2023-03-26 03:07:22 ET
Summary
- Returns remain superior, with 29% ROCE generated in H1 FY 2022/23, and returns to shareholders reaching 38 billion US dollars over the past 3 years.
- The spinoff and merger of the petroleum business is logical and came at the right time.
- Valuation and dividend yield are attractive, and likely to remain so.
- Long-term economic trends will support metal prices, while strong reserves and continuous investment support volume growth.
Resilient Commodity Prices Combined with Production Growth Underpin Sustainable Shareholder Returns
Investors in BHP ( OTCPK:BHPLF ) have had it good all the way for many years now. Every time one crisis happens, another anti-crisis happens to keep commodity prices supported – and the cash gushing into BHP’s coffers. Take last year; the combo of inflation, interest rate rises, the war in Ukraine and prospects of recession have initially given a hit to commodity prices, and to commodity-linked stocks. Not for long. After a brief, steep dip in prices last year, recovery has been as fast and as steep. In May 2021, iron ore reached a peak of USD 215 per tonne and copper reached USD 4.7 per pound. All of them took a nosedive a few months later, with iron ore dropping by 60% to a bottom of USD 86 per tonne in November 2022, while copper dropped by a third to USD 3.4 per tonne in September 2022. And then the rollercoaster swung again, raising iron ore price by 55% since it’s the bottom of last November, while copper is up by 30% since September. Coal, which has been in the doghouse for years, has witnessed a tenfold multiplication its market price from October 2020 to September 2022. This has been reflected in bumper profitability reaped by BHP in coal last year. Coal is trading today at half the September peak, but still four times the levels of two years ago.
While it is easy to explain the recovery in coal prices; the exponential multiplication of natural gas prices due to the cut-off of Russian supplies, the explanation of the rebound in other metal prices is less obvious. As I noted in my article on Rio Tinto, published on 31 January 2023; the impressive rebound in iron ore prices has been explained by robust demand, strengthened by resilient Western economies, and re-opening of China’s economy after the relaxation of Covid-related lockdowns. BHP noted in the Operational Review of Half Year ending 31 December 2022 that “ BHP believes China will be a stabilizing force when it comes to commodity demand in the 2023 calendar year, with OECD nations experiencing economic headwinds. China’s pro-growth policies, including in the property sector, and an easing of COVID-19 restrictions are expected to support progressive improvement from the difficult economic conditions of the first half. China is expected to achieve its fifth straight year of over 1 billion tonnes of steel production .”
Supply, on the other hand, has been restrained due to various reasons, including bad weather in Australia and Brazil, and maintenance closures in Australia. The COVID-era slowdown in investments by mining groups is also still creating tightness in supply. Copper’s price is being propped up by similar factors, with civil unrest in Peru, the world’s second-largest producer, restricting production at the massive Antapaccay mine, while Chile, the world’s largest producer, predicting a shrinkage in production this year.
Long term trends are fully supportive of sustainable growth in demand for the commodities that BHP mines and sells. Global population will keep growing, economies will keep growing, industrialization and urbanization continue to grow heavily, and the shift to renewable energy and electrification is accelerating at an exponential rate. At the same time, supplies of metals are not expected to get better; there are limited volumes of metal in the ground, and a handful of groups in the world have sufficient financial muscle and expertise to extract it at an economic rate. Put all these factors together, and it is crystal clear that prices of industrial metals should be heading in one direction over the long.
Diversified portfolio provides a hedge
While average prices of copper and iron ore dropped by 19% and 25%, respectively, between H1 2021 and H1 2022/23 (ending December 22), nickel prices grew by 24%, metallurgical coal by 3%, and thermal coal by a whopping 157%. BHP increased production volumes of all major products during H1 2022/23, with the production of copper and of iron ore increasing by 3%, metallurgical coal increasing by 4% and energy coal by 9%. In the full year ending 30 June 2022, BHP achieved USD 8.7 billion of profits from the coal division, versus USD 0.5 billion of losses in the previous year. Bumper profits from coal have continued in H1 2022/23.
The major potash project that BHP is developing in Canada would be expected to add another angle of welcome diversification to BHP’s portfolio. Potash is used mainly as a fertilizer for agriculture, but has various other uses in industrial chemicals, glass manufacturing, food manufacturing, soap making, etc. The company is also upping its investments in copper and nickel – all forward-looking commodities with exponentially increasing demand, linked to electrification and renewable energy production.
Returns and profitability remain superior, strategic decisions sound
In the full year ending June 2022 , BHP achieved a return on capital of almost 50% (48.7% to be exact) This dropped to 29.4% in H1 2022/23, but is still quite robust. This compared to 33% in the previous full year, and double the 24% achieved in 2020/21. The EBITDA achieved of USD 41 billion was beyond belief – USD 13 billion achieved in H1 2022/23 still provides a bright outlook. Underlying EPS in H1 2022/23 was 130 cents, comparable to H1 2020/21. The company realized a net cash position of USD 23 billion in full year 2021/22, and distributed dividends of USD 16.5 billion, following a 26% increase in profits versus the previous year. Total shareholder returns were close to USD 36 billion – around 25% of the company’s market cap. The effective spin-off of the oil and gas division seemed sensible and well-timed; coming at a time when oil and natural gas prices were hovering around record highs, and just before they nose dived in the past months. The long-term fortunes of metals are likely to be much brighter than the less popular environmentally popular business of fossil fuels – another reason why it makes good sense for BHP to focus on metals.
BHP generates superior profitability from its three main categories; iron, copper and metallurgical coal represent 95% of group EBITDA. Iron remains the largest contributor to EBITDA, contributing 50% of group EBITDA in the full year ending June 2022 and 56% in H1 2022/23 – though well below the 60% share in the six months ending 31 December 2021. It also leads in the highest EBITDA margin category, with a margin of 71% in full year 2022/23 and 65% in H1 2022/23. Copper follows with 22% of group EBITDA, and a margin of 44%. Coal stepped up its contribution, providing the third-largest share of EBITDA after iron ore, with a 20% share and an EBITDA margin of around 50% – versus a 12% share in the six-month ending 30 December 2021. A total EBITDA margin of 54% is close to double than the EBITDA margin generated by big tech cash machines Alphabet and Apple – both companies generate an EBITDA margin in the range of 35%.
A dividend yield of 9% is usually associated with distressed companies, and the lack of belief of investors that the dividend levels can be sustained. But BHP enjoys a superior credit rating of A by Standard and Poor's, and generates amble cashflows that enable it to continue fast-paced investments while maintaining superior returns to shareholders.
Valuation attractive, and provides a margin of safety
BHP trades at a P/E of 8x, and are 21% off their highs reach only two months ago. This is despite metal prices today being around the same levels of two months ago. BHP traded a year ago at a P/E as high as 29x, and has been trading above today's P/E levels for most of the past five years. The market price of BHP's main products has jumped through the roof over the past three months. Over the past year, iron ore price increased by 35%, nickel spiked by 150% (before settling to only 40% increase), and Brent oil jumped by 70%. The share price of BHP, in the meantime, is off by 21% – as investors are rightly cautious about paying too much for probably a temporary super hike in market prices. Investors are right to be cautious, and they maintain a good margin of safety to cushion possible drops in market prices of iron, copper, and other metals that BHP sells.
Assuming EPS goes back to the lowest level of the past four years of 170 US cents, registered in FY 2019; P/E would still be a reasonable 15.9x. For a dividend yield of 9%, there is a reasonable margin of safety for investors chipping in today – although a more cautious approach would be waiting for a further discount, given the overall bearish market and global economic outlook.
Risks mainly related to timing of entry and commodity volatility
Commodity investments are not for the faint-hearted – but so aren’t stock investments overall. As with any investment in stocks; timing is a key factor in determining long-term returns. With commodity prices being in general so volatile, and mining stocks being as volatile, investors do not want to get the timing of entry wildly wrong. A good strategy with investors keen to have exposure to commodity stocks is to tip toe when metal prices are hit – rather than to go all in when prices are spiking.
Environmental and social risks related to the mining industry would remain, along with increased related costs. But that has not deterred fossil fuel companies from continuing to print money at enormous rates, and given the cash printing machines that BHP has; the company can easily absorb increased environmental costs.
BHP has been for years the gem of the mining and metals industry. Global long-term economic trends, in addition to the current tailwinds for commodity prices, will keep BHP as a leading attraction to investors for years to come.
For further details see:
BHP: No End In Sight For The Good Times