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BHP - RIO -- Merging Bubbles



December 15, 2007 – Comments (13) | RELATED TICKERS: BHP , RIO

I am losing on my BHP call and barely holding on my RIO call.  I believe both these companies to be highly bubled 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, this isn't going to be good,  look at some of the largest shareholders:

Citicorp Nominees    Pty Ltd
HSBC Australia Nominees Pty Ltd377,638,51911.25
J P Morgan Nominees Australia Limited372,983,70011.11
UBS Nominees Pty Ltd20,861,6210.62
HSBC Custody Nominees (Australia)    Limited18,369,7300.55
ARGO Investments Limited6,422,4110.19

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.


13 Comments – Post Your Own

#1) On December 15, 2007 at 11:20 AM, dwot (29.24) wrote:

Chit, dang images...

I'm posting this one at Making Sense of My World

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#2) On December 15, 2007 at 11:36 AM, dwot (29.24) wrote:

Did you see that CAPS is giving 2c for every blog post and reply in December?

Seems I'm indirectly giving a lot of my 2c worth for the holiday month.  Why not join in... 

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#3) On December 15, 2007 at 4:29 PM, devoish (70.13) wrote:

Just my 2 cents worth, and this is more a reply to your base metals falling off a cliff post, but on the demand side many of my friends know the cheapest place to get copper tubing is an empty house.

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#4) On December 15, 2007 at 4:53 PM, camistocks (54.44) wrote:

dwot, we know that you are a bear. But why did you buy calls instead of puts then? BTW, this is the difference between a trader and an investor. I don't care if a stock is going to correct 20-30% over the short term, because I know it is going to be much higher in a couple of years.

I absolutely don't share your view that these are unsustainable earnings. The US economy isn't as important for the world as it was 10 years ago. Many Americans will have to get used to it, they still believe the US is the centre of the world. There are 2.5 Billion (with a B) people in the developing countries (China, India, Brazil, Middle east, etc.) who want to get to the same living standard as we in the developed countries. They will need each year not just the same high amount of commodities, but increasing amounts. The miners are not able to catch up, because there is not enough mining equipment available at a reasonable price. So projects get delayed.

Commodities prices go up and down, but in general, they are still much higher than the long term average. 

Also, there is nothing wrong with debt if you have a high cashflow.

A share buyback reduces the available amount of shares outstanding, and thus increases earnings per share. It is a way of returning capital to investors, without having to pay taxes (dividends are taxed). Again, it makes sense if you have a high cash flow.

i found this connection you were drawing between subprime and share buybacks very "populistic". How can you compare a pyramid scheme company like Ambac with a solid company that provides basic needs...? 

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#5) On December 15, 2007 at 10:05 PM, TDRH (97.04) wrote:


     I have owned BHP for 10 years, and have been well rewarded with the recent run.   Understand that it is cyclical, and maybe I should sell off some or all, but I am not going to do it because of a share buyback program.   

     BHP is global, and demand from its far eastern customers will be a source of continued growth.  I can see forecasting a short term correction, and maybe some profit taking, but long term I believe this company has continued potential for growth 



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#6) On December 15, 2007 at 11:29 PM, dwot (29.24) wrote:

The complete waste of earnings on the share buyback program is only one of the reasons.  The decline in commodity prices is serious.

I think I came up with an estimate that the decline in the home construction in the US would reduce world demand by 4% or so.  It is clear now that all of the G7 is having slowing economies.  Last spring the US still had record number of housing starts so the slow down for copper demand from the decline in housing starts is only now showing up.

I don't see China picking up that much slack.

Besides, the industry is still going full bore building and developing new mining sites to increase world supply.

I think it takes years to work off the oversupply...

But, good luck with it... 

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#7) On December 16, 2007 at 12:07 AM, dwot (29.24) wrote:

Interesting when I looked at buy back programs my conclusion was that they line the pockets of the executives at the expense of the shareholders, a form of legal theft that I suspect will be outlawed in the next 10 years. 

It is problem that goes unnoticed and is cheered by shareholders as they see their share price go up.  The ones selling are the ones being rewarded and the excessive stock options result in decisions that transfer wealth from the investors to the executives, and marginal changes in the number of shares.

So, here is a write up that looks at it closer than I ever did.  Interesting that the argument is made that they are unfair evenwhen shares are undervalued as the selling shareholders are ripped off.  I can't buy that argument.  A share buy back program pushes the price up regardless how the stock is valued.


Here's another share buy back write-up. 

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#8) On December 16, 2007 at 12:09 AM, dwot (29.24) wrote:

And one more...


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#9) On December 16, 2007 at 12:55 AM, camistocks (54.44) wrote:

dwot, there is no doubt that you have a bearish stance. Whatever news comes out, you will find something negative.

my advice: don't read those doomsday blogs and sensationalist articles.


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#10) On December 16, 2007 at 2:51 AM, dwot (29.24) wrote:

And what of all the people I see that aren't making ends meet?  Pretend they don't exist?

Someone said we extrapolate what we know.  I know the degree of decline of lifestyle I have seen in Vancouver over my life, and it is enormous and a lot of it was because of housing.  I know way too many people who struggle to make ends meet and those that don't. 

I know too many people that ended up not having children because they couldn't get their financial house in order to the place they thought they would be able to afford children.  Heck, I was talking to one of my now retired university professors in the summer and asked about his kids (he used to talk about them in class all the time).  Not one had children and all are past the age of reproduction now and that was all about getting finances in order and all because of housing.  Those that had children are the ones that are finding it impossible to make ends meet.  And since about 2000 families have been just packing it in and moving away from the region because they couldn't afford it.

Our housing got past affordability about 15 years ago and I've been living all around me how that plays out in people's lives.  With the high cost of housing, wages went fairly flat and I've had a lot of years to think about why and it has always come back to people not having money to stimulate the economy.  And we saw housing declines.  Five years after we bought our second home was worth 10% less than what we'd paid for it.

I think I've already seen what is coming because of the housing crisis and it will take years to work its way through the economy. 

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#11) On December 16, 2007 at 4:37 PM, abitare (30.30) wrote:


Good analysis. Concur, with you and Mish on the share buy back being a bad move by management especially when there is significant debt. 

The problem with commodities, is there is a huge bull market that has not cooled, yet. As the recession becomes more apparent, I expect commodity prices, drillers, miners etc... to get hit also.  


Although I do like most of your stock picks. I believe the recession will bring down all asset prices including most commodities. There is the possibility of a resource war as countries try and aquire hard assets ie: commodities to cash out of the declining US dollar. 

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#12) On December 16, 2007 at 5:28 PM, dwot (29.24) wrote:

The price declines in commodities means the hit is already there, and it is significant already.

But, probably like Goldcorp, down from 90c/share to 30c/share, insanity can continue for a long time. 

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#13) On December 17, 2007 at 3:16 AM, camistocks (54.44) wrote:

dwot, I don't know, I don't have children, but I think if you really want to have children, you are not going to plan how much they will cost you. You are simply going to dive into this expensive and nerve rattling adventure...

My parents rented, until they were 40+ years old. There's nothing wrong with renting!

BTW, today it is even possible to have children as a woman, if you are 50+ years old...

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