# BHP.....A Fundamental Analysis & Valuation



## ducati916 (20 June 2006)

Current Price $39.91
Code BHP
Yield 1.1%
Market Capitalization $128150
TCI Price Target $18.70 to $13.80
Investment Sector Industrial Metals & Minerals
Price/Earnings ratio 18.73
Recommendation Place on a watch list

Place Price Chart here.

INDUSTRY STATISTICS

Market Capitalization:	360B
Price / Earnings:	15.6
Price / Book:	5.2
Net Profit Margin 	16.7%
Price To Free Cash Flow 	-87.0
Return on Equity:	32.6%
Total Debt / Equity:	0.5
Dividend Yield:	1.5%


Resources, commodity prices have been at historic highs just recently. With prices for the producers of commodities currently so high we must take into account the “cyclical” nature of the businesses involved.
We must ascertain whether the P/E ratio is derived from high earnings due to high prices received for production, or, a low purchase price available for the aggregate earnings over a number of business cycles.

To date the earnings have risen on high prices, and this has already more than been reflected within the prices asked for within the industry. This can further be illustrated within the low current dividend yield.

Purchasing this industry implies continued growth within China & other developing nations.
Is this current growth rate sustainable?
There will be many opinions upon that crucial question, but, the answers are all speculative, and if wrong, could find a very nasty correction in the prices of resource stocks. This has already happened in May, and currently the question remains, after the correction, have the prices become cheap, or undervalued?
The unequivocal answer is no. They are still as a sector overvalued.



CAPITALIZATION

Market Cap (intraday):	116.89B
Enterprise Value (19-Jun-06)	129.64B
Trailing P/E ( intraday):	15.08


The Capitalization structure of BHP is an unqualified good.
The debt, constituting both funded debt & Bank debt is a very small component of the Capitalization.
Further, the Pension & Operating Leases component is currently showing a surplus from my estimations. 

Income Statement
Revenue 	32.20B
Revenue Per Share 	10.64
Qtrly Revenue Growth 	9.70%
Gross Profit 	10.09B
EBITDA 	13.08B
Net Income  to Common 	7.80B
Diluted EPS 	2.56
Qtrly Earnings Growth 	55.10%


The coverage of Interest payments is excellent, and poses little risk to holders of debt, or of equity.
We can see the result of the current high prices of commodities reflected within the two ratios of “revenue growth” and “earnings growth”.

A 9.70% growth in Revenue, contrasted with a 55.1% growth in Earnings. Should commodity prices weaken, and commodity prices are very cyclical, we would see a significant shrinkage within earnings as a result, with a concurrent shrinkage in Revenues.

Due to the lack of leverage within the Balance Sheet, and the high percentage of Common, the expectation would be for a low volatility within the share price. This until just recently was the case. It has not been the case over the past two years.

There has also been a significant improvement to net profit due to a reduction in production costs, quite possibly due to economies of scale. There has additionally been a significant improvement within Selling General & Administration, costs falling. These are both positives, but sustainability is a concern.




Balance Sheet
Total Cash 	1.65B
Total Cash Per Share	0.546
Total Debt 	10.47B
Total Debt/Equity 	0.495
Current Ratio	1.092
Book Value Per Share 	6.98


Cash is lower currently than one would like to see. This in of itself is not a major problem, as of course the ability to borrow cash would be forthcoming, and undoubtedly, BHP, would have a credit revolver available.
The Current Ratio however is not high enough to qualify BHP as “Investment Grade” currently.

Inventory & Receivables display no red flags, and pass muster.
The collections of Receivables is possibly a little low, but is consistent, this will be monitored.

BHP however does not pass muster on the return generated on assets. With the current high prices that are being paid for commodities, a return of $0.97 on each invested $1.00 is indicative of a low return business.



Cash Flow Statement
Operating Cash Flow 	10.04B
Levered Free Cash Flow 	8.27B


Cash-flow analysis throws up some interesting areas.
Depreciation is the problem child. As a percentage of Revenues, Depreciation has fallen from an aggregate of 8.9% to 6.6%. This will after Tax, flow to the bottom line, improving net profit growth, this is some $0.13 cents per share.

Capital Expenditures have fallen quite significantly, some $0.77 per share from the aggregate.
Depreciation compared to Capital Expenditures has also decreased.
Depreciation to Cash from Operations……..fallen.
Depreciation as a percentage of Net Assets………..fallen

What we are left with does not look confidence inspiring currently, especially as we are not even purchasing a bargain, thus we have no margin of safety.

We have reduced Capital Expenditures, thus pumping up net profits.
We have reduced Depreciation being charged against Net Assets, pumping up profits.
In short, there may very well be reduced investment, or more importantly reduced, or inadequate spending on maintenance to pump up earnings.

Examination from a different perspective reveals nothing that allays any concerns.
%growth in Capital Expenditures = 30.7%
%growth in Plant Property & Equipment = 24.3%
%growth in Depreciation = 9.8%

When we compare this to the following;

%growth in Revenues = 22.8%
%growth in Gross Profits = 34.3%

It would seem that the Depreciation charge is being inappropriately rated. This is always a red flag, and may pose problems further down the road. At current prices, it is certainly enough of a question to apply prudence to the investment decision.

The Depreciation or Depletion charge carries an extra importance within the purchase of the common stock of a resources business. The Depreciation charged by the business cannot be the depreciation charge utilized by the individual investor, as of course, the business charges depletion at purchase price, and so must the investor.

Utilizing a pessimistic outlook, and diminishing productive capacity after seven years, the investors return would calculate to 4.5%. This is inadequate, and provides no margin of safety at all.

Utilizing a generous twenty years on productive capacity, we still have only a 6.7% return. For this return, a lot of things would need to move in the investors favour.


MANAGEMENT

Looking at hidden Cash-flows we can identify a discretionary Cash-flow of $295.9 million, or $0.09 per share within Selling General & Administration. This in of itself is generally a positive, as these cash-flows may well be available to the business in harder business cycles.

There is however a discretionary Cash-flow within Capital Expenditures also, calculated to be approximately $593.8 million, or $0.19 per share. Under the present question marks present regarding the Depreciation charge, I am not willing to look at this as a positive, if; in point of fact maintenance spending has suffered.


SUMMARY

BHP is considered a “Blue Chip” business, or share. In my opinion, the business is profitable, but has a very low return. It has some serious question marks in regards to the Depreciation charges and related questions regarding the outcome of Capital Expenditure spending.

At the current price, it is too expensive, and returns accruing to the investor, purchased at these prices will reside almost entirely on speculative outcomes. Will commodity prices remain at 25 year highs? Will China & other developing nations continue their extreme growth rates?

If you do not know the answers to these questions, then BHP is a watch list security. Should prices fall to circa $8.00 then there will be enough value available to warrant an investment with “Fair Value” calculated at the range of $18.70 to $13.80 per share.

jog on
d998


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## michael_selway (20 June 2006)

ducati916 said:
			
		

> Current Price $39.91
> Code BHP
> Yield 1.1%
> Market Capitalization $128150
> ...




Is this old data?

thx

Ms


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## ducati916 (20 June 2006)

The data is from the last annual report, so it's not up to the second.

jog on
d998


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## michael_selway (20 June 2006)

ducati916 said:
			
		

> The data is from the last annual report, so it's not up to the second.
> 
> jog on
> d998




Forward Terminal PE of 10

Earnings and Dividends Forecast (cents per share) 
2005 2006 2007 2008 
EPS 128.4 231.3 278.2 278.1 
DPS 36.7 48.5 54.1 56.8 

So its worth about $28.00, but might need to look at 2009 and 2010 EPS forecast as well

thx

MS


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## ducati916 (20 June 2006)

*Michael* 

And therein lies a crucial difference.
I am not interested in paying up front for *prospective* earnings.
I will only pay for the demonstrated earning power of the business.

The risk in future earnings, is of course that they may never actually materialize in the timeframe you require.
Part of the problem with resource stocks are the valuations that do not take into account the investors depletion charges, and hence the return on capital.

jog on
d998


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## michael_selway (20 June 2006)

ducati916 said:
			
		

> *Michael*
> 
> And therein lies a crucial difference.
> I am not interested in paying up front for *prospective* earnings.
> ...




Hi so how much would you be willing to pay for BHP now?

BHP - Earnings and Dividends Forecast (cents per share) 
2005 2006 2007 2008 
EPS 128.4 231.3 278.2 278.1 
DPS 36.7 48.5 54.1 56.8 

Current PE of 10 = $23.10
Forward PE of 10 = $27.80

Also u say



> I am not interested in paying up front for *prospective* earnings.
> I will only pay for the demonstrated earning power of the business.




So would you be willing to pay more for *demonstrated earning power* now but knowing there will be likely lower future *prospective* earnings? Eg for OXR, how much are u willing to pay now?

OXR - Earnings and Dividends Forecast (cents per share) 
2005 2006 2007 2008 
EPS 5.6 33.2 22.8 21.1 
DPS -- 2.0 2.0 2.5 

Current PE of 10 = $3.30
Forward PE of 10 = $2.10

thx

MS


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## ducati916 (20 June 2006)

*Michael* 



> Hi so how much would you be willing to pay for BHP now?




I'd buy it at $10.00 or below.
Anything higher, and I'm not interested.



> Eg for OXR, how much are u willing to pay now?




I haven't done an analysis for OXR.
I only did BHP for a bit of fun, and my business partner wanted a valuation to compare to the valuation compiled by XYZ.

Therefore, I currently have no opinion on OXR.........

jog on
d998


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## michael_selway (20 June 2006)

ducati916 said:
			
		

> *Michael*
> 
> 
> 
> ...




Why only $10 for BHP i ask?

I mean like its very likely to earn $2.31 per share in NPAT for this yr at least 30/06/06 and next few yrs.

So 2.31/10 = 23% pa return (or PE of 4.33)

Isnt 23% pa return more than the alternative of 5.5% pa return in the Bank (in interest)?

thx

MS


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## ducati916 (20 June 2006)

*Michael* 



> Why only $10 for BHP i ask?
> 
> I mean like its very likely to earn $2.31 per share in NPAT for this yr at least 30/06/06 and next few yrs.




Earnings are [in a resource stock] a combination of Production + Price received.

Therefore to get an idea of how large a component current high commodity prices have impacted the net profits look at the aggregate earnings over the last five years. They are a reported $0.95. [these are actually under-reported, the true earnings to surplus were $1.11]

Current earnings were reported at $2.12
The problems arise because depletion charges are inadequate. They are undercharged by a minimum of $259.5 million or $0.09 cents a share.

Capital expenditures are also reduced.
The question arises as to if these are in actuality required replenishment or maintenance charges, discretionary cash-flows divulge $0.19 cents per share.

Therefore there is the appearance of profits being overstated by 13%
This is not a good thing.
If commodity prices fall, there is the almost certain falling off of profits.
The potential is for a 66% drop. What would that do to the price in the market? Nothing good. Combine the two worst case scenarios, and profits could shrink by 79%

All the above relates to the accuracy of the reporting.
However more importantly, the investor must depreciate the investment from his purchase price, and not the historical basis that the company utilizes.

Therefore, dependant upon proven reserves, the investor can calculate minimum and maximum rates of return based upon purchase price.

At current prices these return a maximum of 6.7% and a minimum of 4.5%
Therefore a much lower price is required to provide that margin of safety.

jog on
d998


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## Magdoran (20 June 2006)

Hello Duc and MS,


Interesting thread...


Magdoran


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## YOUNG_TRADER (20 June 2006)

ducati916 said:
			
		

> I'd buy it at $10.00 or below.
> Anything higher, and I'm not interested.




Good luck to you!   

Your dreaming mate, for 1 simple reason you are dreaming!!!!

The world needs Uranium and by 2008 BHP will be he worlds largest source of it, so again I say good luck to you on getting BHP @ $10

Not even a global recession could send it down that low, it won't go below $20 unless Olympic Dam blows up!

I don't hold any BHP, never have, doubt I ever will, but I have alot of respect for the stock


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## ducati916 (21 June 2006)

*Young Trader* 

I think you are rather missing the point.
If you accept my *fair valuation* of $18, which you don't obviously, but for the sake of the example;

Then if $13 to $18 = Investment value, to buy it as an *undervaluation* you would need to pay less than the pessimistic investment valuation of $13
Therefore my interest in buying it at $10 or less.

You think $10 will never happen?
Lets take a Bear market drop of 40%
BHP as a Blue Chip designate may well drop with the market, therefore at a current $26 odd, we are heading into $10 territory.

What if, commodity prices dropped to 25yr lows.
Net profits would drop, sentiment would turn as it always does very negative, and $10 could be a very real possibility.

BHP traded at $10 or thereabouts for 10yrs. odd At its low it traded circa $5.00. The only people interested were investors, who wanted perhaps the dividend yield, and who understood cyclical stocks.
Why?
Commodity prices entered their bullmarket circa the rise in BHP share price.
BHP is a cyclical stock, and by definition will have quite wide swings.
Sentiment in cyclicals always exceeds the swing in the fundamentals.

If it did fall to $10 on the back of crushed commodity prices, and I bought it, there would be someone telling me it was doomed & I would lose all my money.

To buy it at $26.16, you are paying a speculative price. It may rise higher, and never look back, but then again, it may not. Thus you are partaking in speculation, and as long as you are aware of that and have contingency plans, then no problem.

jog on
d998


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## Nick Radge (21 June 2006)

_The risk in future earnings, is of course that they may never actually materialize in the timeframe you require._

Duc makes a very valid point (and how I hate agreeing with him ) and one that differentiates sentiment between market phases. In bullish phases, such as the one we have just seen, many are willing to pay the risk premium for future earnings - just look at the tech boom. However, when things start to tighten up, like they may be doing now, then that the willingness to pay that premium is removed and is why prices will fall back. 

It all comes back to sentiment and the psychology of the market.  

Now...where is FA texts do they talk about that stuff...


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## Fab (21 June 2006)

In the meantime I just heard this morning on the news that BHP negociated a 19% increase in commodity price with China. I guess this can not be bad for BHP share price today


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## Knobby22 (21 June 2006)

Duc,  you assume an unrealistically bearish scenario when valuing.

BHP is not just a minerals company but also an energy company with gas, oil and uranium. These act as a ballast with a very different correlation to the minerals market.

I don't think the company is on the cheapside at present however.
I would want to buy below $20.

If you are assuming a major recession, then you should be out of all stocks.


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## ducati916 (21 June 2006)

*Knobby22* 



> Duc, you assume an unrealistically bearish scenario when valuing.




Not really, I am not saying that it will go there, only that if it did, based on it's earning power value, viz. $13.00 - $18.00 then at $10 and below I would be a buyer.

As a *Blue Chip* it would take something pretty serious to drop it that low. Unfortunately, in the market, something serious wanders along every couple of years or so.




> BHP is not just a minerals company but also an energy company with gas, oil and uranium. These act as a ballast with a very different correlation to the minerals market.




Indeed.
But oil & gas producers must charge depletion and take charges to operating and production leases. This is an area that is not currently looking particularly well disclosed. When disclosure becomes murky, I pay attention.



> I don't think the company is on the cheapside at present however.
> I would want to buy below $20.




Well, $10 and below for myself.

jog on
d998


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## Sean K (21 June 2006)

I think all the assuming (assume - to make an *ass* out of *u* and *me*) is where all your 'fundamental' analysis is coming from and it all leads to eventually incorrect judgements. And that is the facts folks. 

You are all ass u me ing. On just about everything. It's all just general plucks about supply, demand, costs, US recessions, BRIC demands, U3O8, birdflu, yada yada yada. 

Good fun taking calculated guesses but.

I know that you are all pretty smart dudes who study the market in great detail and have great big brains but really, how can so many people all have such differing opinions? Because you are taking your positions from different assumptions that may or may not be correct.   

My guess: US softish landing, Chindiapanaiwanporeland still pushing ahead over the next 15 years, demand for commodities remains high, war in the Middle East and threats to oil supply keep prices high, nuclear energy expansion continues across the planet including Australia, birdflu petters out, and Australia win the World Cup in 2014 at the MCG.

PS, I bought more BHP at $26.50. Bloody hell I hope Duc's assumptions are wrong!


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## ducati916 (21 June 2006)

*kennas* 



> I know that you are all pretty smart dudes who study the market in great detail and have great big brains but really, how can so many people all have such differing opinions? Because you are taking your positions from different assumptions that may or may not be correct.




Generally because everyone has different;
*timeframes
*strategies [value; momentum; breakouts, countertrend, canslim, growth etc]
*risk tolerances
*reward requirements
*experience
*knowledge
*psychological foibles

jog on
d998


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## Sean K (21 June 2006)

I think the only thing we truly know is past performance. But even that can be doctored up a bit....It's how any entity collapses. Creative accounting to cover arses. Don't think BHP is in that category yet though.


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## TjamesX (21 June 2006)

ducati916 said:
			
		

> *Michael*
> Earnings are [in a resource stock] a combination of Production + Price received.




and any valuation of resource stocks has to make some assumption on what the forward price and production curves would look like....

production is obviously the less volatile of the two and can be reasonably assumed. Price is what really effects resource valuations and thats why they are so volatile at the moment - because no one knows where commodity prices are going?

Most analysts tend to value on the assumption that prices will revert to long 25 year averages - on that basis all resource stocks will be considered  expensive. If you carried out your analysis in Dec 04 when BHP was around A$15, all would have come to the same conclusion - the stock is extremely overvalued if you consider long term commodity prices reverting to long term averages. Cut to 18 months later and BHP will probably announce a profit of around A$2.30 per share..... so was the analysis in Dec 04 wrong?? No it just made assumptions that turned out to be incorrect.

For interests sake UBS did a valuation a few months ago at current commodity prices - I think it came to the DCF value of A$39 per share. i'm pretty sure that since then spot prices have increased........

I think speculation can go both ways, and any forward price assumptions are speculation on where the valuer believes prices will go..... Do I know - no! who knows?? do we assume what the industry has done for decades... maybe... why would it change?.... what assumptions are we making if we assume this?

I'm still young and have a lot to learn but sometimes I smile when people throw up the tech boom scenario as an example. People thought that the world would change the way we do business would change, therefore anything in tech and internet skyrocketed. The naysayers had seen it all before - the companies were really worth nothing!

.... or were they? The fact is 5 years later the way we do business has changed, companies that were worth nothing are now worth hundeds of millions. Some people would have seen this, broader industry dynamics had changed.... its just the majority got the timing and who to invest in wrong....

realestate.com.au - little more than server and a web adress worth hunderds of millions. Same with seek.com.au. wotif just listed valuing it at what 400, or so million? Google has the same market cap as BHP and my boss still doesn't understand how they give away what they do for free? - its been around less than a decade.

Did everything revert to the mean after the tech boom? Sometimes things revert to the mean and sometimes they don't, sometimes things do change and sometimes they don't....


Just food for thought....

TJ


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## Sean K (22 June 2006)

Whatever the 'funamentals' people want this stock for now.

1052 [Dow Jones] BHP (BHP.AU) up 2.5% at A$27.65. Institutional trader says bulk resources weren't factoring in 100 point DJIA rally when London closed, so BHP and Rio (RIO.AU) to rise 4%-5% in London. Also says: "I expect BHP to touch A$30 for June 30. Most local fund managers are heavily overweight and will want to see stocks close on the high for financial year end performance." (DWR) 

Just another opinion though.


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## ducati916 (11 November 2018)

Well it never made it down to $10, but it hit $20 a couple of times, which would have allowed nice capital gains to be earned.







jog on
duc


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## Miner (12 November 2018)

Hey folks
Not sure if this is the only thread for BHP.
My question is what do you think of BHP offering current holders to sell their holdings at a lower price under buy back when they already indicated to declare a capital return? I have outrightly rejected the offer but like to hear from you.


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