capital spending and the business cycle: BHP as an illustration

BHP’s fiscal 2012 earnings report

When BHP Billiton made its full (fiscal) year earnings announcement, it indicated that it is rethinking its planned $20 billion expansion of the Olympic Dam copper/uranium mining project.  It hopes to restructure the expansion in a way that costs less.  The company also recorded $3.5 billion in asset writedowns (“impairment charges”) for the year, the largest being a $2.8 billion reduction in the value of its US shale gas assets.

some perspective

To put these items in perspective, even after the writedowns BHP still made $15.4 billion for the twelve months and had operating cash flow of $24.4 billion.  So, for BHP the announcements aren’t a big deal.  But they do provide the occasion for making several important points about corporate behavior.

1.  Companies rarely outspend their cash flow, no matter what they may say to the contrary.  And if they do borrow to fund capital projects, it’s almost always just after the bottom of the economic cycle, when evidence is accumulating that business is past the lows and is accelerating.  Otherwise, if a firm sees that its projected cash flow over the coming year–sometimes longer–is going to be less than previously thought, it cuts the capital budget.  That’s what’s happening here.

Borrowing to fund capital expenditure adds an additional element of risk because the assets developed are long-term and illiquid, not stuff companies want to stock up on when the future is iffy.

2.  Cash flow isn’t always as available as it might seem.  Companies often have principal repayments on debt.  They can also have mandatory progress payments on capital projects already contracted for.  They pay dividends.  They may need to finance working capital–meaning they need money to buy raw materials, pay workers and offer trade credit to customers.  And (in BHP’s case a minor point, but not always) they may be “capitalizing” interest payments for ongoing projects (BHP capitalized $314 million of interest in fiscal 2012).  Capitalizing means the interest payments are parked on the balance sheet until the associated project is complete.  The money is paid to the creditors, but doesn’t appear as an expense on the income statement.

All this means a large chunk of cash flow is already spoken for each year.  Under normal circumstances, the easiest item to shrink is capital spending on new projects.

3.  Asset writedowns are a form of corporate housekeeping.  Many times–like this one, in my opinion–they occur when earnings aren’t so stellar anyway.  The idea is that more bad news doesn’t stand out so much.  That’s not the whole story, though.

Take the $2.8 billion writedown of shale gas assets.

Taken literally, the asset reduction means that BHP no longer believes the holdings are worth the amount it has invested in them.  They’re actually worth $2.8 billion less.  Conceptually, the firm is required to make the writedown once it becomes convinced this is the case.  Practically speaking, companies have a lot of wiggle room to use to avoid doing so.

Suppose it’s right that BHP has lost $2.8 billion through investing in shale gas.  It has two choices:

–it can either reduced the carrying value of the assets now, to the point where it can maybe make a slim profit in the future–and do so at a time when the business is slack and investors don’t really care, or

–it can keep the $2.8 billion loss on the balance sheet and show it little by little as gas is brought to the surface and sold.  Losses would continue for the life of the operations, until the entire $2.8 billion flows through the income statement.  Most of the red ink would presumably occur during better economic times, when investors are more eager to see earnings gains and would respond more negatively to the losses.

In other words, BHP is (prudently) wiping the slate clean while no one is looking.  In the non-commonsensical way that professional investors think, the writeoff is the mark of a good company.

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