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At some point, BHP and its compatriots in the sector may become good value. This point does not appear to have arrived yet. BHP, one of the giants of the mining world, is facing its own version of the Deepwater Horizon spill that still blights the outlook for BP.
The problem for bargain hunters in BHP shares is that they could be facing a value trap – it seems cheap, but due to deep-rooted factors it is actually likely to get cheaper. Admittedly, the mining sector is in a cyclical, rather than secular slump (ie one that will eventually end rather than go on for an extended period). Commodity demand will recover, but not for some time.
However, in recent years, BHP fell into the same trap as many other miners – it locked itself into overpaying for acquisitions and expanding capacity. Over the past three years, the decline in commodity prices has cost BHP around $29 billion. It also spent $17 billion to gain control of shale gas fields, with these assets now worth around $12 billion.
Most worryingly, the firm’s return on invested capital has been just 2.1% over the past year, versus a cost of capital of 7.4%. As commodity prices continue to decline, BHP is locked into a cycle of increasing production in order to maintain revenues – it must run faster and faster to stay in the same place.
With other miners having to look at their dividend, BHP’s 9% yield looks increasingly unsustainable. Free cash flow is, in the view of Société Générale unlikely to cover the dividend until at least 2018, and with net debt on the rise and credit rating downgrades looming it looks like a new (read: smaller) dividend will be unveiled in due course.
Like other dividend players in this market, one of the few attractions left for BHP is the payout, and with that gone, we could see a rapid acceleration of downside momentum.
Today’s decline has put the shares at their lowest level since November of 2008. The low of that month around £7.30 is the next natural level for real support to emerge, although some may materialise around the £8 mark (the lows of October 2008). In the short-term, the shares are likely to see resistance around £8.50 if a bounce does materialise, with a further upside target around £9.