No longer the ‘big Australian’, BHP is now down to sixth place in the batting order of companies ranked by market capitalisation on the S&P/ASX 200. Its index weight is 4% — only marginally higher than CSL or Wesfarmers. And this is despite the rally over Thursday/Friday that saw BHP climb from a low on Wednesday afternoon of $14.17 to close on Friday at $16.20, a gain of 14.3% in two days.
For shareholders, owning BHP has become pretty ugly and the obvious questions are being asked. Do I average down and buy some more? Do I sell what I have? Or do I just sit it out? Here is what I think and am doing.
I have been wrong on BHP
Firstly, I have to admit that I have been wrong on the timing of BHP over the last two months. Like many private investors, I dabbled when they first hit the $20.00 mark (picking some up for $20.40), and then bought some more when they went below $17.00 in mid December (you may recall my earlier article [1] on 16 November). In 2016, I haven’t been brave enough to add any more.
Commodity prices being crunched I get – and BHP has been copping it on all fronts. Oil going below US$30 a barrel, copper below US$2.00 a pound, and iron ore below US$40 a tonne. Interestingly, these have all recovered somewhat, and with the US dollar weakening, are possibly starting to find a floor.
What I didn’t expect was the belligerence – many would call it the sheer stupidity – of the BHP Board not being prepared to junk the progressive dividend policy. Until it does, questions about BHP’s long-term financial health will float around like a bad smell.
The other news has also been bad. While the write down of the US oil assets was predictable (another disastrous acquisition under the watch of Chairman Jac Nasser), the market was in no mood to be reminded of BHP’s oil folly. And so was the S&P credit downgrade, another reminder about BHP’s financial health.
Consequently, the market has trashed BHP’s share price and notwithstanding the rally at the end of last week, it has underperformed compared to the other major miners. While not directly comparable (due to commodity mix), the following table shows the change in prices of the major miners since 13 November:
[2]The progressive dividend must go
Apart from a bottoming of commodity prices, the best thing to help restore some confidence in the company would be for the BHP Board to shed the progressive dividend policy. If this policy is maintained, BHP will pay a dividend of 124 US cents per share for FY16 – about 172 Australian dollar cents – putting BHP on a prospective yield of 10.6%. With commodity prices where they are, it is very unlikely that BHP can pay this dividend without increasing borrowings. There is also a limit to how much it can prune capital expenditure, without impacting the long-term viability of the business.
Just because “our progressive dividend has withstood previous cycles” and “BHP was the only major not to cut the dividend during the Global Financial Crisis”, these are not reasons to continue with the policy. The numbers simply don’t stack up. The market wants a financially strong BHP.
Shareholders will, in the main, rejoice when this policy is abandoned – so the sooner the better. And if the Directors have a bit of egg on their faces, so be it. Hubris is never a strength.
What the brokers say
The brokers still remain relatively upbeat on BHP, but as is to be expected, all have slashed their target price. They also expect the progressive dividend policy to go, although some still expect that the first half dividend may match that paid in 2015. The consensus forecast dividend for FY16 is down to 84.4 US cents per share (compared to the 124 US cents per share paid for FY15), and for FY17, 86.8 US cents per share. Interestingly, as a group, they are more positive to RIO than they are to BHP.
These are the current forecasts and recommendations:
[3]Source: FN Arena
What can we expect from BHP’s half yearly report?
BHP is due to report at 8.30am on Tuesday 23 February. It has already provided the market with its production data and said that it will book a US $4.9bn impairment (US $7.2bn pre tax), as it writes down some of its investment in US onshore oil and gas. It will also take a hit to underlying attributable profit of between US $300m and US $450m for redundancies, inventory write-offs and additional taxation costs.
So, what to look for?
While the market will have some interest in the underlying profit result for the past half, my sense is that it will pay much more attention to the following:
- the status of the progressive dividend policy. Does it get junked?
- the progress BHP is making on taking cost out of the business and any plans to cut back on marginal production;
- an update on the cost of the Samarco disaster; and
- capital expenditure plans.
All relate to the financial strength of the company and its ability to respond to the commodity cycle. Although BHP has some world-class assets, it is a price taker and has negligible control over its revenue. The game now is to manage cost and preserve capital, and make sure that the Company comes out of the cycle in a stronger competitive position than from where it went in.
How to play?
The first question I want to consider is whether BHP should be a core stock in my portfolio. With BHP now making up only 4% of the S&P/ASX 200 index – less than half the size (by market capitalization) of the Commonwealth Bank, this question – almost unthinkable three years ago – should be asked.
My answer remains “yes”, as I want some exposure to the materials sector, which weighs in at around 12% of the index. With its diversification across multiple commodities, BHP has been my preference over companies such as RIO or Fortescue.
So as a “core stock” in my portfolio, and given that I don’t believe I can predict commodity cycle peaks and troughs with accuracy, I am not selling. I am a patient, long-term holder.
Buy more? Well, my dabbles, as they have turned out, have been too early. I can’t believe commodity prices (in particular oil) have dropped as far as they have and so quickly. Despite the uptick last week, I am also not prepared to call this the bottom yet. This is a supply driven led rout – I think the markets need more evidence that production has been curtailed.
But the US dollar showing signs of weakness is a positive, and if this has topped, then commodity prices will rise.
BHP’s half-year report will be pretty critical to how I play it going forward. If the progressive dividend is junked and some good progress on cost and productivity initiatives is reported, then I will be inclined to add some more BHP to the portfolio.
If the Board says nothing about the policy and in the absence of a weakening US dollar, I think it is quite possible that BHP could retest its $14 lows again. If this plays out, my next dabble point will be in the $13 area.
See what our technical expert Gary Stone has to say about BHP’s share price movements [4].
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.