Watch out!
There were few surprises for readers of our blog in the BHP Billiton (ASX: BHP) result last night. BHP’s revenue declined 21.4 per cent and normalized Net Profit After Tax from continuing operations declined 70.5 per cent from US$14.9 billion to US$4.4 billion. Basic earnings per share declined from $2.50 to $1.20, putting the shares of this cyclical business on a price to earnings multiple of close to 20 times.
We have always expressed the view that the best returns come from the long-term ownership of a portfolio of businesses with true competitive advantages, the most valuable of which is the ability to increase prices in the face of excess supply and without any adverse impact on unit sales volume. Commodity businesses cannot do this.
BHP is a price taker, it cannot charge more for its products because customers would simply go elsewhere. You don’t want to own a business where the first question a customer asks is ‘how much?’ The results confirmed this with 2015 “uncontrollables” (commodity prices) wiping US$14 billion from EBIT (Earnings Before Interest and Tax). For the previous year EBIT was $22.1 billion. It is worth noting that a US$1/tonne change in the price of iron ore has an impact of US$148 million.
Back in 2005 the company reported a profit that was higher than 2015. Indeed every year since then has been higher than 2015. But what is really telling is that a decade ago the higher profit was generated on $23 billion of equity (owners’ money) and $13 billion of debt. This year’s materially lower profit was generated on $70 billion of owners’ money and $31 billion of debt. If you aren’t prepared to own the whole business for a decade, don’t own a little piece of it for ten minutes.
But perhaps the most interesting part of the BHP result was the fact that the company has reduced its costs of production. Unit costs for iron ore are now $15/tonne and for Queensland coal $61/tonne. Sadly, for those trying to pick the low point in resource stocks this means the price of these commodities will remain under pressure and are likely to fall further. Why? Because no benefit accrues from lower production costs when all your competitors are also reducing their costs of production. The industry is, in aggregate, incentivised to produce more volume to grow nominal revenue and earnings – especially when dividends are being increased (BHP) or there is a large amount of debt required to be facilitated (FMG).
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
