2023-04-04 12:55:19 ET
Summary
- BHP Group Limited's recent drawdown presents a lucrative opportunity for investors seeking to lower their portfolio cost basis.
- The company is yet to realize the benefits of higher base metals prices. And as discussed in our previous articles, abated rainfall in Australia provides scope for production increases.
- Although the stock's price-to-book ratio is of concern, its other primary price multiples and dividend metrics are well situated.
- Do not overlook recent events; BHP's exploration pipeline and planned pivot out of coal might add volume to its stock's valuation.
- Strong Buy Assigned to BHP Group Limited.
BHP Group Limited's ( BHP ) stock is in a slight tizzy, given its near 5% month-over-month drawdown. However, it is time to remind ourselves that BHP is the kind of stock that investors usually utilize for dividend growth strategies or dollar cost averaging purposes. Therefore, we believe the asset's recent drawdown presents another lucrative buying opportunity.
Furthermore, as discussed in our previous analysis, BHP possesses various inflection points that are yet to be priced by the market, providing us with a valuable foundation to base our bullish thesis on.
Let us delve into a few of our latest findings on BHP.
BHP's Recent Performance – Explained
In our view, BHP stock has recently lost value due to headline events. Firstly, the company missed its H1 earnings target in February, revealing a 32% year-over-year decline in bottom-line earnings. Therefore, much of the stock's recent underperformance likely stems from investors' "flight to safety."
Furthermore, fears of a global banking crisis caused many cyclical stocks to shed value during the past month, with BHP being one of them. In addition, mining investors have favored gold assets instead of base metal and energy producers, leading to a selloff in BHP's stock price.
Lastly, many high-dividend-paying stocks often lose market value after their ex-dividend dates due to market participants' perception of a lower tangible book value tradeoff. Investors usually reinvest in a stock shortly after its post-dividend slump; however, due to the aforementioned reasons, many of BHP's investors seemingly chose to collect their dividends and run for the hills.
After its recent selloff, BHP's stock is trading at an RSI in the low 50s. A stock's RSI is a technical display of its value, and a mid-50s RSI for a stock like BHP can be considered low. The reason we think BHP's RSI should be higher is that investors are usually net long on the asset as a passive investment instead of considering it a zero-sum play.
After its most recent drawdown, the question becomes: What could change BHP stock's trajectory?
From an operational point of view, the company is likely to benefit from the sustained year-to-date uptick in base metal prices. Although the stock booked much of the mid-to-late 2022 base metal recovery scenario, we think a second wave is on its way.
Although mining stocks react to prospective material prices, they also react to coincidental prices as corporate profits tend to rise for a sustained period. Additionally, a copper shortage remains rife, and analysts (including ourselves) anticipate the supply side to play a critical role in sustaining higher copper prices. With both factors considered, we anticipate BHP to produce higher top-line revenue in the coming quarters.
Another factor that could soon tilt BHP's fortunes relates to Australia's improved weather outlook. The region experienced heavy rainfall in 2022, squandering its iron ore and coal projects, and a turnaround in 2023 could add to BHP's corporate profits.
- Sidenote: Click on this link for a detailed discussion about our outlook on BHP's mine-specific production outlook.
Furthermore, BHP might experience higher gross and operating profit margins due to softening input costs pertaining to fuel prices and wage inflation. Although OPEC has decided to cut production , oil prices remain well below their 2022 levels, lending BHP an opportunity to run at a lower cost per unit. Moreover, the wage demand cycle is on a downward trajectory as slower economic growth coupled with an inflationary inflection point has led to lower labor bargaining power, lending the argument that BHP's cost base will stop growing for the foreseeable future.
Lastly, as mentioned before, BHP's stock sold off sharply after its latest earnings release presenting its investors with an opportunity to reduce their cost basis. More than 50% of BHP's investors are institutional or state-owned corporations that generally follow passive investment strategies, thus, raising the argument that the stock is mean-reverting in the long run (meaning investors generally buy the dip).
Noteworthy Developments
In recent news, developments have occurred regarding the planned sale of BHP's Daunia and Blackwater coal mines. According to reports, New Hope is interested in buying both assets , which would assist BHP in achieving its long-term vision of divesting from fossil fuel activities.
In general, we see this as a positive bit of news. Although coal has provided BHP with lucrative profits over the years, risk premiums on the mines are set to surge in the coming years/decades due to political pressure against coal production. Therefore, offloading coal projects and deploying the cash toward a strategic metal such as Copper might yield benefits.
Furthermore, we would like to remind investors of BHP's greenfield pipeline, which includes lucrative projects such as Jansen Potash and Western Ridge Iron Ore. We covered Jansen in our previous article on BHP; however, Western Ridge is largely uncovered by analysts. The project is in its study phase and hosts an anticipated CapEx of A $500 million to A$1 billion . Details remain scarce; however, it is a project to look out for.
A final piece of news to take notice of is BHP's $400 million increase in extension costs relating to its Antamina mine in Peru. The company recently decided to extend the mine's life by eight years, and despite the increase in cost outlay, we see this extension as a positive move because Antamina is one of the most sought-after copper-zinc mines on the planet; the open-cast mine produced 468 000 ounces of Copper in 2022 alone and is a pivotal contributor to BHP's 53.42% EBITDA margin .
Valuation and Dividends
BHP's EV/EBITDA ratio of 5.33x is in undervalued territory, as it sits 9.69% below its cyclical average. The EV/EBITDA multiple provides a useful indicator of underlying performance as EBITDA is often considered a close substitute for operating cash flow, while EV (Enterprise Value) considers a company's capital structure. Moreover, unlike net income and EBIT, EBITDA phases out subjective depreciation policies.
Furthermore, BHP has a price-to-book ratio of 3.79x, which is a concern as mining investors usually emphasize a basic material stock's tangible book value. However, closer observation shows that BHP's price-to-book multiple is merely 4.76% above its 5-year average, indicating that the stock is fairly valued instead of overvalued.
What stimulated our investment decision in BHP is its dividend profile, which contributes dearly to its total return profile. At a 5-year average yield-on-cost of 12.01% , a forward dividend yield of 5.73%, and a 5-year dividend CAGR of 24.84% , BHP's stock presents investors with an excellent dividend growth opportunity.
Based on historical data, BHP's long-run total returns will primarily derive from its dividends. We encourage investors to adjust their BHP exposure throughout the economic cycle, as price drawdowns can be abrupt and phase out much of the stock's total return prospects. Nevertheless, the asset does provide sound long-run returns to buy and hold investors.
- Sidenote: The returns in the diagram below are normalized and not displayed as compounded returns.
Risks
As mentioned before, the economy remains in an uncertain space, and BHP is a cyclical stock. Therefore, an unwanted cyclical trough might cause further drawdowns for BHP's stock.
Furthermore, both base metal and coal prices tend to be highly volatile, meaning BHP's commodity basket is a risky bet. Moreover, OPEC's recent production cut might sustain elevated production costs for the time being, leading to lower-than-anticipated profit margins.
A worthwhile final mention is that BHP's dividend coverage ratio of 1.22x does not provide us with confidence that BHP will be able to sustain further operational drawdowns without trimming its dividend policy.
Final Word: BHP Is A Cost Averaging Stock
Our analysis showed that BHP Group Limited presents lucrative total return prospects after its latest drawdown. First of all, the stock's price is situated in favorable territory, given its technical, value, and dividend features.
Furthermore, BHP's operational outlook is underestimated by the market, with higher base metal prices yet to be realized by the firm. Additionally, lower fuel costs and an enhanced weather pattern in Australia must be accounted for.
Although BHP Group Limited possesses numerous risks, we are bullish on its stock and think its current price level is very investable.
For further details see:
BHP: The More It Drops, The More We Buy