Fair value $4.74 per share, page-47

Questor says SELL
BHP Billiton shares [LON:BLT] are heading back towards their lowest level in more than 10 years as the collapse in the oil price threatens to seriously undermine the strategy of diversifying the miner into oil and gas.

No escape from downturn
The strategy of diversification makes sense on paper. Mining has traditionally been a highly capital-intensive pastime, and the industry has a habit of spending big on new projects when prices are high, only to suffer when they subsequently fall. The oil and gas industry is not immune to bouts of irrational expenditure but, once the oil rig or gas field is up and running, they throw of plenty of cash for whoever owns them.
The theory is that combining cyclical mining assets with more defensive oil and gas assets provides the best of both worlds, and crucially a steady cash flow that can support regular dividend payments.
However, nobody envisaged the escalation of a bitter oil supply war between Iran and Saudi Arabia that has pushed the energy industry into a renewed price war. The China slowdown has plunged the mining industry into an equally dismal outlook. For the FTSE 100 miners there is simply no escape, whatever their strategy may have been.

Oil exposure

BHP leans on the oil and gas division more than most to prop up the rest of the business. The miner generated about a third of its total group earnings from petroleum two years ago but that slumped to just 15pc in last year’s results. The oil price has almost halved again since those results at the end of June.
The upshot of the commodity price moves on the company’s diversification is that the earnings are now looking increasingly lopsided. The miner generated about 28pc of its earnings from copper, and 57pc from iron ore, with a small contribution coming from coal in last year’s annual results. The price of copper has fallen a further 20pc and iron ore is down almost 30pc since that date.

Disaster strikes

On top of this challenging market, BHP has also had to deal with the tragedy of a dam bursting at its Samarco mine in Brazil.
The cause of the November dam burst, which left 17 people dead, is still unclear, but the joint venture, which is 50-50 owned with local partner Vale, could prove costly.
The Brazilian government has said it will levy a £3.5bn fine on the dam owners. The first payments to victims began yesterday.
Photo: AFP

Rapid response

BHP has taken drastic action to respond to the downturn. Capital expenditure has fallen from $15bn (£10.2bn) in 2014, to $11bn last year, and is forecast to drop to $7bn by June 2017. The company sold off unwanted assets into the South 32 vehicle, which began trading separately in May last year.
The management response is laudable, but the downturn has now entered a new phase. The forecast is for pre-tax profits to fall a further 40pc next year to about $5bn. BHP is expected to generate about $10bn in free cash flow, but $6bn of that will be eaten up by capital expenditure and the company will have to use borrowing if it wants to maintain the $6.6bn in dividend payments. It is a strategy that looks unsustainable in the current environment.
We recommended selling shares in BHP at £17 in September 2014 and, until there are some sign of stability in the price for commodities, that advice remains.