BHP Billiton Limited is recovering, but you still shouldn’t buy

Credit: Lucas Walters

BHP Billiton Limited (ASX: BHP) is coming out of a very rough patch. After a steep decline in commodity prices and a major disaster in the failure of the Fundao Tailings Dam in late 2015, the stock price plunged by 60 percent and investors took huge losses.

While BHP seemed to have been firing on all cylinders during the mining boom in Australia on the back of huge demand from China, things turned bad very quickly for the company. Management immediately rushed to Brazil to resolve what would later be a possible $61.1 billion dollar fine for both BHP and Vale, in addition to major backlash from the community and a number of the company’s major shareholders.

Since then, BHP has recovered significantly. In a difficult environment, management has proved extremely well prepared to tackle a difficult environment and has been able to improve productivity levels massively. Unit costs are down more than 40% since 2012, resulting in a net savings of $12 billion dollars. Management has also de-levered the balance sheet at a critical time and net debt is down to $16 billion dollars from $25 billion in 2016 with safety levels having improved significantly.

Additionally, a wind in at BHP’s back, commodity prices have inched up from their near recent lows. Here is a simplified table of the major commodities and their respective price increases since 2016 from the company’s annual report.

Natural Resource Price 2017 Price 2016 Price 2015 Price 2017 vs 2016
Crude oil $49.6 $48.4 $61.1 15%
Ethane $10.3 $9.7 $8.4 24%
Copper $2.7 $2.2 $2.6 10%
Iron ore $69.5 $55.0 $59.50 35%
Metallurgical coal $190.4 $91.50 $88.0 133%

BHP still has major economies of scale and the company is still the low cost producer with a highly integrated supply. This gives the company a massive competitive advantage.

Despite all of these factors, the stock is still on the expensive side, trading at twenty times its last five years’ cash flows. Despite having dealt effectively with its last major disaster, the company is still vulnerable to another major disaster taking place and operates in a sector where natural and operational risks could jeopardize profitability levels at any time. Given BHP’s global reach and ongoing exploration efforts it is also subject to significant geopolitical risk and a number of pending project approvals all over the world. This lowers the predictability of free cash flows that we have as investors and means that earnings may very well continue to be lumpy in the future.

BHP is also a very mature business, paying out more than 50 percent of its earnings in dividends. This leaves a smaller amount of capital for share buybacks and capital to reinvest in the business, meaning that returns are not likely to be great in the future.

Foolish Takeaway:  

At this valuation level you should hold off on buying shares in BHP and wait for a better entry point sometime in the future. If BHP is part of your existing portfolio and you bought it years ago – hold on.

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Motley Fool contributor mpinto has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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