Shares in focus: Should you buy this mining behemoth?

Investors have rightly been nervous of miners, but BHP Billiton is different, says Phil Oakley.

It might not feel like it, but anyone who has owned shares in miner BHP Billiton for the last ten years has done very nicely. With all dividends reinvested, the shares have returned 445% over the last decade, compared with 135% for the FTSE All-Share index on the same basis.

The last five years have not been as kind. You’d still have made money, with total returns of 88%, but a stock-market tracker fund would have been a better investment (up 104%).

How times have changed. Before the financial crisis, mining companies such as BHP were the kings of the stock market.

The stunning growth of the Chinese economy and other emerging markets, combined with investors putting more of their money into commodities, saw their profits and share prices soar. But like most things in life, what goes up quickly can come down just as fast – if not faster.

The sensitivity of profits to changes in commodity prices is a double-edged sword. Having been burned after the commodity bubble burst, it seems that many investors lost faith in mining companies. They have no idea what profits will be from one year to the next and find them difficult to value.

For many, the miners have become trading stocks to buy and sell, depending on whether people think China’s economy is roaring away or going to the dogs.

These are legitimate concerns – it is quite understandable why many people give mining stocks a wide berth. However, should all mining shares be tarred with the same brush?

How the company has fared

It has taken a while for the managements of mining companies to adjust to a different world. If they want to keep shareholders happy then it’s no good pouring billions of dollars into grandiose mining projects and hoping that high commodity prices will bail them out.

BHP and most of the mining sector has been guilty of thinking and acting in this way. During the last five years just over $107bn of cash has come in to the business from selling commodities such as oil, iron ore, copper and coal.

The trouble is that BHP has been spending more money on new projects, paying interest on its debt, and shelling out for taxes. So there’s been no cash left over. Although it has been paying a rising dividend, this is ultimately unsustainable if the amount of cash going out keeps on being more than the amount of cash coming in.

Why BHP stands out

Thankfully, BHP has seen sense. It’s cutting back on the amount of money it spends on new mines and is focusing on getting more stuff out of the ground with the assets that it already has in place.

As long as commodity prices don’t take a steep nose dive, this should mean that the amount of surplus cash generated by the company (known as free cash flow) could increase significantly and boost future dividend payments.

However, what makes BHP arguably more attractive than perhaps many other mining companies is that its profits are spread out across different types of commodities, which makes it more diversified and therefore less risky than single-product miners. Sure, iron ore still accounts for around half of its profits, but for now the outlook here is quite positive.

The Chinese government is currently cracking down on pollution, forcing steelmakers to buy higher-grade iron ore for their smelters. This is good news for the likes of BHP, which produces and sells what they need.

Unlike other mining companies, though, BHP also has a significant oil business that provides a good source of cash flow while adding some welcome stability to the company’s profits. Last year its oil business accounted for more than a quarter of BHP’s total trading profits – a proportion that could well grow in the years ahead.

The company has some solid oil assets in Australia that underpin the business, and it is hoping to boost growth by investing heavily in US shale gas.

Some oil companies, such as Shell, have failed to make their investments in shale gas pay off, but BHP reckons that in a few years’ time its investments could be churning out $3bn of cash flow a year. Time will tell.

Should you buy the shares?

Another attraction for investors is BHP’s dividend payouts. The shares currently offer a prospective yield of over 4%, which is none too shabby.

The relatively stable oil profits arguably make this dividend a lot safer than many on offer elsewhere, and provide a decent tangible return from owning the shares. This should make the shares less risky than other miners, where returns are more reliant on their share prices going up.

If the company can stay disciplined with its investments and keep a tight rein on costs, there’s the possibility for some dividend growth too. The company is in good shape financially and has a sensible amount of debt, which means that interest payments aren’t eating too much of the shareholders’ lunch right now.

Miners are not for the nervous, but with the shares trading on just over 11 times June 2014 earnings, BHP doesn’t look particularly expensive just now. A decent yield and diversified profit stream makes BHP the pick of the big mining companies to own.

Verdict: buy for the dividends

BHP Billiton (LSE: BLT)

BHP Billiton share price chartShare price: 1,768p
Market cap: £99.5bn
Net assets (June 2013): $72.0bn
Net debt (June 2013): $27.4bn
P/e (prospective): 11.1 times
Yield (prospective): 4.2%
Dividend cover: 2.1 times
Interest cover: 12.7 times

BHP Billiton dividends per shareDirectors’ shareholdings

A Mackenzie (CEO): 201,921
G Kerr (CFO): 94,584
J Nasser (chair): 81,200

What the analysts say

Buy: 19
Hold: 11
Sell: 4
Target price: 2,105p

Merryn

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