BHP Billiton - Issues on Stocks, Investments and Earnings

Invast Insights

Week Commencing February 24, 2014

www.invast.com.au | 1800 468 278

This week we look at the following topics:

1.0 Why BHP’s result is a turning point

2.0 Aussie set for a bull market run

3.0 Gold risk/reward levels

4.0 AUD/NZD the start of a major reversal?



1.0 Why BHP’s result is a turning point

BHP Billiton is the largest stock on the Australian market and by a large factor.

It's been a tough few years for the mining giant, lower commodity prices and

legacy issues from cost blowouts have hurt earnings. Investors have also been

on the cautious side due to Chinese manufacturing numbers tending to print

lower. But last week’s numbers we believe will be a turning point for the stock.

Underlying earnings beat expectations by around 10% and the group is now

starting to create some large shareholder value.

For us, the most important takeout from

the result release is that BHP have

booked underlying returns on capital in

the order of 22%. The company’s cost of

capital is in the low teens, so that

returns on capital are almost double the

cost of capital. This is what creates

shareholder and leads to higher

dividends in the future.


The 22% return on capital excludes investments on new projects which

haven’t yet gone into production, so there is some work still to do. BHP has

listened to what the market wants. Prudent capital management, no more

lavish acquisitions or growth at any cost. This report card is the first sign that

this feedback working.

BHP’s earnings are derived from two main sources, petroleum and iron ore.

There’s no point in spending too much time on iron ore. Our focus is more on

what BHP has reported and what this means for the average investor. Read on

below and we will tell you what we think. Back to the result, Iron ore prices

will continue to hold in the order of US$120 per tonne over the next five years

and that is good enough for BHP to generate an excellent return on capital. If

energy prices continue to hold solid, with Brent now at around US$110 per

barrel, BHP has one of the most attractive global energy portfolios to benefit.

We think the Board and management feel more comfortable with the

petroleum assets this time around relative to other result releases.


So where does BHP make its money? The chart below explains everything

beautifully. Underlying EBIT is basically the most important earnings number

and tells the whole story, the second column from the left.


Image: Breakdown of BHP’s operating divisions released to ASX on 18 February 2014


Bottom line: BHP feels much more comfortable going into 2014, knowing it

has one of the best global portfolios and costs now under control. It’s all well

to grow your earnings but at the end of the day what matters is the rate of

return on investment. BHP has learnt an important lesson and we think the

results of better capital management will continue to flow through to

shareholders over the next decade. The stock will rally and could have a 5 in

front of it within twelve to eighteen months and we will take this opportunity

to start adding into our model portfolios. We plan to buy BHP in the Wealth

Preservation Portfolio next month.

Where to buy: In last week’s report, we wrote “Should report good numbers as

commodity prices rise and the currency moves around. Needs a good number

to breakout from here, long term buy regardless of the result” The good result

did see it breakout.


2.0 Aussie set for a bull market run

When the largest stock in the market breaks through resistance, the rest of

the market usually follows. We’re taking a more positive view on the Aussie

200 index and while there might be some resistance at current levels,

potentially a small downward leg, the market should start trending higher for

what we think is the next phase of a major bull market run. There are many

reasons to sit on the sideline and remain cautious about the Australian

market but there are equally more reasons to start taking a bullish view. Some

of these are summarised below:

1. Record low interest rates are starting to feed through the corporate world

and a major feature of this reporting season has been the absence of large

interest charges or balance sheet issues. Most large Australian companies

have recapitalised their balance sheets over the past few years and exploited

cheap debt, not just in Australia but globally. The impact of the RBA’s interest


rate cuts are still yet to have their full impact, monetary policy usually has a

lagging effect of around 12-18 months.

Even though there is large anecdotal evidence that the broader Australian

economy is struggling, the stock market usually front runs the economy by

around six months. The impact of cheap money in Australia is already starting

to have an impact on higher inflation, something the RBA has warned. Rising

price pressures will feed through into the stock market. Higher inflation for

example is positive for retailers like Woolworths when the average price of a

basket of goods and services rise. This means higher earnings growth and

when interest rates are low, investors chase yield driving stock prices even

higher. Don’t confuse the economy with the stock market.

2. Resources are a major part of the broader market and resource stocks have

been in a slumber for at least two years. We’re starting to see the very early

signs of a recovery here. BHP Biliton is one obvious example but results have

also been better than expected for stocks like Rio Tinto and Fortescue Metals


– both key index constituents. Even stocks like Newcrest Mining which have had a horrible past few years have bounced strongly off their lows. Newcrest was large trading at around $11.15 as of the time of writing compared to its recent low of $6.96.

The first stage of a mining recovery is stabilising commodity prices. Iron ore is currently stable at around US$120-125 per tonne and this is the most statistically significant bulk commodity for the Australian market. Other commodities are important but they don’t represent a large part of the index. Panoramic Resources for example is a key nickel miner but it is statistically insignificant to the broader market and so what happens in nickel does not really dictate what happens to the broader Australian stock market. As commodity prices recover, mining companies start to report improving numbers.

The next phase usually sees mining companies tapping the market for cash through capital raisings. We think this will be a prominent theme over the next six months. Western Areas is a perfect example of this – announcing a large capital raising last week. Investment bankers and brokers will be


licking their lips at the prospect of more deals coming to market. When

companies raise money, they start spending on growth which is positive for

the mining services stocks. Drilling, bulk handling, front end engineering and

eventually construction and procurement are all set to grow in 2015 and

beyond. We think the mining stocks are all in the very early stages of the next

uptrend.

3. We’re noticing more talk of large IPOs and deals coming to the market.

While this is still largely an anecdote, sentiment can change quickly. The

successful IPO of Dick Smith, Veda and Nine Entertainment Group late last

year have no doubt encouraged plenty of other vendors who have been

eyeing the IPO market. The Australian government is also contemplating

privatising key assets as it needs the cash to balance its fiscal situation –

Medibank private and potentially Australia Post are the most obvious

candidates. Deal flow is positive for the market, it brings with it liquidity and

interest from a whole range of other investors. It also creates new benchmarks

for valuation and could see existing listed companies rise as comparable

valuations flow through the market.


The three points above are all small positives in isolation but when taken

together they become key drivers of a major upward trend in markets. Your

authors have seen similar market trends emerging and develop. Usually when

the newspaper headlines spell doom and gloom it is a good trigger to buy.

Newspapers are currently running front page stories about huge job losses in

the Australian economy, spiralling unemployment and the demise of local

industries. This is a major contrarian signal. It’s time to start turning bullish

when the newspapers are negative and as the stock market usually front runs

the economy and it’s time to start buying the Aussie market.

We believe Invast clients have two options – either buy direct shares with the

guidance of our monthly model portfolios or alternatively take a Long

Position in the Aussie 200 index which we provide via our MT4 platform.

Below is a monthly chart of this index position with our key technical levels

via Invast MT4.



The Aussie 200 index is trading above the Ichimoku cloud with solid support

at around the 5000 level (4996 to be precise). We doubt that this level will be

tested again in the near term but it might be a good level for a deep stop loss.

There is some obvious resistance at around the 5400 level which is where we

are at as of the time of writing, we expect this to remain so for the coming

weeks. If we can nudge above this level and form some solid support, the next

upward leg could see a major rally towards 6053 or thereabouts. The jury is

split among the Invast trading desk in Sydney – the technicals don’t

necessarily show major bullishness but our fundamental views should not be

completely discarded because of this. The bulls among the analyst team are

winning the argument for the time being. We believe long the Aussie market

with the key levels above in mind, also make sure you visit Invast’s daily

technical analysis by Vito Henjoto to keep your positions updated.

3.0 Gold risk/reward levels

We have had a flood of client interest in the gold price in recent days and so


have adjusted our levels accordingly. The recent move above US$1300/oz has

come as the Federal Reserve continues to taper but US data equally printing

lower than expectations – setting off an argument that perhaps cheap money

will be around for a bit longer than expected and with inflation rising, gold

stands to remain a major beneficiary. The recent rally might have been

enough to break the recent downward trend, we did talk about a floor price

at around the US$1100/oz level prior to the New Year. For those that missed

this, click on the video to the left to hear our interview with Bloomberg

calling for this floor price when many were expecting gold to slip below

US$100/oz.

Our key technical levels on gold for this week are as follows:

• We could see a technical pullback to the US$1296/oz level where there will

be a test for support.

• Failure to find support here might see gold come back further and test

support at US$1274/oz which is the 38.2% Fibonacci level and also the


level which meets the Ichimoku cloud. This is be an important test, previously

a level of resistance which could become major support.

Watch full video here: http://www.bloomberg.com/video/gold-floor-seen-at-1-000-1-100-an-ounce-esho-RR6OExvEQS2e8Qt6TJmUvg.html

http://www.bloomberg.com/video/gold-floor-seen-at-1-000-1-100-an-ounce-esho-RR6OExvEQS2e8Qt6TJmUvg.html
























• Upside resistance from here is next at around US$1332/oz, the level hit last

week. If we see a convincing break above here then gold can continue to

rise much higher. It will be important to keep an eye on rising volatility

from emerging markets – Turkey, Ukraine etc and volatility on the S&P500.


Image: Daily gold price chart via Invast MT4 as of 20 February 2014


4.0 AUD/NZD the start of a major reversal?

In keeping with the bullish theme of this week’s report we thought it

worthwhile touching on the Australian dollar (Aussie) relative to the New

Zealand dollar (Kiwi) and the start of what might potentially be a very

significant reversal. The one thing we have seen in Australia over the past two

years is the impact of a high currency.

The Australian economy is still

feeling the impact of the Aussie

rising above parity against the

US dollar. The interest rate

differential has the potential to

prop up a currency in the short

term but eventually a high

currency curbs growth and then

monetary policy must step in.

We are seeing this in Australia


and we could potentially start seeing this in New Zealand over the next few

years.

Reserve Bank of New Zealand Governor Graeme Wheeler last month said

“Most of our economic indicators are positive; with the terms of trade at a 40-

year high, business confidence is the strongest since 1993, and consumer

confidence is at a seven-year peak” “Growth has been driven by expansionary

monetary policy; high export prices for our major commodities; strong

construction investment, particularly in Canterbury; and the increase in

private consumption,” Mr Wheeler said. “The high exchange rate has been a

headwind. The Bank would like to see a lower exchange rate and does not

believe the exchange rate is sustainable in the long run.”

New Zealand’s overnight cash rate is in line with that of Australia at 2.50% but

the central bank has been hawkish as inflation starts to rise. This has seen

traders backing the Kiwi in anticipation of sooner interest rate rises relative to

the Aussie. New Zealand’s economic growth composition at the moment


is very different to that of Australia. The devastating Christchurch earthquake

is seeing large investment into rebuilding which Australia obviously doesn’t

have. This is largely rebuilding what was lost and so the rate of growth is

purely playing catch up. Australia’s growth is undergoing a slow patch as

mining investment ramps down from record high levels. It’s not just the level

of GDP that matters, it’s the quality and composition over the long term.

For that reason, we think the Aussie dollar is destined to turn a corner against

the Kiwi as the short term market drivers phase out over the next few years.

We think the Aussie dollar is going back towards its long term average

against the Kiwi somewhere in the order of A$/NZ$1.20 range from around

A$/NZ$1.08 currently. This represents a return of about 11% when excluding

any benefits from leverage which will obviously compound the return.

In the spirit of patriotism, we recommend backing the Aussie at this crucial

period of time, particularly against our Trans-Tasman cousins and arch rivals.

Key levels are as follows:


• There is solid support at around the A$/NZ$1.0750 on level so this is

where we would be positioning our short term stop loss level.

• Key short term targets for our long position are A$/NZ$1.1035 which is the

50% Fibonacci level from last month’s low and then A$/NZ$1.1640 which is

the 61.8% from this level.

• We see a strong potential bottom at A$/NZ$1.04912 which is a historically

very low level. If our stop loss is triggered and we so see this level being

hit again we would use it as another opportunity to re-enter the position.


Image: AUD/NZD daily price chart via Invast MT4 platform

To read more about these topics, stop by our blog.

http://blog.invast.com.au/


7.0 Disclaimer

Please note that you are receiving this report complimentary from Invast Financial Services Pty Ltd (AFSL 438 283). Invast staff members may from time to time purchase securities which are included in this or future reports. The authors of this report may or may not be holding a position in the securities mentioned. Please note that the information contained in this report and Invast's website is of a general nature only, and does not take into account your personal circumstances, financial situation or needs. You are strongly recommended to seek professional advice before opening an account with us.

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BHP Billiton - Issues on Stocks, Investments and Earnings