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BHP used to boast about its size. It mined everything from bauxite to uranium and it operated a vast collection of mines around the world. It was, as those in the mining industry called it, The Big Fella.
Not anymore. It has sold US$25bn of assets over the past six years, including the spin-off of South32 and, more recently, the sale of its remaining onshore shale assets in the United States.
That sale alone brought in over US$10bn of cash that went straight to shareholders and it further shrinks and simplifies the once sprawling BHP empire.
With so many mines now sold, one could ask whether BHP is as good as it was. With a shrunken asset base, can BHP still generate the big bucks it has in the past?
Five years ago BHP counted over US$110bn of property, plant and equipment on its balance sheet, mostly reflecting the value of its various mining operations. Today, that sum is just US$67bn.
Over US$40bn of asset value has been wiped from the balance sheet. That has come from a combination of asset sales, disposals and write-offs, but also by simply lowering capital expenditure while depreciation remains constant.
Petroleum assets have fallen from US$44bn to just US$12bn, due to writedowns in and the eventual sale of the US shale business. The rest of the fall comes from the iron ore and coal divisions, mostly from depreciation charges outpacing capital expenditures.
In the meantime, earnings before interest, tax, depreciation and amortisation (EBITDA) have fallen from US$28bn to US$22bn, so it's tempting to conclude that a smaller BHP is also less profitable. Yet the falls in EBITDA over the past five years have come almost entirely from lower prices and currency changes - mostly in the iron ore and petroleum businesses. Asset sales have barely caused a ripple.
As a result, the return on tangible assets (ROA) has soared. In 2014, BHP generated an ROA of 25%, thanks to high iron ore and oil prices. Today, it generates an ROA of 33%, even with commodity prices well off their peaks.
As investors, our concern isn't raw profits, which tend to grow when capital is deployed. Instead, we want to see decent returns on capital. The numbers suggest BHP has indeed improved its business by making it smaller. It has jettisoned the least attractive mines and retained the best.
The best parts of BHP remain the same as they have for decades: the storied iron ore business; the biggest copper mine in the world; unmatched coking coal assets; and a modestly sized yet high-returning conventional petroleum business. Shedding the rest has allowed the quality of these assets to shine.
The greatest impact of asset sales has been in the petroleum business. Shale demanded enormous capital expenditures because it featured high decline rates that needed to be plugged with ever more drilling.
BHP spent between US$2bn and US$4bn annually on growing production of US shale oil and gas. That expenditure is now gone. Margins in the petroleum business will also rise to about 70% and returns on capital will increase.
The importance of petroleum, however, will diminish. With shale, petroleum earnings accounted for about a third of the total (and the division also demanded the most capital to operate); without it, petroleum accounts for just 20% of earnings today and, when we factor in field decline, it could go as low as 15% within a few years.
With the importance of oil declining in the BHP portfolio, we wonder whether it too may face the chop. Yet BHP has been spending about US$800m a year on exploration and we think an acquisition or continued investment in petroleum is more likely than an exit. Woodside Petroleum, for example, would make a sensible fit with BHP's own asset base.
We first upgraded BHP back in 2015 when we recommended slowly building a position in the miner. Shares fell heavily and we recommended buying more as iron ore prices crashed and the Samarco disaster hurt.
BHP has been a sound investment to date, delivering strong capital returns and juicy dividends along the way. With the economic cycle now threatening to turn, is it time to sell?
Not yet. BHP will always be a cyclical business dependent on commodity markets but its big drivers of profit and value - iron ore, coking coal, copper and oil - all remain intact and their quality is no longer diluted.
We think BHP is worth at least $40 a share and maybe more with some cyclical help. The company has changed markedly since we first upgraded it but those changes have improved the business, especially the tendency to allocate capital better. The miner's balance sheet is now stronger and it generates oodles of free cash flow at modest commodity prices. Using spot commodity prices, the free cash flow yield would be close to 20%.
BHP may no longer boast about its size but there is every chance of it continuing to boast about its profit. HOLD.
Disclosure: The model Growth and Income portfolio own shares in BHP.
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