Friday, December 14, 2007

BHP - RIO -- Merging Bubbles

I play CAPS and I am losing on my BHP call and barely holding on my RIO call. I believe both these companies to be highly bubbled values and BHP is courting RIO.

BHP has a market cap of about $190 billion and I believe BHP has been artificially sending its share price higher with its share buy back program. I simply see no value for long term shareholders, as I have previously written.

I think share buy back programs are gross violations of shareholder interests as ultimately they tend to line the pocket of the executives with stock options at the detriment of the company and shareholders. A share buyback creates a temporary increase in demand which increases price. Mish has a very good example of a share buy back that fell apart. I can't see the BHP buyback being much different.

Ouch, isn't this going to be good, look at some of the largest shareholders:

Citicorp Nominees Pty Ltd
HSBC Australia Nominees Pty Ltd 377,638,519 11.25
J P Morgan Nominees Australia Limited 372,983,700 11.11
UBS Nominees Pty Ltd 20,861,621 0.62
HSBC Custody Nominees (Australia) Limited 18,369,730 0.55
ARGO Investments Limited 6,422,411 0.19

Aren't those companies related to companies already in trouble because of subprime?

So, BHP has been making record profits, but when you look at their liabilities, they have increased from $17 to $28.5 billion. There is no question that equity has increased nicely, from $12.8 to $29.7 billion, but price to book is over 7x. Additionally, P/E is around 17-18. Say earning cut in half, then the P/E is about 35, and earnings cutting in half is highly realistic.

The problem is that many commodity prices have gone down and with weakening demand, and they are likely to decline further.

Take a look at BHP's earnings over the past six years:

Year Total Income
2002 $1.25
2003 $1.58
2004 $2.72
2005 $6.32
2006 $9.75
2007 $13.16

BHP's business segments (and relative share of 2007 profit) are petroleum (16.4%), aluminium (9.9%), base metals (31.5%), diamonds and specialty products (1%), stainless steel (20.1%), iron ore (14.6%), manganese (1.4%), metal-lurgical coal (6.8%), energy coal (1.4%), and eliminations (-3%).

Take a look at the 5 year spot price for aluminium, some base metals and nickel, of which 60% of segment profits are dependent.

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For Aluminium the profit before taxes was 31%, $1.8 billion out of $5.9 billion. The year ended in June and spot price graph shows a full year of strong price when the US dollar was on average about 15% stronger. A rough estimate of where the 2008 price will be with both spot price and currency declines is about 25% less. That comes off revenue and costs stay relatively the same, so expecting to see revenue decline to about $4.5 billion for 2008 for aluminium is highly realistic. Well, $4 billion was costs, so the aluminium segment declining to $0.5 billion in earnings isn't unrealistic, or $1.3 billion shaved off earnings.

There are a few base metals, but they all have strong prices so an estimate can be made just by looking at copper. The revenue was $12.6 billion and profit was $5.8 billion, or 43% of revenue. Copper had a 2-3 month period for 2007 with a strong price decline in the winter/spring so average copper price for 2007 looks to be around $3.20ish. Copper is currently 10% less and with the G7 economies all slowing down it is not likely to have the same kind of price support. So copper revenue down 20% for 2008 is not unrealistic. That would shave $2.8 billion off earnings.

Steel is nickel and nickel price is indeed scary. BHP caught the entire unsustainable nickel price spike in 2007. Whoo-hoo, no wonder it had a race to the bank 310% EBIT increase over the previous year. It looks like the average 2007 price was about $17-18/lb. Nickel is under $12/lb and there is about a 15% currency decline to consider. Expecting to see 2008 revenues will be down in the range of 40% is not unrealistic. That would be $2.8 billion off revenue and would take profit from $4 billion to $1.2 billion.

Looking at just 60% of the market segments of BHP and considering commodity and currency declines there is a feasible estimate of $7 billion decline in operating profit, or about 37% gone. For this year the energy earnings look sustainable, and could be up, but I would expect energy to decline as the gross over supply of housing used a lot of energy and that part of the demand is already declining as manufactures that supplied the housing boom are finding their inventories increasing and are cutting production.

For the merger with RIO they need $70 billion, $40 billion to restructure Rio's debt and another $30 billion for a share buy back. Their existing long term debt is about $9.3 billion, so they are looking to increase debt about 9-fold. They had $13 billion in earnings for 2007 and Rio had $7 billion. Wouldn't it be reasonable to expect debt servicing costs on $80 billion to be about $8 billion? With the kind of unsustainable record earnings of the past 5 years wouldn't you expect zero debt on the books?

This is the wrong time to increase debt. With $80 billion in debt, and say earnings go down 25% overall, would result in increased costs by about $7 billion and decrease income by $5 billion, and combined $20 billion in earnings would decline to $8 billion. Scraping the share buyback would reduced the debt burden by $3 billion so earnings would only decline to $11 billion.

But, overall, I would anticipate more like a 50% decline in earnings by the time the next year or two play out without increased debt costs.

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