World Economy Slow Down

I am looking forward to the next stream of financial and annual reports that will be coming soon. I predict that the press releases will focus on the annual earnings and completely gloss over the 4th quarter earnings, which I expect will not be rosy for any base metal company. However, the 4th quarter earning are probably more representative of the company's next quarter earning potential rather than looking at the full years.

In a recent post I was asking if base metals would fall off a cliff. There were many indicators that economic growth was slowing.

The US is of particular concern. According to Nobel economist Joseph Stiglitz the US has been drawing down home equity at a rate of $700 to $800 billion per year.

That's a lot of unsustainable US economy. Further, the US consumption economy is about $9.5 trillion. The home equity borrowing has been 7-8% of the consumption US economy. Now that lending standards have tightened, and home equities have declined, that borrowing is not likely to continue at anywhere near the same rate. It has to be a strong US slow down in the economy and the trickle down effects can not possibly be pretty.

Emerging markets are not likely to make up the slack. China's consumption economy is a mere $1 trillion, so $700 billion is 70% of their economy. Anyone who thinks China will pick up the slack is smoking something pretty strong.

This can't possibly be good for base metals. There are a lot of base metals that go into consumer goods. Additionally, commercial construction is rapidly declining as well, and municipal budgets that might do big capital projects that require base metals are in trouble because municipal budgets are in trouble due to declining revenue from declining home prices in the US. Cities are demanding all departments cut budgets.

Mining projects in the process of being developed do not just stop in the middle of hundreds of millions of dollars being committed to them, so increases in supply tend to strongly lag changing economic conditions. Data showing slow downs for material usage tends to be lagging rather than leading. In the US housing starting were going full throttle as late as last March, and all of the materials that go into housing would have continued to be used until some time in the fall or winter, yet by then housing starts had plummeted, but the actually declines in demand from that reduction will not be fully showing up in financial reports until the end of Q1, and it should be significant. So far Q4 earnings are down about 20% for companies that have reported Q4 earnings. That's gigantic and it is crazy to not think that that isn't have an effect on commodity demand.

Base metals have had enormous leverage of earnings from record commodity prices and they've been bid up in price, valuing the base metals stocks like a coca-cola stock, only base metals are at far more risk to supply and demand price fluctuations that demand a low P/E when prices are strong. When the market looks good and the company has good growth prospects I'd never give a second look to a base metal stock with a P/E of 12 or higher. It has room built in for down side risk and a opportunity to exit without wiping you out should the market turn, which it appears to have done.

There are numerous examples now of how the downward leverage affects earnings. From Q2 07 to Q3 07 FNX mining's revenues declined 28.3%, but earnings declined 64.3% despite the fact that "the total tons of ore, pounds of nickel, pounds of copper and ounces of precious metals produced and sold was were higher ... than in any previous quarter," according to the Nov 1, 2007 news release. According to google finance the current P/E is 21.7, but that has earning of $12.5 million (the last report), $35 million, $30.2 million and $19.7 million included. Go four quarters forward based on last quarter and you get $50 million per year of earnings compared to the current last four quarters of $97 million. It means the P/E for last quarter reported is about 43. Average nickel price was $11.65/lb and copper price was $3.57/lb. FNX is still richly valued despite being down 37% from its high. The $24.87 shares earned 15c/share last quarter. Even if you believe they can double earnings, the shares seem richly valued.

Teck Cominco's earnings declined from $2.01/share to $1.16/share for the same two quarters, only Teck Cominco did not get so insanely valued. Their revenues were down about 1/3rd yet earnings were down 42%. Their loss of leverage of earnings was not nearly as drastic as FNX. Teck's current P/E is 6.46 and forward P/E is 10.63. It is down 40% off its high. The $32.51 shares earned $1.16/share last quarter.

It is likely any base metal company examined will show a higher decline in earnings than revenue because of the leverage and it is also likely that all established companies will experience a significant decline in earnings due to the declines in commodity prices, which are at risk to decline further due to the economic slow the entire world seems to be experiencing.

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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:

Company Citicorp Nominees Pty Ltd	Shares 440,460,280	% 13.12
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 (billions)
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.







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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BHP's $10 billion share buyback - A good move?

Reading that BHP plans to spend an additional $10 billion, bringing the total to $13 billion, buying back its shares stopped me in my tracks.

Due to the record commodity prices, BHP has been making record profits, $6.2 billion in the last six months of 2006.

A share buyback will not add to shareholder value. Indeed, if I was a shareholder, I'd be taking that extra 5% and selling out, at least that was my gut reaction to the news.

So, lets have a look at BHP.
Market cap - $131 billion
Shares - 2,982 million
P/E - 12.8
EPS - 3.45
Price - $44.03

The EPS works out to a healthy 7.8%. But the earnings are only healthy on the surface. They are based on record prices for aluminum, alumina, copper, iron magnesium and molybdenum. Record prices means the share is at record levels, indeed, just 4 years ago the share price was around $10.

A number of commodity prices have declined. EPS can be expected to decline by 20, 30, 40%. Buying back shares will make it so that there are less shares to average the earnings over, but there will also be less assets being held, less cash. Commodity prices have declined enough, the eps will still decline despite having up to 10% fewer shares to average the earnings over.

The commodity market is cyclic, and buying back your shares when they are premium prices simply rewards those who sell. It does not give share holder value to those who hold. The smart money buys low and sells high. BHP is high.

Just 4 years ago the share price was about $10. How much real value has been added in the way of new properties, new resource, new mines, etc.? I am not sure, but the current price is more than 5 times the book price, and 3.9 times the sales.

The ideal time to buy back shares is when they are priced low, then share holders that stay are rewarded.

Alternatively, because the market is so cyclic, put the cash away for days when commodities aren't priced so well. That's when there'll be a fire sale on many asset rich properties, and that's when to buy them.

Indeed, a bet plan would be to wait for the next bear market and line the company with asset rich properties from the fire sale.

BHP reports record profits; pledges $10B buyback

By MarketWatch
Last Update: 2:40 AM ET Feb 7, 2007

HONG KONG (Menafn - MarketWatch) -- BHP Billiton Ltd., the world's largest mining company, announced a surprise $10 billion share buyback Wednesday, sending its Australian-listed shares up more than 5%.

The larger-than-expected share buyback comes amid record commodity prices last year.

BHP BHP reported net profit rose 41% to $6.2 billion for the six month period ending in December, up from $4.36 billion in the year-ago period, bolstered by strong production results for most mineral commodities, the company reported in a statement published on its Web-site Wednesday.

The result is the seventh straight half-year record profit for the miner.

BHP said it will add $10 billion to its previously announced $3 billion share repurchase plan. The equity purchases will take place over the next 18 months and include off-market purchase s as well as open market purchases, the company said.

Analysts said the interim profit was in line with expectations but the size of the share buyback was a surprise to the market.

Shares of BHP rose 5.85% to close A$28.24 ($21.97) on the Australian Stock Exchange Wednesday.

BHP declared an interim dividend of 20 U.S. cents per share, an increase of 14% over the last year's interim dividend.

The miner said it has set aside $17.5 billion for 29 projects across the globe.

BHP said it has repurchased $1.7 billion of stock at an average price of $18.23 since announcing its earlier buy back plan in August last year. Including Wednesday $10 billion pledge, BHP has returned $17 billion to shareholders since August 2004 the company said.

The Anglo-Australian mining group also said 49-year-old chairman Charles Goodyear plans to retire in 2007.

BHP said it saw half-year production records for aluminum, alumina, copper cathode, iron ore, magnesium ore and molybdenum.

Shares of BHP are traded in Sydney and London.

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