Further share price weakness for BHP

While one broker may have recently replaced Rio Tinto (ASX: RIO) with BHP Billiton (ASX:BHP) as its preferred miner, don’t assume this means its again time to start buying it with your ears pinned back, even if the share price is down 18% for the year so far, and over 60% since its 2014 peak of $39.15.

Given the gloomy outlook for iron ore – currently trading at around US$39.51 per tonne – and Brent crude oil (currently US$29/barrel for the first time in more than a decade), there’s every likelihood BHP has further to fall.

The global market selloff has only added to the disastrous run experienced by BHP in 2015, with a disaster at one of its mines in Brazil (Samarco) and speculation over the sustainability of its ‘progressive dividend’ policy adding extra reason for shareholders’ to be nervous.

BHP’s share price did receive some short-term respite following its announced US$7.2 billion impairment on its US onshore shale business. This is the second time BHP has written down its US onshore division — now valued at $US16 billion — over the past six months.

Both impairments raise major question marks over BHP’s US shale punt, made during the China resources boom. But to be fair, the latest impairment was driven by commodity prices rather than problems with geology per se.

Meantime, BHP’s latest share price falls are really only mirroring the underlying fortune of oil prices. Brent crude recently collapsed another 6.3%, and there’s growing speculation it could fall as low as US$20/barrel.

Admittedly, based on a forward price to earnings (P/E) of around 22, BHP does appear to be attractively priced. But the share price has been progressively moving closer to its 2016 intrinsic value (IV) of $3.86, which is never a good sign, and its forecast value has decreased by more than 20% in the last three months.

Assuming spot prices for BHP’s commodities were to persist longer term – which appears likely – one broker believes the company’s fair-value share price would be closer to an unflattering $7 per share.

Based on these assumptions, iron ore would average around US$35 per tonne over the next few years.

Within the current trading environment, BHP is likely to come under growing pressure to cut the dividend and capex – to US$5 billion by FY18 – to prevent issues from snowballing and mitigating any further balance sheet risk.

Cash flow from BHP’s operations produces a funding surplus of $14.4 billion, and it has fairly modest net-debt to equity of around 38%. However, its return on equity (ROE) which has averaged 29.03% since 2006 is forecast to deliver 4.02%, 6.14% and 8.61% in 2016, 2017 and 2018 respectively.

Equally unimpressive, earnings per share (EPS) growth has been poor over the last five years, and is forecast to decline – with EPS of $2.22 in 2015 falling to $0.64, $1.00 and $1.45 in 2016, 2017 and 2018 respectively.

Based on these figures, it’s easy to see why brokers are quick to halve their dividend forecasts for the stock to more sustainable levels. However, even if BHP’s (forecast 2016) dividend yield (fully franked) was halved, it would still remain attractive to many at around 5.2%.

Given that lower iron ore expectations have forced one broker to put a ‘sell’ on pure-play Fortescue Metals Group (ASX: FMG), the same broker – who had a ‘buy’ on BHP – is clearly placing a lot of faith in the big miner’s ability to significantly reduce costs, and slash capex spending.

Within the current market dynamics, you need to be wary of robust 12 month target prices on BHP. Even for those who like the underlying long-term growth story, $15 may prove to be an expensive entry point.

Interestingly, despite oil prices have fallen more than 70% over the past 18 months, BHP hasn’t changed its long-term oil price expectations. However, with Saudi Arabia selling product as fast as they can, and Iran kicking off plans to boost oil exports, shareholders and would-be shareholders faith in long-term oil prices will be sorely tested.

Buying BHP during cyclical lows does make for a winning strategy, and the BHP share price will at some point rebound. Admittedly, BHP is one of the strongest diversified miners both operationally and financially, however more share price pressure looks inevitable.

Why pay too much for this stock if you don’t have to? Given BHP’s appalling track record at acquiring assets, CEO Andrew Mackenzie needs to prove to investors he knows what he’s doing.