BHP and China’s overcapacity

Posted on 29 November 2009

Two useful contributions to the global information glut last week. The first being the documentation coming out of BHP’s AGM. The second a report published by the European Chamber of Commerce on “Overcapacity in China“.

So to BHP, the world’s 11th largest company by market capitalisation (at least last Thursday). This is a company at the peak of its powers. The strategy is simple, if a bit of a mouthful, to own a – ‘portfolio of tier one, low-cost, long-life, expandable and export oriented assets, diversified by region and commodity”. Couple that with low financial risk (net gearing ~12%) and an EBIT margin of 40% and you are on a winner.

BHP - EBIT margin

The one metric that keeps coming up is the 40% EBIT margin. I have discussed it before as something that should prove hard to maintain. BHP makes the claim that their strategy has delivered this margin and the resultant return on capital of 25%. This is only partially true of course. It takes two to tango. So while BHP operate a resources business that has the scale, reliability and a relatively low cost base - the other dimension to achieving such gratifying margins is demand.

And this is where, in the short term, China’s overcapacity comes in. In the longer term this slide, from a presentation by Don Argus, suggests the cost of carbon could be a problem.

BHP - carbon costs

Now don’t get me wrong – notwithstanding the inevitable managerial inertia that will set in – BHP is, and will continue to be, a great company. And I’m happy to accept a 2025 vision that has long term demand being underwritten by the urbanisation and industrialisation of China and India. It’s just that a lot can change in 15 years.

Again, the market wisdom that a company’s share price peaks with earnings momentum comes to mind. As I’ve suggested before, I just can’t see current commodity prices being sustained over the near term. At a P/E around 20 times BHP is trading expensive given these demand side risks.

Let’s come back to the European Chamber of Commerce report separately…

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