BHP: The Positives Still Aren’t Enough

Since I wrote about the Australian multi-commodity miner BHP (NYSE:BHP) in July, its price is up by 16.4% and total returns are up by an even bigger 19.7%. There was a case for the stock even at the time because of its lower market valuations compared to the materials sector and a solid trailing twelve months [TTM] dividend yield of 9.4%.

I had, however, gone with a Hold rating at the time on weak fundamentals. Not only had it seen an earnings crash for its year ending June 30 (FY23), but the outlook was weak too, especially as China’s prospects weren’t as positive as had been earlier expected. The situation has changed somewhat since, however, driving optimism. But the real question is whether it has altered enough to defend even bigger price gains for BHP.

Why has the price risen?

The key reason for investor optimism on BHP is the iron ore price rally on China’s improved prospects. Iron ore prices have now risen by over 26% YTD, with much of the enhance coming in only from October onwards. The commodity is particularly significant for BHP, with a 46% contribution to revenues in FY23 and an even higher share in EBITDA and EBIT of 60% and 64% respectively.

It’s probably no coincidence that Rio Tinto (RIO), which also depends significantly on iron ore has seen a recent uptick as well. In contrast, other miners appreciate Anglo American (OTCQX:NGLOY), with a smaller share of iron ore and Glencore (OTCPK:GLNCY), which doesn’t mine the commodity at all, have lagged behind (see chart below).

Production on track

The company’s first quarter operational review (quarter ending September 2023, Q1 FY24) encourage confirms that BHP is on track, with unchanged guidance for each of its commodities (see table below). Significantly, copper, the second biggest contributor to both revenues and earnings for BHP, has seen an 11% year-on-year (YoY) uptick in production during the quarter. Sales for both iron and copper are also up by 9% and 3% respectively in volume terms as well.

Improved outlook

Sustained production and better prospects for iron ore prices are particularly significant for BHP in this year, going by its weak outlook following a poor FY23. Last year, the company saw a revenue reject of 17% and underlying attributable profit fell even more by 37%. Commensurately, dividends declined by 48%.

Unsurprisingly, projections for BHP have improved. When I last checked, analysts on average expected a 2.5% reject in revenue. By contrast, they now expect a 2.5% enhance in revenue. Assuming that the net attributable profit margin stays the same as in FY23 at 23.8% and the underlying attributable profit margin stays at 24.7%, BHP’s forward GAAP price-to-earnings (P/E) ratio comes in at 12.5x and the non-GAAP P/E at 12x.

Both the forward ratios are competitive compared with the materials sector ratios and are also lower than BHP’s own five-year average (see table below). However, do note that my projections are more optimistic than the average of analysts’ forward estimates, which are higher than the five-year averages.

The risks

I would be willing to base my rating on just my own estimates if there were limited risks for BHP. That’s not the case, however. First, it remains to be seen how much more upside there is still possible for iron ore prices. As I pointed out in my recent article on Rio Tinto, which is linked above, China’s government is ready to step in to curtail the runaway price rise in iron ore. In other words, the latest price rally can’t be assumed to continue. This in turn can limit potential gains during the year.

Next, the company is at risk of industrial action. It started with a planned strike by train drivers at the Pilbara iron ore operations in Australia in October, to protest their terms of employment. They have since withdrawn the action after the company proposed updated terms.

But there’s more uncertainty in store as 80 open-cut coordinators at the Queensland coal mines, who supervise safety compliance at mines, are gearing up for industrial action on redundancy and accident payouts. While BHP is in negotiations with the workers, the situation is still ongoing.

The bigger point here is that the company, appreciate many other from auto companies to Hollywood have seen labour unrest this year. While the situation is under control for BHP at least for now, at this time, the risk of encourage industrial action can’t be ruled out. If strikes do go ahead, the outcome can be particularly damaging for a company that’s in a muted commodity cycle already.

What next?

There’s no denying that there are good reasons for investor’s recent positive sentiment towards BHP. Not only have iron ore prices risen, its own production is on track as well. Additionally, my estimates of its forward market valuations also contemplate increased competitiveness both against the materials sector and its past five-year averages as well.

But there are clear downside risks too. For one, the upturn in iron ore might not continue if China’s government steps in and copper price, its second most important commodity, hasn’t gone anywhere this year anyway. In any case, even now the revenue upside for BHP for FY24 isn’t significant.

It might even be impacted if planned industrial actions go through. It has averted the action at its iron ore mines but it’s still in discussions about a potential strike at its coal mines. The bigger point here is that industrial action is a risk for now and the near future.

In the meantime, its forward dividend yield has fallen to 4.9%, down by 0.5 percentage points from the last I checked. Normally, I give a heavy weightage to my own estimates of market multiples, but in this case, I’d appreciate to make an exception. The risks are very much around and so far the upside isn’t significant enough to overcome them if things go south. It doesn’t help that I’m in the minority across forecasters to see an upside to the stock.

I’m not ruling out a continued positive turn for BHP, just that it hasn’t gathered enough momentum yet to defend continued price gains.

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