We cut our fair value estimate for BHP Billiton (BLT) from £11 to £9.20 per share. The reduction reflects lower near term oil and gas prices and more conservative petroleum volume forecasts.
We think it is both likely and prudent BHP substantially cuts its dividend
Our analysis shows that the fair value estimate for BHP is between a bear case of £4.90 per share and a bull case of £13.60 per share leading to our high fair value uncertainty rating. The bulk of our BHP Billiton fair value derives from just three commodities: iron ore, copper, and petroleum in broadly equal one-third contributions. Coking coal is a minor contributor.
We now expect flat petroleum volumes for the foreseeable future reflecting BHP's capital constraints and the lack of incentive for reinvestment. In addition, we are increasingly concerned about greater steel scrap availability in China beyond 2020.
While the bulk of China's steel production currently comes from blast furnaces, the rapid build-up of steel stock in the past decade suggests an increasing amount of steel scrap will become available in the long term. This impacts BHP through two of its four pillars: iron ore and coking coal, which make up nearly half of group revenue to fiscal 2020. Electric arc furnaces will play a growing role in the country's steel production, taking share from blast furnaces and magnifying the weakness in underlying steel consumption at the expense of iron ore and metallurgical coal demand.
BHP Has No Competitive Advantage – and a Falling Dividend
We maintain our no-moat rating. The low-cost iron ore division should generate excess returns through the cycle but it only accounts for about a third of forecast revenue. The remaining core divisions; petroleum, copper and coking coal, as well as noncore thermal coal and nickel, lack cost advantage and are unlikely to generate returns above the cost of capital through the cycle.
After adding back write-downs, BHP's invested capital base has nearly quadrupled in the last decade. This significant pro-cyclical investment, and subsequent dilution to returns, is a key reason why BHP lacks a moat. Our unchanged high fair value uncertainty rating reflects BHP's operating leverage and cyclicality.
With further sharp reductions in metals and energy prices in late 2015/early 2016, we think it is both likely and prudent BHP substantially cuts its dividend. Throughout the boom, BHP's balance sheet was strong, but now we only regard it as sound. The dividend cut will see BHP with approximately $3 billion per annum of free cash flow after the dividend to repay debt, which we think is prudent given the challenging outlook.
With the lower copper price, the general flattening of commodity producer cost curves and the weight of the considerable poor investment made during the boom, we do not think BHP can sustain excess returns or a narrow moat.
