BHP Billiton Limited (ASX: BHP) has risen by 15% in 2016. That's 13% higher than the ASX's return and the key reason for this is more favourable commodity prices. For example, oil has increased from a low of US$27 per barrel in January to over US$50 per barrel. Further commodity price rises cannot be ruled out, but I believe that BHP is still an unappealing investment.
Strategy
BHP has adopted a strategy which is in direct contrast to other resources companies such as Woodside Petroleum Limited (ASX: WPL). BHP has spun-off or disposed of a number of assets in a bid to become more efficient and competitive.
Most recently, it sold half of its interest in the offshore Scarborough LNG assets in WA to Woodside for US$400 million. In my view, this is a questionable decision by BHP since its financial standing is such that it is not in need of a cash injection. For example, its net debt to equity ratio is 44% and it had over US$10 billion in cash as at 30 June 2016.
Further, its net operating cash flow of US$10.6 billion covered capital expenditure of US$7 billion in financial year 2016, leaving free cash flow of over US$3.6 billion for dividend payments.
BHP has disposed of assets at a time when commodity prices are relatively low. In the long run this may not maximise shareholder value. BHP's asset disposals also make it less diversified and potentially increase its risk profile. This makes it less equipped to survive a prolonged downturn in commodity prices in my view.
Cash management
BHP's dividend is overly generous in my opinion. Although it was reduced from US$6.5 billion to US$4.1 billion in financial year 2016, it was still US$500 million higher than free cash flow. That's despite a reduction in capital expenditure of 42% versus financial year 2015.
In future, BHP has committed to pay out at least 50% of underlying earnings as a dividend each year. I feel some of this cash could be better spent on developing its asset base for the long term, rather than as a short term income return for its investors. Although an additional dividend cut may hurt investor sentiment in the near term, I think it could create a stronger and more financially sound business. That's especially the case since dividends in excess of free cash flow are unsustainable in the long run.
Outlook
BHP has a forward P/E ratio of 27.1 using forecast earnings for financial year 2017. This compares unfavourably to the materials sector P/E of 14.6 and also to sector peer Rio Tinto Limited's (ASX: RIO) P/E of 16.7. Although rising commodity prices could push BHP's share price higher, in my view its dividend policy and the disposal of a range of assets mean that its risk/reward ratio is unfavourable.
Allied to this is its status as a price taker, which means that if commodity prices fall then BHP's share price could do likewise. Therefore, I'm avoiding BHP shares.
