BHP Billiton Ironing Wrinkles

BHP Billiton, Ltd. (BHP - Analyst Report) is the world's largest diversified resource company with operations in 25 countries. Notwithstanding the associated anti-trust issues, we believe a potential merger between BHP and Rio Tinto (RTP - Analyst Report) can deliver synergy benefits and offset rising operating costs, which have been trending upwards.

In addition, the merged company would become the world's largest producer of copper and aluminum and the second-largest provider of iron ore. Nonetheless, given that Rio Tinto rejected the terms of the original proposal, the deal seems far from certain. Moreover, fear of a global economic slowdown leads us to maintain a cautious outlook on the stock. We retain our Hold recommendation on the shares of BHP.

BHP Billiton is well positioned to benefit from continuing strong demand primarily from China and the broader Asian region for commodities such as copper, iron ore, and nickel and continuous supply constraints of most metals. These factors are likely to keep prices at elevated levels.

Further, BHP has a strong balance sheet with healthy cash generation and low debt level (current net debt-to-capitalization ratio of 17.8%). The company generated net operating cash flow of $18.2 billion during FY08, up 13.8% year-over-year. Healthy cash generation will enable BHP to successfully invest in its growth projects.

Currently, the stock is trading at 8.8x our FY09 earnings estimate of $6.39 per ADR. We do not expect a significant expansion in P/E multiple at this time. Our target price of $57.75 is based on a P/E of around 9.0x our FY09 earnings estimate of $6.39 per ADR.

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