Expansion Moves that are Good for Long-Term Investors
Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
BHP Billiton (NYSE: BHP) is moving to leverage its profits by expanding its operations and reserves in Australia. The press is reporting that Billiton has filed paperwork seeking an environmental review of the planned expansion of its iron mines in the Pilbara region.
This move indicates that the miner has reversed course. In May, the company’s chairman, Jacques Nasser, told reporters that Billiton was suspending $80 billion worth of expansion plans that included the Pilbara iron mines and the building of a new open pit mine at the Olympic Dam uranium copper mine in Australia. At the time, Nasser said the prices of the commodities didn’t justify the company’s expansion plan.
Yet press reports now indicate that Billiton is intent on increasing iron production in Pilbara to 350 million tons a year by 2014. Increasing production to that level would cost around $20 billion. Most of the money would go for harbor improvements, which would make it easier to ship iron from Pilbara to China. The plan submitted also outlined proposals for new mines and rail lines to reach them. Interestingly enough, BHP Billiton is also thinking of raising the overall production in Pilbara to 450 million tons a year at some point.
This action seems to indicate that Billiton may have more leveraged profits than its management previously thought or admitted. One strong possibility is that commodities prices are higher than the management’s projections. Another is that increased prices for some commodities such as gold could be offsetting lower prices in other areas.
Hording of Resources
The International Business Times newspaper speculated that BHP Billiton’s actions constituted the hoarding of resources. It speculated that the company is staking out claims to Australian resources in order to keep competitors such as Rio Tinto (NYSE: RIO) and Vale (NYSE: VALE) from developing them.
Billiton is increasing iron ore production at a time when economic growth in the biggest market for that product, China, is decreasing. So there are some potential risks to this strategy. Reuters reported that Chinese economic growth has slowed for six quarters in a row.
To make matters worse, there is no indication that trend will be reversing any time soon. The best news economists interviewed by Reuters could give is that Chinese growth should stabilize in the next quarter. Such pronouncements do not seem to indicate any sort of increased demand for iron and other raw materials in China.
A Good Long-Term Play
The company is laying the groundwork to greatly increase its iron ore and copper production if and when the Chinese economy recovers. If a Chinese recovery occurs when those new mines go online, Billiton will be in a position to generate a lot more cash.
The Billiton expansion can be viewed as a means of leveraging profit. The company is using its present resources to increase profit potential in the future.
It will also have secured those resources against competitors such as Fortescue Metals Group (FSUMF), which have been ramping up their operations in the same area. Both Fortsecue and Rio Tinto have been expanding aggressively in Western Australia in recent years. Billiton is taking the steps necessary to secure its position.
That makes Billiton a good long-term buy and hold play because it is trying to increase its long-term value. Any gains from this expansion are years away, but potential losses could hit the balance sheet as early as next year. That means Billiton is increasing its risks with additional investment at a time when a return is not guaranteed.
Another advantage this kind of expansion provides for investment is that it does increase the assets available to Billiton. The company will have more mineral reserves, so it won’t have to invest money to buy more reserves or expand in the future. Since the cost of mining and developing new mines is expected to increase in the future, you can make the case that investing in infrastructure today will cut costs in the future.
Part of the reason why Billiton is a good risk is that it has demonstrated an ability to increase production with additional expenses. Billiton’s copper production has increased to 312,500 tons a year according to Bloomberg. That figure is 15% above the forecasts made by analysts.
Billiton has also been able to increase its iron ore production by 15% a Bloomberg article indicates. That alone presents a potentially high level of leveraged profits. The company was able to produce 40.9 million metric tons of iron in April, May and June of 2012. That is 5.4 million tons more than the same period last year when Billiton dug 35.5 million tons of iron ore. This figure also exceeded analysts’ predictions for the company’s copper production. 2011 is the 12th year in a row that Billiton’s iron production has increased.
It would also give Billiton an edge over one of its biggest competitors in iron, Vale, because most of Vale’s mines are in Brazil, which is twice as far from China as Australia. That will give Billiton lower transportation costs which will make its iron ore more competitive. It wouldn’t give Billiton much of an edge over Rio Tinto which mines most of its iron in Australia just like Billiton does.
Future Costs and Future Risks
Investment today will not necessarily lower future costs. Even though expansion today can eliminate future construction or expansion costs, it won’t affect other costs, such as energy and labor. So any money Billiton saves by expanding mines right now might be eaten up by rising costs in other areas in the future.
That means Billiton is a buy and hold play, but there are still some pretty high risks that are associated with it. Those risks are the spending on expansion and the possibility of lower commodities prices. Unfortunately, commodities prices seem to be falling right now.
Billiton stock could take a real hit in the next few months and years because commodities prices are the first to fall in a downturn. Billiton’s stock price could be hurt if investors think that it is expanding production and costs at a time when prices for its products are falling.
That means the next few years could be rough on Billiton shareholders. The company’s profits could be down substantially at a time when its costs are going up because of increased production. Some experts think that a recession, which will hurt miners like Billiton, has already begun. The recession will hurt miners because it will drive down the prices of commodities.
A Real Gamble
By concentrating on its core iron ore business, Billiton is showing that is willing to defend its market share. It is also trying to protect itself from the expansion at its biggest competitor, Rio Tinto. Like Billiton, Rio has been increasing its capacity even as the market seems to contract.
Yet the expansion gives Billiton an edge over Rio Tinto because it is expanding production at a time when Rio’s is falling. Rio Tinto’s Australian iron production is actually slightly lower than it was last year. Billiton has demonstrated an ability to increase its production when one of its key rivals hasn’t. That means Billiton seems to be the iron producer best situated for growth. It also shows that Rio Tinto hasn’t been able to translate its expansion into increased market share but Billiton has.
My prediction: Billiton’s shares will remain steady for the foreseeable future, despite the talk of recession and expansion. Investors will wait to see whether the demand for all that extra iron ore it plans to dig is there. Then they will move on this stock.
Even with the risks it’s taking in Pilbara and at Olympic Dam, Billiton is still a good stock to hold long-term. The investments the company is making right now may lead to big profits in the future.
jordobivona has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.