BHP Billiton: Interesting yield with some volatility

Summary

  • BHP is a pure play in the basic materials sector.
  • Since 2016, BHP shares shows twice the ETF’s return.
  • Is it time to forget the dividend cut and buy some shares?

As it is the case with the rest of the basic materials sector, BHP Billiton (BHP) saw a strong rebound after 2016. The mining company didn’t only see its shares outperforming the sector, BHP shares show twice the ETF’s return.

Source: Ycharts

Bolstered by strong demand in China and supported by various projects  across the globe, BHP is growing full speed ahead. Is it too late to jump on this commodity train? Let’s take a deeper look.

Understanding the Business

BHP is a pure play in the basic materials sector. The company is one of the rare solid dividend payers in this sector due to its highly cyclical nature. You can download the complete list of dividend growing stocks in the basic material sector here.

BHP is producing commodities, including iron ore, metallurgical and energy coal, conventional and unconventional oil and gas, copper, aluminium, manganese, uranium, nickel and silver.

Source: BHP Feb 2018 presentation

The company is the world’s largest mining conglomerate. This is a key element when the company hits a resource downturn cycle. Through its size, BHP has built a solid balance sheet and a well diversified asset portfolio going across different commodities across numerous countries.

Growth Vectors

Source: Ycharts

BHP enjoys low cost iron core exploitation in Australia which leads to natural business with China. While the golden years of the world’s second largest economy is behind it, China’s economy remains strong and continues to  grow. The demand for iron and other materials will continue to be strong for many years to come. Since BHP owns several assets near this part of the world, it has an important advantage over its competitors.

Another strong advantage BHP has over many other commodities producers is its size. Being big in this industry means that you can offer different commodities coming from various countries. In other words; when it’s not going well in one part of the world (economic, politic, etc.), you can count on another part to support demand. This makes BHP less vulnerable to basic materials cyclical nature. This is also one of the reason why its stocks jumped by 80% over the past 18 months.

As it is often the case with the energy sector (you can download the energy dividend list here), the quality of a company’s assets portfolio managed is crucial for its profitability. BHP has built a large low-cost portfolio of various commodities. This enables the business to go through more challenging periods. Considering the long life of most assets, BHP will show low cost of productions for several years.

Dividend Growth Perspective

When you look at BHP’s dividend history, you realize you haven’t found the Klondike yet. As many companies in the basic material sectors, dividend cuts are often the easy options during cyclical downturns. BHP had to cut its dividend in 2016 following a difficult period in the commodities market. Therefore, we are far from considering BHP to be the next Dividend Achievers.

The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 266 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Source: Ycharts

With 2 consecutive years with a dividend increase and a yield of 4%+, is it the time to reconsider your investment? After all, the company is on its way to offer the same payout post-dividend cut.

Source: BHP Feb 2018 presentation

From BHP’s presentation, we can clearly see that the dividend cut was the consequences of several years of capital expenses hurting BHP short-term cash flow to build long-life assets. The company’s financial situation looks better now and the current payout ratio is under control:

Source: Ycharts

However, I would not hope for a strong dividend growth going forward the next decade. In fact, I think it would be safe to expect a low single-digit dividend growth rate as dividend cuts could happen later down the road.

Potential Downsides

It is difficult to predict where a company like BHP will stand in 10 years from now. Chances are that it will be well and generating money since BHP is strong enough to go through an economic recession. With its low costs assets, it can survive poor demand periods. However, it doesn’t mean its dividend can survive the same path.

What happened in China in the 2000’s will not likely never happen again. This should put additional pressure on commodity costs for decades to come. A major weakness that all basic materials companies show is their dependence to a highly cyclical demand. You may be the largest and most diversified mining company, but you are still waiting for others to ask for your product. The problem is that demand is extremely volatile from one year to another.

Finally, with such a ride on the stock market, investors wonder if there is still room for growth on the market for BHP…

Valuation

This leads us to the final part of this report: valuation. BHP’s PE ratio history is quite hectic (what a surprise!):

Source: Ycharts

This doesn’t help us much to determine its fair value. Digging deeper, I’ve used the dividend discount model. I’ve used a 4% growth rate for the first 10 years and reduced it to 3% afterwards. I rather be conservative than overly hyped with this kind of company.

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $2.20
Enter Expected Dividend Growth Rate Years 1-10: 4.00%
Enter Expected Terminal Dividend Growth Rate: 3.00%
Enter Discount Rate: 10.00%
Discount Rate (Horizontal)
Margin of Safety 9.00% 10.00% 11.00%
20% Premium $48.91 $41.81 $36.49
10% Premium $44.84 $38.33 $33.45
Intrinsic Value $40.76 $34.85 $30.41
10% Discount $36.69 $31.36 $27.37
20% Discount $32.61 $27.88 $24.33

Please read the Dividend Discount Model limitations to fully understand my calculations.

I had to use a 10% discount rate due to the volatility of BHP sector and the fact the board already cut its dividend not too long ago. It’s not really a surprise to see a dividend based valuation model finding poor value in BHP…

Final Thought

In the light of this analysis, I don’t think BHP is a bad company or a bad investment. However, as a dividend growth investor, I find little interest in investing my money in such hectic dividend payer. The yield is interesting at 4% and the payments are sustainable. I understand why an income seeking investor would want to look at BHP. But for my own portfolio, I will pass.

Disclaimer: I do not hold BHP in my DividendStocksRock portfolios.

 

Announcement of an All-Stock Merger with Scana & Dominion is down 20%

Summary

  • Scana struggled with their nuclear plants and Dominion saw an opportunity.
  • This is risky play as Dominion could burn lots of cash on Scana’s business.
  • The stock is down, the yield is up, should you buy this dividend growth utility?

Understanding the Business

Dominion Resources changed its name in 2017 (was previously named Dominion Energy). It is one of US largest producers and transporters of energy, with a portfolio of approximately 25,700 megawatts of electric generation, 15,000 miles of natural gas transmission, gathering, storage and distribution pipeline and 6,600 miles of electric transmission and distribution lines.

Most importantly, the company has made a business shift from energy production to distribution over the past decade. It is still an important energy producer, but its distribution business is gradually increasing. D has built a predictable business model with 90% of its revenues coming from regulated operations.

Growth Vectors

Source: Ycharts

Management expects a 6-8% EPS growth through 2020. This is some great perspectives coming from a stable and predictable business. D can count on various projects to sustain its growth in the upcoming years like Greensville Power Station (combined cycle plant, 73% completed), Cove Point Liquefaction (LNG production, 100%  completed) and Atlantic Coast Pipeline.

As it is the case with many utilities, D counts mainly on new projects to generate additional growth. The recent Tax Reform will also give a hand to the EPS boost.

Finally, D has announced an all-stock merger with Scana energy (SCG) at the beginning of 2018. As Scana struggled with new nuclear plants construction and shares plummeted, Dominion saw an opportunity to grow its business. All stock merger will provide 0.669 shares of Dominion Energy for each share of SCANA Corp… in other words; there is a deal if you buy SCG now… unless the deal goes south! I’ll detail why it’s not so simple in the “potential downside” section of this article. Yes, it is THAT bad…

Dividend Growth Perspective

Dominion Resources shows 14 consecutive years with a dividend increase. This make it part of the elite Dividend Achievers list. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Source: Ycharts

With the recent stock price drop, D’s yield is getting closer to 5%. This make it a very attractive play for income seeking investors. Management confirmed its intention to grow its dividend by 10% annually through 2020.  Shareholders can expect a mid-single digit growth rate afterwards as management plans a 5% EPS growth rate post 2020. You will rarely find a stable company paying such growing payouts with an interesting yield. However, you will on have a chance to invest in such company if the deal with Scana doesn’t go sideways…

Potential Downsides

The deal with Scana is not that simple. Dominion tries to acquire a client base but wants off any liabilities Scana may have towards its customers. D is looking at buying a company at a cheap price, but this company has several lawsuits against it. It’s definitely not a slam dunk. Through this deal, Dominion also adds another $7 billion ($6.7) in debts. With rising interest rate, growing debts Telsa Style may not be the smartest moves.

Due to the complexity of this deal and uncertainties around it, I would wait until the situation is settled before making any investments.

Valuation

After the recent price drop, D seems like a bargain when you look at its PE ratio. The company hasn’t been trading at such good price for a while:

Source: Ycharts

When I used the DDM to determine D’s fair value, I realized that it was fairly priced before the merger announcement. The stock should trade around $88 and there is definitely a deal now.

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $3.34
Enter Expected Dividend Growth Rate Years 1-10: 8.00%
Enter Expected Terminal Dividend Growth Rate: 5.00%
Enter Discount Rate: 10.00%
Margin of Safety 9.00% 10.00% 11.00%
20% Premium $134.06 $106.34 $87.91
10% Premium $122.89 $97.48 $80.58
Intrinsic Value $111.72 $88.62 $73.26
10% Discount $100.54 $79.76 $65.93
20% Discount $89.37 $70.89 $58.61

Please read the Dividend Discount Model limitations to fully understand my calculations.

An interesting combination of a sector slump and uncertainties around the Scana merger has created an opportunity to investors. However, the price didn’t drop for nothing; the deal could turn sour and it could get worst for Dominion as well. There is no reward when there is no risk!

Final Thought

Dominion resources show a strong and predictable business model. With a steady investment of $3 billion per year in projects, management make sure to put enough growth on the table. Over the long run, Dominion seems a good investment, but expect additional volatility until the merger deal is closed or abandoned.

Disclaimer: I do not hold D in my DividendStocksRock portfolios.

GM is an Icon… But Can It Be More Than That?

Summary

  • GM has greatly improved its financial health and is back on “growth mode”.
  • GM has eyes on the future to fuel its growth (electric & autonomous car).
  • There are several clouds looming (competition, high debts, underfunded pension plans).

Are you ready to give it a second chance? This is often a question investors must ask themselves when they look at a company that already cut their dividend. Did management really understand what put them there in the first place? While General Motors (GM) has done a marvelous job at getting back from the dead, I’m not sure it can be qualified as a “safe dividend payer” yet. GM was once admired by many as the world’s #1 automotive constructor. After its fall in 2008-2009, the company worked very hard to bring its iconic brand to the top. It did a great job, but is it enough?

Understanding the Business

General Motors doesn’t need a presentation. Even my 6-year-old can tell the difference between a GM and a Ford since there are so many of their cars on the market. GM is not only a leader in the automotive industry, it is also a leader in the high-margin pickup truck sub-segment.

GM’s presentation

GM is obviously tied to the car industry and its cycles. After becoming a low leaner, it is now showing a breakeven point when production reaches around 10-11 million units. The company counts on less brands and more productive processes. GM has switched from an old model where it used to overproduce some models and shove them through consumers’ throats to a business model where it produces what clients want and meets the demand instead of exceeding it.

Growth Vectors

Source: Ycharts

GM counts on its leadership in the pickup truck segment to boost its cash flow in the upcoming year. The demand for such vehicles remains robust and offers growth possibilities for the years to come. It seems that everybody wants to drive a pickup these days! China and other emerging markets are obviously stable a growth vector for the automotive constructor.

Now that the company is back on track with stronger financial results, it has an eye on the future. This is a future with electric and autonomous cars. Two very intriguing, yet promising segments.

Source: GM’s investors presentation

As the population grows and move toward urban areas, the desire of driving their Corvette with their hair in the wind, is being replaced by low gas consumption transportation. Even better, if people can start working early in their car and don’t have to mind traffic while commuting to work, they’ll go for an autonomous electric car. This was pure Sci-fi a few years ago, but now we have a feeling that GM could possibly be among the pioneer in this sector.

Source: Ycharts

GM has made gigantic steps in improving their cash flow generation abilities. As a dividend investor, I’m also pleased to see that management used $25B for its shares repurchase program (GM bought back 25% of outstanding shares) along with its dividend payments. Speaking of which…

Dividend Growth Perspective

GM reinstated its dividend payment in 2014 and has increased it twice since then. We are not talking about a super-powered dividend grower. To be honest, there are tons of Dividend Achievers I prefer before picking GM. You can get the full list here.

Source: Ycharts

At a 3.5%-4% dividend yield, GM could please income seeking investors such as retirees. GM dividend brings back good old memories spent of summer vacation in an Oldsmobile. However, we are far from driving on that highway right now.

Source: Ycharts

As previously mentioned, GM has seriously improved its cashflow generation abilities and that shows through its cash payout ratio. Before the tax bill changes short term EPS, GM’s payout ratio was also well under control. While GM tries to seduce investors with shares buyback programs and juicy dividend, I expect low-single digit growth for the future. As you are going to see in a moment, GM has other cash flow priorities.

Potential Downsides

GM obviously counts on its strong reputation and brand awareness to sell more cars. However, I doubt this will be enough going forward. The competition is fierce, and consumers are already loaded with car debts. There is a limit in refinancing their old car with a new one.

Developing, manufacturing and marketing cars is a capital-intensive business. It becomes even more expensive when you are going outside the box and go with new technology (electric/autonomous). While GM’s cash flow from operation is skyrocketing, its debts are also raising fast.

Source: Ycharts

Such high debt will need to be paid at one point in time. As long as the global demand for cars remains stable, this is not a problem. However, an economic downturn could quickly get GM back on its heels. Don’t be too quick to forget about 2008 disaster. GM is not out of the woods yet.

Finally, GM is still dragging substantial pension funds expenses. In their Q4 2017, the company estimated its pension funds underfunded debt to be around $14 billion. This is not pocket change.

GM Q4 2017

Valuation

Assessing the value of a company that went through so much over the past decade is quite a challenge. In fact, the problem is that there are absolutely no trends here:

Source: Ycharts

The PE valuation is completely useless as GM went up and down and completely transformed its business over the past 10 years. Now, using the Dividend Discount Model is also a big guess as we have limited dividend history and lots of assumptions to take into consideration.

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.52
Enter Expected Dividend Growth Rate Years 1-10: 3.00%
Enter Expected Terminal Dividend Growth Rate: 3.00%
Enter Discount Rate: 10.00%
Discount Rate (Horizontal)
Margin of Safety 9.00% 10.00% 11.00%
20% Premium $31.31 $26.84 $23.48
10% Premium $28.70 $24.60 $21.53
Intrinsic Value $26.09 $22.37 $19.57
10% Discount $23.48 $20.13 $17.61
20% Discount $20.87 $17.89 $15.66

Please read the Dividend Discount Model limitations to fully understand my calculations.

Since GM hasn’t increase its payouts since 2016, I can’t go crazy with the dividend growth rates. I decided to stick to 3% going forward. I also used a 10% discount model mainly because GM could fact many headwinds going forward.

Final Thought

I don’t think GM shares will fall by 40% this year. However, the DDM calculations show me there is no deal in buying GM today. That’s too bad because I like that the company is going toward electric cars. I really hope they succeed as a consumer, but I’ll pass as an investor.

Disclaimer: I do not hold GM in my DividendStocksRock portfolios.