BHP Billiton – the free cash machine of the future

Chief Investment Officer and founder of Aitken Investment Management
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Last week I flew down to Melbourne and met with Andrew Mackenzie, CEO of BHP Billiton.

BHP @9.00% of the ASX200 is obviously an important stock for all investors and for perceptions of Australia.

Mackenzie is of Scottish heritage and, like all good Scotsmen, watches the pennies very closely. I believe you can look forward to a period of BHP being run hard, very hard, with a ‘through the business’ focus on productivity, margins and free cash generation.

It’s worth noting Mackenzie has even appointed a group “productivity officer”, who reports directly to him. The business unit leaders have been given productivity benchmarks and I suspect it’s fair to say we all could be underestimating the cost out story at BHP. It’s worth noting BHP reduced controllable costs by $US2.7 billion in FY13, with Mackenzie only in control for two full months of FY13.

This cost out story is coming at a time of increased group production. While all of us, myself included, get besotted with daily moves in spot commodity prices, it’s easily missed that BHP, through new production coming on line and debottlenecking existing production, has guided to 8% group production growth in FY14 and 8% again in FY15 on a copper unit equivalent basis. Considering the scale of BHP’s existing production base, that is solid (16%) production growth on any measure. It’s also worth noting, this is bottom of the commodity cost curve production growth, due to BHP’s tier 1 asset base, so highly profitable in the current commodity price environment.

While BHP is significantly more diversified by commodity than its peers, the company still has significant leverage to commodity prices. BHP is delivering higher volumes of commodities into high prices, from its place at the bottom of the cost curve. BHP clearly illustrates its FY14 NPAT leverage via commodity and currency in the table below.

If iron ore, oil and Australian dollar prices were to average what they did in Q1 for the entire of FY14, and all other things being equal, on my rough back of the envelope calculations that would see BHP consensus NPAT forecasts lifted by between US$2.5 billion to US$3 billion.

The current consensus forecast for BHP FY14 NPAT is US$13.8 billion. My calculations suggest BHP consensus FY14 NPAT would need upgrading by between 18% and 21% if the average commodity price trends of Q1 FY14 were evident all year.

The current consensus USD EPS forecast for FY14 for BHP is $2.57. Under the what if scenario above, that could climb to between US$3.03 to US$3.10.

My point is, even on Q1 average received prices alone, BHP consensus estimates for FY14 are too low. Of course, analysts won’t do what I do above and extrapolate those trends for the entire FY14, they will do baby step upgrades, as they get each quarterly production report and then multiply by average prices. Anyway you cut it, BHP is cum consensus upgrades. That is an inflection point in itself after a multi-year downgrade cycle.

When you focus back on BHP Ltd listed on the ASX and translate everything back to Aussie dollar, the investment arithmetic for BHP even pre consensus upgrades is solid. Ditto FY15.

On FY14 current Australian dollar consensus forecasts, BHP Ltd, is trading on a PEG ratio less than 1 times and progressive dividend yield of 3.58%. EV/EBITDA is also a low ratio at 7.21 times before upgrades.

Free cash flow

Even on the current consensus view, BHP generates FY14 free cash flow of AUD $1.70. That is underestimating the free cash flow BHP can produce this year and beyond, as capex peaks and sustainable cost out/productivity drives reap rewards.

In BHP’s FY13 results pack, they had one very clear slide titled “our plan will deliver substantial growth in free cash flow”, and in my conversation with Mackenzie the words “free cash flow” were mentioned often in terms of strategic focus.

The chart below shows consensus FY14 free cash flow estimates for BHP over the last 12 months. The current estimate is simply too low.

So what will BHP do with all this free cash flow?

Progressive dividend is now truly progressive

Only one third of BHP Ltd is held directly by domestic mums and dads. That equates to roughly 500,000 domestic individual direct shareholders, about two thirds the percentage and number of shareholders that the major banks and TLS have on their registers.

On that analysis, BHP Ltd is directly under-held by individual Australian investors. What could change to bring more mums and dads onto BHP’s register? The obvious answer is the sustainable fully franked dividend yield.

This is where I am going to fall on my sword and reverse my view of the last decade. I now think in a period of rising compulsory superannuation contributions and an ageing Australian population, that BHP’s progressive US dollar dividend policy, and the certainty of income that brings, is appropriate to a primary listing in Australia. In fact, it could actually drive a re-rating on BHP as US dollar dividends step up and the Australian dollar bubble bursts.

If the mums and dads of Australia get more confidence in the certainty of the BHP progressive dividend policy, and that progressive dividend policy drives BHP to deliver a bank-similar fully franked dividend yield, then BHP’s P/E will expand as more and more individual investors buy BHP for income certainty.

Mackenzie made a point of reminding me the progressive dividend policy is in US dollars. Note the step up in the 2H FY13 Australian dollar dividend as the Aussie fell. Note the step up in AUD 2H FY13 dividend despite the profit fall in the half.

In summary, under Mackenzie, I think BHP is going to be the free cash machine we all hoped it would be. I just don’t think you’re going to wake up one morning under Mackenzie’s leadership and by surprised by a $50 billion tilt at some other company. We might actually be surprised how “boring” BHP becomes, but boring is good when you are at the bottom of the cost curve and increasing production, while simultaneously stripping out costs and reducing capex.

The funny bit is the best total returns BHP shareholders generate will be past the peak of commodity prices as the free cash flows.

Earlier this year I made a clear strategic mistake. I took BHP and RIO out of my high conviction portfolio at what was the bottom for the year. I lost my nerve for a variety of reasons I regret in terms of BHP, not RIO, which remains an inferior company. I kept FMG in, which was at least one small reprieve.

After sitting down with Mackenzie, revisiting our BHP models, looking at consensus, looking at global PMI readings, looking at global growth, looking at relative value in the Australian equity market, and considering the federal governments re-engagement with big business, I am going to right that wrong and reinstate BHP to my high conviction portfolio.

There is simply no mathematical possibility I can be right on my 6000 Index call without BHP participating in that rally from here.

The chart below shows BHP underperforming the ASX 20 (XTL) on a common performance base over 12 months. Under the top-down and bottom-up scenarios I believe for BHP this gap will close in favour of BHP.

My simple view is Mackenzie is going to be good for BHP and BHP is going to be good for medium-term investors.

Go Australia, Charlie.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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