Tuesday, August 13, 2013

Will This Mining Giant Abandon Its Only Remaining Mega Project?

Mining giant BHP Billiton (ADR) (NYSE: BHP) is getting ready to make one of its most difficult decisions; whether or not to pull the plug on its $14-billion Jansen potash project located in Canada. In fact, this is the company’s only remaining mega-project that hasn’t been scrapped.
Potash woes
With each passing day, the massive project in the Saskatchewan province is looking less and less lucrative. In the sluggish economic environment, the company’s investors were already unwilling to commit to large projects with enormous capital requirements. Then there was the oversupply in the potash market, which made it even more unattractive.

To make matters much worse, the Russian potash behemoth Uralkali has pulled out from its venture with Belarussian potash producer Belaruskali, and now the prices of the crop nutrient are expected to plummet by 25%, sending them back to early-2010 levels.

Jansen is a big and a lucrative project that could produce 8 million tons of potash every year; that is equivalent to 15% of the global supply in 2012. Moreover, BHP would be producing its output at considerably lower costs, which could give the company a huge advantage in this competitive market. However, there is just too much uncertainty in this market at the moment, and unlike PotashCorp (NYSE: POT) and Mosaic (NYSE: MOS), BHP Billiton is not an established player in this arena.
While the Russian cartel has broken up, the North American cartel comprised of PotashCorp, Mosaic and Agrium isn’t going anywhere simply due to the economies of scale that have been coming from the combined efforts of the three firms.
Plummeting shares
With the fall in prices, Mosaic’s earnings could take a serious hit. If potash prices actually do fall by about 25% to nearly $300 per ton, then Mosaic’s estimated earnings could drop by as much as 29%. But analysts believe that such a drop could be a worst-case scenario and a ~20% drop is more likely.
The same is true for PotashCorp. The two have significant exposure to potash, and a drop in prices would lead to a drop in earnings in the near term. Therefore, the market’s reaction to the news, more than a 17% drop in the shares of Mosaic and PotashCorp, was justified.
PotashCorp has reasonable debt levels and has, over the years, earned healthy profit margins. In the last five years, its net profit margin has averaged 31%, ahead of industry’s margin of 18% in the corresponding period. The recent drop has made both PotashCorp and Mosaic relatively cheaper as both of them are trading at lower multiples to their earnings as compared to the industry’s price-to-earnings-ratio. PotashCorp and Mosaic’s price-to-earnings ratios are 11.2 and 9.3, respectively, below the industry’s average of 19.6.
At these price levels, PotashCorp and Mosaic are looking attractive for a long-term play because the global demand of potash will only go higher. With the increase in population, the demand for food and hence the demand for higher-yield crops will increase, which will translate into years of healthy demand for fertilizer and crop nutrients. Therefore, I am long-term bullish on PotashCorp and Mosaic.
A tough call
BHP Billiton’s current financial position is far from stellar. The company’s current ratio is 1.1, far below the industry’s average of 3.8. Its long-term debt-to-equity ratio is 47.6, much worse than the industry’s average of 15.3. The company’s cash reserves have also fallen significantly from $11.6 billion in mid-2009 to $5.3 billion by the end of 2012.
During this period, its total long-term debt has ballooned from $15.3 billion to $31.8 billion. On a trailing-12 month basis, BHP has leveraged free cash flow of negative $7.0 billion. It simply doesn’t have the financial muscle that it had a couple of years ago. If it abandons the project now, then it would be taking a popular decision, which could cause its shares to rally.
But what makes it a tough decision is that BHP has already spent $2 billion on it and has touted Jansen as a potential “fifth pillar” of the organization besides iron-ore, copper, coal and petroleum. Moreover, the management is also pro-potash. The new CEO Andrew Mackenzie has been one of the driving forces behind the company’s move towards potash and its unsuccessful hostile bid for PotashCorp in 2010.
Conclusion: So what is going to happen?
I believe that BHP Billiton is not going to abandon the project but will delay it until the pricing environment improves. The company won't be overly worried about the expected drop in potash prices since, currently, it is not exposed to the commodity. Moreover, the prices could very well recover by 2017 – that is the time when Jansen will start producing its output. BHP Billiton has time on its side and it will wait until it starts seeing signs of improvement.
The math for this is simple. Based on Citi and Deutsche Bank analyst estimates, with the long-term potash price close to $300 per ton, BHP is better off abandoning the project. But if prices average out at around $500 per ton, then it should stick with it despite all of the shareholder criticism. 
The Jansen project has highlighted the uncertainty surrounding the mining stocks. Some of the leading miners such as BHP Billiton, Rio Tinto and Vale have struggled after the end of the China-growth story. BHP Billiton’s stock has dropped by 18.4% this year, and has actually outperformed Rio Tinto and Vale, which says a lot. And it is still not cheap. BHP Billiton’s shares are trading at 17.4 times its earnings, which is above the industry’s average of 14.3 times.
I believe that it hasn’t bottomed out yet. With falling revenue and income, increasing debt and negative free cash flow, investors are advised to stay on the sidelines with BHP Billiton until the Chinese economy picks up. 

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Disclosure: I, Sarfaraz A. Khan, have no position in any stocks mentioned and no plans to initiate any within the next 72 hours of this publication. I have no business relationship with any company mentioned in this article.

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