Shares in BHP Billiton (LSE: BLT) and Home Retail Group (LSE: HOME) have both fallen by around 50% this year.
Investing in either stock after such big falls may seem risky, but good turnaround plays are often uncomfortable buys.
In this article I’ll take a look at the pros and cons of investing in each company, and ask whether now is the time to buy.
BHP Billiton
BHP Billiton stock looks very cheap relative to its historic earnings. Even last year, when the mining downturn was already starting to bite, BHP managed underlying earnings of $1.20 per share. At today’s share price, this equates to a trailing P/E of just 9.
The problem is that earnings will be much lower this year, and probably next year too. However, commodity prices will eventually stabilise and start to rise. As this happens, BHP’s earnings will recover.
As investors, we need to decide how much BHP would need to earn to justify today’s share price. In my view, earnings of $1 per share would be enough as this would put the shares on a P/E of about 10 and support a dividend yield of perhaps 3.5%.
I think it’s likely that when the market for oil, copper and iron ore improves, BHPs earnings will rise to at least $1 per share, possibly much higher. On that basis, I think BHP is probably good value at around 700p, although further falls are still possible.
Home Retail Group
Home Retail Group owns Argos and the Homebase chain of DIY and homewares stores. Home also has its own finance business with assets valued at £589m and net cash of £193m. The finance assets are customer loans that could easily be sold and converted to cash if necessary.
Given that Home Retail’s market cap is currently only £745m, this means that the group is trading roughly in line with the value of its customer loan book and its net cash. Argos and Homebase are effectively being valued at zero.
Some of Home’s net cash will be used up this year in order to support the firm’s dividend and to fund Argos’s new same-day delivery service. However, Argos and Homebase generated a combined operating profit of more than £40m during the first half of the year, with combined sales of £2.6bn.
I think that two profitable retail businesses of this size should be worth a lot more than Home’s current valuation suggests.
It’s also worth noting that Home trades on just 9 times current year forecast earnings and offers a prospective dividend yield of 3.9%. This modest valuation and cash-backed income looks quite low-risk to me.
What if I’m wrong?
Of course, the reason Home and BHP have such depressed valuations is that they face a number of serious headwinds.
Commodity prices may continue to fall, depressing BHP’s earnings even further. If interest rates continue to rise, BHP could also face higher borrowing costs.
For Home Retail, the main challenges in my view revolve around the challenge of reinventing Argos as a successful digital retailer with a high street presence.
Management at BHP and Home Retail have a tough job ahead of them, but I don’t think it’s impossible. That’s why I own shares in both companies.
