Failure of a tailings dam and damage to another at the 50%-owned Samarco iron ore mine in Brazil, in joint venture with Vale, is a disaster for BHP Billiton (BLT). The environmental mess and loss of life dents investor confidence at a time when sentiment for BHP is fragile as a result of falling commodity prices.
Much needs to be done to repair BHP's reputation, regardless of economics
Managing director Andrew Mackenzie has responded admirably in trying circumstances, promptly on the ground, offering sincere condolences and pledging BHP's full support in the recovery. That said, in no way do we put a positive spin on the event for BHP.
Given the uncertainty around the remediation cost and any possible restart, we have removed Samarco from our earnings forecasts and fair value, but the direct impact is quite small. Our fair value estimate falls 3% to AUD 29 per share. Forecast fiscal 2016 earnings decline 9% to USD 0.35 per share and fiscal 2017 by 5% to USD 0.81 per share. We still expect free cash flow to cover our unchanged USD 1.24 per share dividend forecast in fiscal 2016 and 2017, but it’s skinny, averaging just USD 0.10 per share in those years.
We maintain our narrow moat rating, reflective of BHP's low-cost positions, notably in iron ore. However, lost Samarco earnings means it will be several years before group returns again exceed BHP's cost of capital.
Analysts Uncertain for BHP Share Price Outlook
Our fair value uncertainty rating worsens from medium to high. BHP's medium uncertainty was an outlier in our global mining coverage, but we're no longer satisfied the firm's diversification is sufficient to justify a distinction versus peers. BHP's key commodities, namely oil, coal, iron ore and copper have been relatively correlated in the downturn. Our high fair value uncertainty rating better reflects operating leverage and cyclicality inherent in BHP and brings it into line with peers.
Also, lower earnings means the balance sheet is now sound rather than strong, with some pressure on the credit rating. We forecast EBIT interest cover to trough at less than three times in fiscal 2016.
Samarco Disaster Will Cost BHP
In terms of quantifying the impact of the Samarco disaster, it's very difficult. It wouldn’t surprise to see remediation costs reach USD 1 billion, but at this early stage, no one really knows.
Compensating the victims, cleaning up the tailings and exposure to the loss of income from downstream industry will be costly. There is a small chance remediation costs could have a further impact on the fair value estimates for BHP and Vale.
The tailings dam will need to be rebuilt if operations are to restart, but much needs to be done to repair BHP's reputation before that can be considered, regardless of economics.
We had previously forecast Samarco to contribute approximately 4% to group EBIT and valued the venture at USD 2.4 billion. Group earnings for our five-year forecast period decline by approximately USD 0.04 per share per annum as a result of removing Samarco from our forecasts.
Costly investments made during the boom, such as iron ore and U.S. onshore shale gas, weigh greatly on returns, particularly given the subsequent commodity downturn. In the five years ended fiscal 2012, BHP's return on invested capital averaged 25%, but those heady days are gone, reflecting the weaker external environment and balance sheet obesity from boom-time spending. We only forecast returns to reach 9% by fiscal 2020.
