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Returns and profitability remain superior
BHP (NYSE:BBL) generates superior profitability from its three main categories; iron, copper and metallurgical coal. It represents 95% of group EBITDA. Iron remains the largest contributor to EBITDA, contributing 60% of group EBITDA in H1 of FY 2022, ending 31 December. It also leads in the highest EBITDA margin category, with a margin of 71%. Copper follows with 23% of group EBITDA, and a margin of 62%. And metallurgical coal represented 12% of group EBTIDA, with a margin of 51%.
Superior profit margins allow BHP to generate superior returns for any corporate in any business sector. Return on Capital Employed (ROCE) jumped from an already high 28% in H1 FY 21 to an astoundingly high 43% in H1 FY 22. Free cashflow had increased by 43%, reaching USD 8.5bn, higher than the total net debt of USD 6.1 billion. An EBITDA margin of 64% 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. Not in this case, I believe, as BHP is boosting superior financial strength. A credit rating of A by Standard and Poor’s confirms the already clear financial strength of BHP, its high level of liquidity, and its ample cashflow strength that can enable it to continue fast-paced investments and super high returns to shareholders, while keeping leverage levels in check. And returns to shareholders have been high consistently over the past few years. In the past three years along, BHP distributed USD 38 billion – equivalent to 20% of the company’s market cap.
BHP is one of the most cost-efficient among its peers. At USD 16.5 per tonne, BHP has the lowest cost of production for iron ore among the major mining groups. Peer Rio Tinto’s unit cost is around USD 18-19 per tonne. And at a cost of production of USD 10.82 US Dollars per barrel, BHP is already one of the lowest cost producers among the oil majors. Cost per barrel at Exxon Mobil (XOM) has been in the range of USD 12-19.
Petroleum merger with Woodside is coming at the right time
With oil prices hovering near historical highs, the timing of the planned merger between BHP’s petroleum business and that of Woodside could not have come at a better time. Both entities between them would be producing a combined 200 MMboe, making the combined entity among the top 10 oil majors. The merger will achieve USD 400 million of synergies, and will help the combined group maintain lower cost of production and higher efficiencies.
The merger will also create a natural separation between the fossil fuel business and the iron, copper and nickel businesses – the growth prospects of which are linked to the increasing global drive to replace fossil fuels with renewable energy. In effect, the fortunes of BHP’s spun-off petroleum business should theoretically be going in opposite directions to the rest of BHP’s metals business. The separation between the two gives investors clear cut choices of where they want to put their money.
Valuation attractive, and provides a margin of safety
BHP trades at a P/E of 11x. Although shares trade at a 10-year high, valuation levels are not. 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. Since the 1st of January, iron ore price increased by 35%, nickel by 150% (before settling to only 40% increase), and Brent oil jumped by 70%. The share price of BHP, in the meantime, only increased by 30% – 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, cooper 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.
Short-term and long-term trends promising – on both volume and price fronts
Learning from the 2008-2009 experience; abnormally high market prices of commodities rarely last when they result from monetary policy abnormalities that are correlated with economic and political shocks. Having said that, the economic trajectory currently is not weak; economic growth across the board is supercharged, associated by rampaging inflation, while major central banks will be wary about pressing on the brakes too fast, not to repeat the 2007-2008 financial crisis. Commodity prices are poised to continue benefiting from the current combo of economic and political factors in the foreseeable future. It would take a major reversal in economic growth prospects globally for metal and commodity prices to fall considerably. Even then, long-term prices are likely to continue being supportive of global economic trends, and mainly the increased investment in fossil fuels replacements. Wind turbines, electric vehicles, solar panels, battery charging, electric vehicle batteries, grid storage solutions – all of which consume large amounts of cooper, nickel and iron. While the global trend is to replace fossil fuels with cleaner, renewable energy – there are currently no like-to-like alternatives to iron, copper and nickel. Think of it this way; BHP products represent about a third of the material used in smartphones, close to half the material used in computers, majority of the material used in data centres and cloud infrastructure, and almost all the material used to make wind turbines. This is not to mention most of the material used in land, air and sea transport vehicles. So on both the traditional and growing technologies and machineries that humanity uses, the metals and minerals that BHP produces will remain the core production material needed to continue driving development of global economies.
BHP is well positioned to grow volumes, and not only to rely on price growth. The company maintains balanced investment in developing new reserves for its main metals. Current iron reserves can keep BHP going for a decade, without needing to develop new mines. And, rightly so, six of the ten new projects for development are focused on copper, and exploration opportunities are also focused mainly on copper. Copper is at the core of the growth of electrification and IT.
With high returns, comes high risks
For years, I have steered away from commodities and commodity-linked companies. I kept in mind Warren Buffett’s ‘moat’ advice, and his focus on businesses that have a long-lasting niche, and the ability to keep producing more and more of the same goods and services at low marginal cost. The vulnerability of commodity-linked companies to factors outside of their control, affecting wildly the market price of what they sell, was a key put-off for me. I wanted to be able to see through the future of how my investments will be performing; I would not sleep well if I felt that one month my stock could be up 20%, while on another month it could be down as much or more.
So what made me change my mind finally and be bullish on commodity-linked investments?
It is not so much the recent super hike in commodity prices, although it raised red alerts for me to investigate further. The rampaging inflation over the past year was transitory, I kept telling myself, and commodities and commodity prices will go back to earth at some point in the near future. This might as well be the case; no one knows. And this is the absolute clear risk for investors who consider commodity-linked stocks, especially at this stage when stock prices and commodity prices are at multi-year highs. However, with BHP entering this cycle with a strong financial position – assuming its experienced management keep being conservative – BHP should remain strong if a downturn returns. If the current 8-9% yield shrinks by half, investors would still be handsomely compensated.
A revolution in recycling is also another long-term risk. Mining is not a renewable industry, and although it does not get as much heat as fossil fuels due to their impact on emissions, mining is still not a loved industry for environmentalists. Nevertheless, despite at least two decades of heavy global investment in renewable energy, fossil fuels are still the bulk of what we consume for transport and energy. A dramatic shift in demand for mined metal versus recycled ones is unlikely to occur for decades to come.
The planned de-listing of BHP form London’s main market, to be listed only on the Sydney market, is another technical headwind. While it allows management easier control and less hassle, it would reduce market liquidity. This does not take away anything from the fundamentals of BHP, but might put off some institutional investors.
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.
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