By Paul Rickard

The announcement by BHP that it was booking an impairment of US$9.7bn (US$7.6bn after tax) with its annual results was yet another reminder of the “Big Australian’s” atrocious track record in acquisitions. US$7.2bn of this impairment was to write down the value of its onshore US oil assets, and followed US$2.8bn the previous year. More than US$20bn was spent buying shale oil and gas interests in the US at the peak of the boom in 2011, and a large chunk of this has now been written off.

Then there is the failed US$43bn offer to take over Potash Corporation in 2010, the purchase of the Biliton assets, and the US$2.6bn that is being invested in the Jansen potash field, the so-called“fifth pillar”.

Fortunately, acquisitions are currently off the agenda for BHP, and with cash flow generation starting to improve, let’s hope that the Board isn’t tempted to get the cheque book out again. In fact, Tuesday’s full-year results highlighted BHP’s tight focus on cost control, improving productivity, and measured capital investment.

BHP’s result

BHP reported marginally better than expected underlying earnings of US$1.22 bn. Down a massive 81% on the previous year, the second half was an improvement on the first half.

Reflecting the boom and bust in commodities, underlying EBITDA has declined from US$32.9bn in FY11 to just US$12.34bn in FY16.

On a segment basis, iron ore contributed 45.3% of Group EBITDA, up from 39.6% in 2015. Lower prices in particular impacted the petroleum division, while a decline in the ore grade from the Escondida mine reduced earnings from the copper division.

Share of Underlying EBITDA by Segment

On the productivity side, BHP said it achieved gains of US$437m during the period, placing it on track to deliver a total of US$2.2bn over the two years, with US$1.8bn expected in FY17. Unit costs to produce iron ore in WA declined from an average of US$18.65 in FY15 to US$15.06 in FY17, a fall of 19%. BHP says that it expects this to decline by a further 7% in FY17 to US$14 per tonne.

This compares favourably to RIO, which reduced its costs in the first half of 2016 to US$14.30 a tonne, down 13% on the corresponding period.

With free cashflow, BHP generated US$3.4bn in FY16. Free cash flow is the operating cash flow less capital spending, and can be used to pay dividends or reduce debt. It says that based on current spot prices, it is on track to deliver over US$7bn free cash in FY17.

For the second half, BHP declared a dividend of US 14c per share (approx. AUD 18.4c), which takes the full-year payout to US 30c per share. Both halves included an additional amount above BHP’s minimum payout, which is 50% of underlying profit in every period. In the second half, the additional amount was US 6c per share.

The market and the brokers

In response to the results on Tuesday night, BHP shares rallied by 3.26% or 66c yesterday, closing at a 2016 calendar high of $20.91. From a low of $14.06 in late January, the shares have rallied by 48.7%.

The major brokers were in the main positive about the result, citing the forecast improvement in free cash flow, reduced capital expenditure in FY17 and the work to reduce costs.

Guidance on 2017 production volumes was largely in accord with market expectations.

Like BHP, the brokers are somewhat cautious with their outlook for commodity prices. Most expect downside pressures for iron ore and coal, but have a more positive outlook for copper and oil and gas. These price forecasts have a huge impact on valuation, and according to data compiled by FNArena, the brokers see BHP as being close to fully valued. The consensus target price of the major brokers is now $21.57 - just 3.1% higher than Wednesday’s closing price.

Bottom line

BHP has got its house in order. Like RIO, it has a “back to basics approach” - improve productivity, reduce costs and allocate capital carefully. Cash flow is improving, and the balance sheet is sound.

Downside risks include Samarco, where it has already booked a pre-tax loss of US $2.45bn that includes a provision of US$ 1.2bn for future costs, and any rush of blood to bring out the cheque book and start buying assets.

It is also still largely a bet on commodity prices. While it is not as leveraged as Rio is to the strength of the Chinese economy and directly the iron ore price, if demand for steel making commodities softens, BHP will be hit.

As I can’t get too excited about commodity prices, I am with the brokers in thinking BHP is close to fully valued and it is no bargain. The patient, long-term investor will probably still be rewarded.