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Morningstar | BHP Remains Optimistic on Productivity Initiatives, AUD 24.50 FVE Maintained

No-moat-rated BHP's fiscal 2018 unadjusted net profit after tax declined 37% to USD 3.7 million. The unadjusted result was impacted by several once-off items totaling USD 5.2 billion aftertax. These included USD 650 million of expenses associated with rectifying the Samarco disaster, USD 1.8 billion of noncash charges relating to the balance sheet impact of the change to U.S. tax rates, and a USD 2.75 billion after tax impairment of the U.S. onshore shale assets, which are to be sold later this year.

Adjusted net profit attributable to BHP, including the discontinued U.S. shale operations which were held for the full period, was USD 8.9 billion, up 30% on the prior year. Shale contributed an adjusted net loss of USD 0.7 billion. Copper was the key driver of the improved adjusted profit in fiscal 2018. Divisional EBIT more than doubled to USD 4.4 billion. This was mainly due to the copper price with the 24% rise in volumes also helping. For the whole group, price added USD 4.1 billion to EBITDA higher costs offsetting about half of that benefit.

The result was slightly weaker than we expected, due to higher operating costs and slightly lower revenue. BHP says it will also take an additional year to achieve its planned USD 2.0 billion of cost savings, now aiming for fiscal 2020. Temporarily higher waste mining requirements at Queensland coal in fiscal 2019 and divestment of the shale means the target was extended. However, the company remains committed to the USD 2.0 billion target, and more broadly, ongoing productivity initiatives across the group. The headwinds from lower earnings and a slower rate of cost savings are not sufficiently material to warrant a change in our fair value estimate, and it remains AUD 24.50 per share. Higher medium- and longer-term thermal coal price assumptions, though of low importance to BHP, are an offset.

BHP leaves its capital expenditure guidance unchanged, but with the exit of shale, some incremental additional expenditure will be directed to likely higher returning projects. Improving returns at Olympic Dam, now one of the lowest returning of the group, is a key focus. Another is mining fleet productivity with automation of the fleet an enabler. BHP still expects to be able to reduce medium-term unit operating costs at both its Pilbara iron ore and Queensland coking coal assets, in line with our broad expectations. The company also expects productivity initiatives to offset some of the impact from lower future copper grades, particularly at Escondida. BHP should maintain Escondida copper output around 1.2 million tonnes a year for the next five years, despite the forecast grade decline.

The company is in strong financial shape with net debt declining 33% to USD 10.9 billion, thanks to free cash flow of USD 12.5 billion, in line with last year. Net debt is towards the bottom of BHP's preferred USD 10 to USD 15 billion range for net debt. We think this means a greater share of future free cash flow will likely be directed towards shareholder returns.

The final USD 0.63 per share fully franked dividend was a record for the second half while the full-year payout of USD 1.18 per share was 42% higher than fiscal 2017. We expect dividends to moderate slightly in the future and forecast USD 1.10 and USD 1.00 per share in fiscal 2019 and fiscal 2020, respectively. A rising payout ratio, given the strong financial position, should partly offset the expected decline in earnings from lower forecast iron ore, coal, and copper prices.

No news on shareholder returns from the USD 10.8 billion sale of shale assets. BHP says it will consult shareholders as to the preferred form of the return and the board decide once the proceeds are received. As discussed in our last note, a large buyback, special dividend or capital return appear the most likely possibilities. However, the preference of shareholders will likely depend on the tax treatment of returns to the different types of shareholders and their different jurisdictions. An off-market buyback of the Australia-listed shares will liberate franking credits to Australian shareholders who can use them, but the Australian shares trade at a premium to the London-listed stock, and a buyback is also procyclical.

BHP's management is participating at the Management Behind the Moat conference held at Morningstar’s Chicago office on Nov. 7-8, 2018. If you are interested in attending the conference, please reach out to your sales representative for registration information.