Yesterday BHP Billiton
Net profits, excluding one-term items, put in an even more solid performance, rising 58% to $10.2 billion, roughly in line with Wall Street expectations. The company generated operating cash flow of roughly $10.5 billion, up 25% over fiscal 2005, and plans to use part of this bounty to increase its capital expenditure budget by 10% in 2007 (to $7.5 billion), and buy back $3 billion worth of shares over the next 18 months. Did I mention that BHP's management just raised its full-year 2006 dividend by 28%, to $0.36?
Little wonder that many investors consider BHP Billiton to be the top dog in the diversified resource sector, which includes rivals such as Anglo American
Such strong results vividly illustrate that the commodity super-cycle is alive and well and that BHP Billiton should continue to benefit from robust global demand. China's and India's appetites for commodities remain vast, and a recent pickup in economic activity in both Japan and the Eurozone should help offset the effects of the recent slowdown in the United States.
That being said, I'd be remiss not to mention that there are some concerns about long-term margin pressure within the sector. After all, BHP did report that its costs increased by 5.7%, or $1.3 billion, due to higher energy costs and rising labor expenses. While I tend to view the increased energy cost factor as a non-issue, since that expense is likely to decrease in the face of cyclical downturn in the commodity sector as a whole, the same cannot be said of labor expenses.
Simply put, labor expenses in the industry are increasing due to a shortage of skilled workers and a desire by these workers to get a bigger slice of the pie. The current strike at BHP's majority-owned Escondida mine in Chile is a case in point. Workers at the world's largest copper mine (which, according to Macquarie Bank, contributes nearly 20% of the company's earnings) are demanding raises of 10% and a special bonus of $30,000 per worker. BHP has countered with an offer of a 4% raise and $18,000 bonus - an offer which was just rejected.
If that isn't the definition of rising labor costs, I don't know what is.
A second, somewhat related issue that concerns me is that BHP seems to be gearing up for an acquisition, and there is a real possibility that it could overpay in the process. While some analysts point to the recent share buyback announcement as proof that the company isn't on the prowl, I respectfully disagree.
In my Foolish opinion, the small size of the buyback relative to cash flow and the protracted buyback period are a confirmation of acquisitive intent rather than denial, as is the fact that the company's dividend payout ratio continues to decline. Furthermore, BHP's $7.5 billion capital expenditure budget for 2007 stands at only a little more than 41% of 2006 earnings before interest, taxes, depreciation, and amortization (EBITDA) -- on the low side in terms of both company and industry standards. Lastly, management has made repeated comments about the shortage of skilled workers. What better way is there to increase the worker pool and garner increased production than through acquisitions?
I'm not saying an acquisition would necessarily be a bad thing -- look how BHP's acquisition of WMC Resources turned out -- but I'd be wary of the cost in an environment with inflated asset prices.
At a recent price of $42.50, shares of BHP Billiton trade at around 12 times fiscal 2007 estimates, a considerable premium to the average multiple sported by competitors such as Rio Tinto and Rio Doce. While I acknowledge BHP's industry-leading position, I believe the shares are fully valued at these levels, especially in the face of growing labor expenses and the likelihood of a dilutive acquisition. Investors looking for exposure to the mining sector might instead want to take a look at some of the company's potential acquisition targets, such as Alcoa
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