BHP Delivers Strong Outlook But Headwinds Remain

This story features BHP GROUP LIMITED. For more info SHARE ANALYSIS: BHP

-FY15 outlook skewed to iron ore
-Modest valuation upside
-Performance driven by simplification?
-Will there be buy-backs?
-US liquids to offset gas volumes
 

By Eva Brocklehurst

BHP Billiton ((BHP)) met or exceeded analyst expectations with its production numbers for FY14. But there is more. FY15 is shaping up as another strong year as the company fine tunes its large diversified asset base. The four main contenders in the production guidance mix – iron ore, coal, oil and copper – are forecast to increase in excess of previous broker expectations, with the possible exception of petroleum, although this is more a reflection of the mix of product in that segment. Despite the robust numbers on the company's slate, broker estimates and forecasts are not upgraded to the extent the FY production report suggests they should. Macro headwinds, such as commodity prices, provide one of the key reasons why.

Citi rates the stock Neutral, acknowledging the strong FY14 production result but downgrading earnings expectations by 5% to account for impairments, site rehabilitation and redundancy costs. Iron ore, petroleum and metallurgical coal guidance figures were ahead of estimates but Citi upgrades FY15 forecasts by less than 1%. Why? The broker's latest commodity price and Australian dollar forecasts provide the answer.

Production was described as solid, not spectacular. Suffice to say, the numbers support the stock's valuation, with Morgan Stanley highlighting a dividend yield just below 4% and free cash flow yield around 4% for 2015, using spot commodity prices. BHP may not be very cheap in absolute terms but remains attractive, in the broker's view. Of particular interest to Deutsche Bank was iron ore pricing achieved, at US$96/t. This was US$2/t higher than the broker's estimates. Jimblebar production ramped up quicker than brokers expected and the mine is scheduled to reach nameplate in the first half of FY15, six months ahead of schedule. Pilbara iron ore production and sales are are guided to increase to 245mt in FY15.

CIMB foresees iron ore will do the heavy lifting in FY15 and the company has a low cost option to expand Jimblebar to 55mtpa. Broader reductions in bottlenecks in the supply chain are expected to underpin further growth in iron ore capacity to 270mtpa.  BA-Merrill Lynch echoes this emphasis, noting the implications of the iron ore upgrade are significant, given the lower capex requirements needed to reach 270mtpa and the increased potential for lower unit costs.

Goldman Sachs believes the company's productivity gains will underpin industry-leading returns and margins, despite the uncertain and volatile market conditions. The deterioration in commodity prices, particularly for iron ore, has significant reduced the broker's expectations of capital management at the upcoming FY14 result. Still, Goldman Sachs remains happy with the strength of BHP's balance sheet and the flexible nature of its capital position. UBS has not dismissed a capital management plan as yet and expects one to be unveiled at the FY14 result, although, along the lines of Citi's comment, expects an impact on net debt from impairments.

Macquarie has no doubt the company is delivering on its productivity agenda and offers high returning growth options, but envisages more modest valuation upside from this point. Performance should be driven by expectations for portfolio simplification and buy-backs. On the subject of buy-backs the broker is cautious. There is a growing need in the short term for the balance sheet to shelter operations from macro headwinds. Morgan Stanley expects to hear more about efficiencies, buy-bank potential and non-core asset divestment at the upcoming results and expects these aspects have the potential to underpin the stock's valuation.

One bone of contention was US gas volumes. UBS found petroleum guidance of 255mmboe for FY15 disappointing, but stresses this is because of the lower gas expectations and as these are lower margin products there is less impact on cash flow. Morgan Stanley observes the petroleum mix is starting to deliver benefits to earnings. The improvement in the return on investment from US onshore operations should help convince the market that BHP can achieve the 20% post-tax returns that it targets for future growth capex.

Confidence is also high over at Deutsche Bank. Liquids from US onshore production are expected to increase as gas volumes fall. Rigs have been moved to the liquids-rich Permian and Black Hawk and away from the dry gas fields but this takes time to implement. Importantly, the drop in volumes only implies a reduction in revenue of US$300-400m because of the higher margin liquids production. Deutsche Bank believes the company's US$15bn purchase of US tight oil assets in 2011 has demonstrated a focus on further diversification and the importance of energy in the portfolio. The petroleum business should be seen as a positive, in the broker's view, when a rising energy cost environment returns.

Elsewhere, copper production increased 8% in the June quarter, well above Deutsche Bank's forecasts for a 1% increase. Copper is expected to increase to 1.8mt in FY15, largely from Escondida, while production will be flat at Olympic Dam and lower at Antamina. Deutsche Bank notes Caval Ridge coal mine also came in under budget, but this was very necessary, in view of the capital intensity of this mine. Higher volumes in metallurgical coal are expected to be driven by the early ramp-up of Caval Ridge. In fact, all divisions except aluminium, nickel and manganese reported positive quarter-on-quarter production growth, and even these three still exceeded Deutsche Bank's forecasts.

Deutsche Bank rates BHP as a Buy because of an attractive valuation and superior growth and diversification relative to peers. JP Morgan believes BHP is trading around fair value and maintains a Neutral recommendation. Brokers are content to maintain their ratings. There are five Buy and three Hold on the FNArena database. The price targets range from $38.00 (Citi) to $43.90 (Merrills) and the consensus target is $41.35, suggesting 6.5% upside to the last share price. This compares with $40.88 ahead of the report.
 

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