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Date : 03/12/2020

BHP Group

ASX :

BHP

Market Cap : $195.02 Billion

Dividend Per Share : $0.75

Dividend Yield : 4.44 %

Hold

52 Week Range : $21.05 - $41.47

Share Price : $41.25

Stable earnings outlook is expected to continue as we recover from the pandemic. We recommend members to "Hold".

Company Analysis

BHP Group (ASX: BHP) is arguably the most well diversified mining and exploration company there is, and it is a part of every investor’s portfolio for different reasons – maybe for the stable dividends, or to decrease the overall volatility of the portfolio. BHP derives revenues from 4 main commodities – Iron Ore, Copper, Coal, and Petroleum. These commodities are very sensitive to the global economic outlook and activity. In addition to this risk, they also come with a currency rate risk as commodities are traded in USD. The stock price of BHP has returned 12.85% since our first recommendation – a high return for a very mature company and very little growth prospects.


Source: Tradingview.com

Economic and Sector review

We expect that the global economy will take some time to stabilise and recover from the ongoing COVID-19 pandemic. High unemployment and spiralling debt are likely to reinforce global concern about inequality and systemic disadvantage. We believe BHP values, strategy and actions are well positioned to navigate the period ahead. BHP produce raw materials that are essential to modern life.

The company’s success is tied to sustainable growth of emerging economies. Hence, the company performance is influenced by a wide range of factors that drive relationship between supply and demand. The global economy has been dramatically impacted by the COVID-19 pandemic.

BHP’s operating environment is complex with demand volatility and price uncertainty expected. While the outlook remains uncertain, within the scenarios that we consider, our base case has the world economy recovering in 2021. Considerable variation at the national level is to be expected. Even with a rebound, we can estimate the world economy to be 6 per cent smaller than it would have otherwise been in 2021.

As of mid-2020, much of the developing world was still in the escalation phase of their initial COVID-19 outbreaks. There remains a significant degree of uncertainty in terms of how the COVID-19 pandemic will progress, and its longer-term effects.

Risk Consideration

The natural resources are affected by many factors, both specific to BHP and to the overall raw material trading industry. The following factors may expose the company to systematic or/and unsystematic risks. We have recognised the following components that we believe are significant and would influence the performance of the company:

  • Society influx
  • Demand volatility
  • Price uncertainty deriving from supply and demand
  • Exchange rates transaction risk
  • Interest rates risk
  • COVID-19 risk

Iron Ore

Iron Ore prices have been soaring recently. The commodity is used to make pig iron, which is used in the production of steel. Over 95% of all the mined iron ore is used in the production of steel. Commodity prices are essentially derived from supply and demand. Iron ore prices stayed resilient during the pandemic and have now surged off late. There have been 2 key incidents to trigger this. China is the larger consumer of iron ore. They import 70% of all the iron ore produced in the world. The other big importers are Japan and South Korea. China faced the brunt of the pandemic in February, while the world believed the pandemic was only restricted to China. March onwards, China’s economic activity began to recover, and iron ore did not see too much of a drop off in demand. Coming to the supply, Australia and Brazil are the biggest exporters of the commodity. With Brazil still affected by the pandemic, it has led to temporary suspension of mining operations – causing a shortage of supply. The decrease in supply, an increase in demand, and a weaker US dollar has led to higher iron ore prices, and hence, Australian firms with exposure to iron ore have had the benefit of increased margins.

Copper

Copper prices are very sensitive to the global economy. The metal is extremely important to the manufacturing and infrastructure industries that usually determine economic activity. As global economies were put on a standstill, the price of the commodity took a pounding during March and April. However, since then the price has been climbing. Again, China is the largest importer accounting for about 30%-35% of global imports. The quick recovery of China has ensured that the demand for the commodity does not fall as other economies were put to a halt. On the supply side, Chile and Peru are the largest exporters of the commodity and they were under strict lockdowns – impacting productions and leading to a shortage in supply. A weak US dollar during the period has also added to the copper price increasing. News of a vaccine and return to normal are all fuels to the demand for the commodity during 2021. Another very important consideration to be made here is that a shift to renewable sources of energy will increase the demand for copper in the future.

Coal & Petroleum

The story has been very different in the crude oil and coal. Coal is used for electricity and metallurgy. With demand for electricity decreasing during the pandemic, it has not been good news for the commodity. The need to move over to renewable sources of energy has not helped the cause of the coal in the long-term. In the last couple of months, however, coal prices have climbed due to increased economic activity in markets such as India and China. Crude oil has been the most volatile of all major commodities during the crisis. We even saw negative oil prices due to the excess supply in the market as economic activity fell. In the long-term, however, much of the oil prices are controlled by OPEC – an organisation in the Middle East that determines the supply levels for the commodity. This adds a lot of risk that is not diversifiable. Again, week USD does push up prices of these commodities.

BHP Performance

The chart below shows us how weighted BHP’s revenues are to these commodities. The inner circle represents revenues from FY2019 and the outer circle from FY2020.

Geographically, BHP generates 62% of its revenues from China. Japan and South Korea come in second and third at 9% and 6%, respectively.

Solid cashflow and record coal production

In FY2020, improved operational stability and record production at BHP’s coal facilities generated solid cash flow despite field and grade declines at petroleum and copper.

Decrease in revenue, lower volumes in copper and petroleum

BHP reported an underlying EBITDA of US$ 22.1B this year compare to US$ 23.2B in FY2019 due to:

  • raw material lower prices and lower volumes in copper grade and petroleum,
  • and an increase in the closure and rehabilitation provision for closed mines,
  • and other stripping depletion in line with mine plan also weighed on the revenue.

However, the decrease in income was partially offset by record volumes at some facilities as BHP improved its operating stability combined with favourable exchange rate movements.

Decline in net operating cash flows, increase in net debt

BHP net operating cash flows accounts for US$ 15.7B in FY2020. The 12.11% decline in operating cashflow compare to FY2019 which was US$ 17.4B reflects lower underlying EBITDA results is due to FY2019 tax payments and higher instalment rates. Despite a decrease in cash from operating activities, operating income slightly increased by 3% this year. Despite the challenging period, BHP’s balance sheet remains strong with net debt at US$ 12B this year, which is at the low end of the company’s target net debt range.

The 4.95% increase in net debt is primarily related to:

  • the impact of the application of IFRS 16 Leases
  • returns to shareholders of US$ 6.9B
  • dividends paid US$ 1 billion, being offset by free cash flow generation of US$ 8.1B.

Increase in capital and exploration expenditure

Free cash flow declined slightly due to a US$ 0.5B increase in total capital and exploration expenditure to US$ 7.6B in FY2020. The increase in capital expenditure included:

  • continued investment in high-return latent capacity projects, and investment in South Flank (iron ore), Spence Growth Option (copper) and Mad Dog Phase 2 (crude oil production facility).
  • Capital and exploration expenditure guidance is targeted at approximately US$ 7B for FY2021, subject to exchange rate movements.

Outlook

BHP is a very stable business with its assets operating at highest capacities already. Given the scale of their existing operations, it is very difficult to see much growth in revenues that can be driven by new assets that can produce at scale. The outlook for BHP thus relies on 3 major entities – commodity prices that will determine EBITDA margins from its stable revenues, acquisition that can dramatically increase production levels, and the geopolitical risk arising from the tensions between China and Australia.

Earlier in this report, we explained how the different commodities that BHP deals with derive their price from, and also what has been the catalyst during the pandemic to cause sudden changes in commodity prices. The outlook for these commodities is robust. Iron ore prices are expected to be around the $100/mt mark through to June next year. Governments around the world will look to increase infrastructure spending in order to increase economic activity as countries recover from the pandemic. The demand is thus expected to sustain. However, with Brazil Vale coming back to previous production levels, the price will be capped with the supply and demand moving towards equilibrium.

The average price of Copper in 2020 was $6043 a ton. In 2021, this price is expected to increase by about 12% according to polling data from investment institutions. This translates to about $6800 a ton. Much of the demand here will again be driven by increased economic activity in the construction industries. Oil and Coal is a rather tricky affair. Energy commodity prices in convention should go up with increased economic activity. However, the long-term demand for both coal and crude oil does not look too good. Crude oil prices are usually maintained very well at desired levels by OPEC. The organisation constantly takes calls on supply levels and we may see a return to levels around $50 a barrel. Stability is therefore what we can count on once the crisis is behind us. Coal is the commodity that everybody wants to stay away from, and demand is thus expected to decline as the push for renewables will become aggressive in the coming years. These outlooks do not change the narrative of BHP and we do not expect to see a significant rise or fall in growth rates for the firm.

On the 6th of November, BHP announced that it acquired an additional 28% of Shenzi from Hess Corporation. The transaction is estimated to have cost US$505 million and will add 11,000 barrels of oil. This takes BHP’s holding to 72%. Production guidance remains unchanged for BHP for FY2021.


Source: BHP Group

The geopolitical tensions between Australia and China have been increasing for the past few months. While Australian coal imports and other commodities are impacted, copper and iron ore have so far not received any push back from China. While nothing can be forecasted regarding how this plays out due to the political agenda that is in play, it is worth noting that copper and iron ore is extremely important for the continued expansion of China’s economy.

Recommendation

The outlook for BHP is stability in earnings as long as the world continues to emerge from the pandemic. The stock has soared since the news of a vaccine emerged and it thus looks like it has accounted for the increased economic activity. We recommend long-term investors to “Hold” BHP as a part of their portfolios.

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