investors should embrace the cheaper share price

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BHP's share price is down over 25 per cent from its 52-week high. Rather than being fearful, potential investors should embrace the cheaper share price, writes The Motley Fool.

Given the shocking slide in the value of BHP Billiton Limited (ASX: BHP), it would be reasonable to suspect that some sort of disaster has befallen the world's largest mining company. Did it miss its earnings targets by a mile? Was there some sort of financial scandal or environmental catastrophe? Is someone going to jail?

No. The company is caught in an economic and financial downdraft that has put pressure on the price of copper and other commodities. As a result, the shares of mining companies — which never kept pace with the soaring price of actual commodities — have been hammered.

Understandable… to a point
It's reasonable to expect the price of a company such as BHP to be sensitive to shifting expectations for the global economy, which drive demand. Nonetheless, it's difficult to justify BHP's current price of around $37 a share, down from a 52-week high of $49.81. Its price-to-earnings ratio is only 10 times last year's earnings. If the consensus estimates are right, that number drops to less than 8 times based on this year's projected profits.

BHP is underpriced, even in comparison to other mining companies. Its revenue, which hit US$71.7 billion in 2011 (the company reports in US Dollars), has grown an average of 6.5% over the last three years. That is much better than the 43% loss for its industry. Over the last three years, it has posted earnings growth of 15.8%, just more than twice the industry average. Its operating margin of 44.4% is a bit better than the industry average, too.

Given the low share price, the solid financial performance, and an appealing dividend yield of 2.8%, why have investors suddenly dumped BHP?

Caught up in the noise
Demand for natural resources fell during the month of September, for a variety of reasons. Expectations for economic growth are slowing, from China to the U.S. and seemingly everywhere in between. That has depressed demand for copper, silver, lead, iron ore, and other raw materials, which are BHP's stock in trade.

BHP management is planning for the long term — no surprise for a company that has been around in one form or another for more than a century. Its US$12 billion acquisition of energy explorer Petrohawk, completed in August, strengthens its presence in oil and gas. Despite the current economic slowdown, demand for oil and gas is likely to remain strong, given the growth of emerging markets.

While the company took on about $3 billion in debt to get the deal done, that makes sense. Interest rates are at record low levels, and Petrohawk production is expected to grow more than 10% a year for the remainder of the decade, according to BHP Chief Executive, Petroleum J. Michael Yeager. On Sept. 27, BHP announced that it planned to triple iron ore production in Western Australia to 450 metric tons a year.

Well placed for recovery
Producers of raw materials have little direct control over the prices, which are set by the market. That means it is critical for raw materials companies to keep their costs low. Like rivals Rio Tinto (ASX: RIO) and Fortescue Metals Group (ASX: FMG), BHP has warned that labour, equipment, and currency costs are rising. However, it has sensibly told shareholders that it will not hedge movements in the currency markets, thereby limiting downside risk.

Other international players in the mining business such as Vale (NYSE: VALE) and Freeport-McMoRan (NYSE: FCX) have taken a beating, and their shares may bounce back as well. But there are concerns that Vale might not be able to develop an iron ore mine because of ecologically sensitive caves in the Amazon. Freeport has been hit by a strike in Indonesia.

Foolish take-away
There's one overarching reason why shares of BHP and other miners are so beaten down, though, and it has little to do with strikes in Australia, ancient caves in Peru, or even the slowdown in the global economy. The main reason is a psychology of fear that has compelled equity investors to sell the good with the bad. As a result, share of these companies — and BHP in particular — are trading at a fear multiple.

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This article authorised by Bruce Jackson.

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