BHP: Bullish On A Miner That Doesn't Fit Our Usual Criteria

Investors often believe mining companies are a uniform phenomenon. However, corporate portfolio structures vary among entities as some opt for horizontal and vertical integration, while others decide on ‘conglomerate’ structures.

A corporate portfolio’s structure affects a company’s stock valuation as synergies and efficiencies are often telling in determining shareholders’ residual value.

At Pearl Gray, we prefer streamlined mining companies that limit their scope to a specific mineral resource group while integrating downstream operations. Thus, BHP Group (BHP) wouldn’t usually be on our watchlist as it is a diversified mining organization.

Nevertheless, most of the company’s commodity basket could receive serious price support in 2023, and production ramp-ups might add value to its balance sheet. Moreover, BHP presents an alluring dividend profile, which holds utility in today’s uncertain financial market environment.

Let’s jump into a few of our recent findings on BHP Group!

Overly Diversified Vs. Economies of Scope

Starting With The Ugly

Bigger isn’t always better if you’re a mining investor. In other words, a company with diverse business activities won’t necessarily yield greater risk-adjusted stock returns.

I base my statement on the theory of conglomerate discounts. Sure, companies often increase synergies whenever they delve into additional industries. However, at times the stock market starts pricing a conglomerate discount as soon as it believes a firm needs to utilize its residual value to stay competitive in its various industries. Although BHP isn’t a multi-industry conglomerate, its wide range of resource offerings is often recognized in proximity.

Furthermore, a common trend among mining companies is “empire building”. The term refers to a state where mining companies invest in every desirable asset they can find, even if it means acquiring at a premium. You’ll often find miners’ management diluting shareholder residual to expand for their own interests instead of focusing on shareholder value creation.

As visible in the diagram above, BHP is a diverse miner. As stated before, I concur that it doesn’t host a pure conglomerate structure. Nonetheless, its resources cater to vastly different industries with varying business cycles.

It is evident that BHP’s reinvestment rates have increased steadily versus its revenue since inception. Therefore, indicating continuous expansionary investing and high maintenance costs. In our opinion, this is an indication of empire building.

Discovering The Good

In spite of BHP’s underwhelming CapEX to Revenue value and our concerns about the firm’s empire building strategy, the mining house hosts encouraging net operating profits after tax (NOPAT). Thus, suggesting it deploys its working capital with optimal efficiency. Moreover, BHP’s profit margins are in spectacular condition, with its EBIT margin of 50.36% implying embedded economies of scale and scope.

Furthermore, we support BHP’s commodity mix in the current market climate. Reopenings in China and a potential interest rate pivot in the U.S. could give rise to ferrous metals as they rely on industrial production. On top of that, Copper prices are expected to surge towards the back-end of 2023 as precious metals are aligned with a support level if further U.S. dollar weakness occurs.

Operational Update

Iron Ore

As per its latest production report, BHP’s iron ore production grew at 3% year-over-year. Although the firm’s Western Australian Operations delivered impressive throughput, it suffered from abnormally wet weather, offsetting much of the segment’s progress.

Furthermore, BHP expects to ramp-up South Flank for the full year of 2023 and consistency from Samarco, which could see it reach its original guidance of up to 256 metric tonnes.

In our opinion, supportive prices will be the catalyst, given the rejuvenated demand from China. Although iron ore grade will be variable from various assets until full post-covid ramp-up is achieved, BHP’s is well-aligned to benefit from settling supply chains and demand from Asia.

Copper

Copper is a recent standout for BHP Group. The company’s latest production results show that its copper production surged by 9% year-over-year as key factors cointegrated. The BHP’s Escondida asset delivered better than anticipated grade to achieve a 4% year-over-year increase in throughput. In addition, a ramp up of Pampa Norte translated into a 5% year-over-year increase in production.

Furthermore, the company’s Olympic Copper Dam project’s production surged by an astonishing 68% year-over-year as its smelter maintenance campaign ended. The project could ramp up even further after refinery maintenance is complete.

Another key factor for BHP’s copper unit is tailings processes. Tailings are a lucrative value add to mines and add to broad-based profit margins. BHP’s Spence Tailings Storage facility is currently being emphasized and could deliver meaningful results in the upcoming years.

As previously mentioned, we believe price support will be the catalyst for BHP’s copper segment. Moreover, BHP’s vertically integrated model provides it with significant cost efficiencies, concurrently widening its copper segment’s profit margins.

Coal

Lastly, let’s run through BHP Group’s coal activities.

The company’s energy coal unit (New South Wales Energy Coal) experienced a disappointing showing in its latest quarter, with a 38% year-over-year drawdown in production amid unfavorable weather and labor shortages. Though, the tides could soon turn amid prospects of diminishing rainfall and the recent uptick in Australia’s labor participation rate.

Although BHP’s Metallurgical coal activities also suffered from disappointing production (down by 1% Y/Y). However, idiosyncratic impacts were marginal as inventory drawdowns, and ramp-up of autonomous truck activities at Goonyella phased out much of the damage. As with its energy coal business unit, a rebound in labor participation and more favorable weather could recover the segment in the coming quarters.

We are skeptical of coal prices, as last year’s price surge could’ve been an overreaction. In addition, a more constructive energy supply/demand framework could also see coal prices recede to pre-pandemic lows. Thus, BHP’s operational recovery might be counteracted by diminishing price support.

Valuation & Dividends

There is no doubting the fact that BHP’s price-to-book ratio is of concern. I have never been convinced that market participants price mining stocks based on resources on the ground. Nevertheless, BHP is an asset-heavy business, meaning its book value speaks volumes.

Although BHP presents an unfavorable book value per share, its price-to-earnings multiple of 8.6x is in good shape considering its PEG ratio of 0.11x. A stock’s PEG ratio contextualizes its P/E Ratio by intertwining earnings-per-share growth, and a PEG below 1.00 is usually regarded as progressive.

As investors, we often need to remind ourselves of the obvious, which is that expected returns are bound to both price speculation and carry returns. Carry returns refer to dividends or coupons and are often overlooked as a means of generating lucrative investment returns. BHP’s forward dividend yield of 10.33% is highly appealing and well covered by cash from operations worth $32.17 billion.

The stock’s dividend profile has experienced cyclical swings in the past. Yet, shareholders can expect lucrative yields on average.

Noteworthy Risks

As previously mentioned, most of BHP’s commodity prices could be supportive throughout 2023. However, coal demand will likely recede amid leveling in the supply/demand in Europe’s energy space. In addition, China’s reopening might add supply to the market, phasing out increased regional coal demand.

Furthermore, BHP’s valuation is of concern as most of its ratios exceed their cyclical averages. Thus, adding validity to the argument that the stock’s current price doesn’t provide an optimal entry point.

Concluding Thoughts

BHP Group is aligned to benefit from supportive iron ore and chrome prices. Although coal prices are retracing, BHP’s coal operations are set to ramp up after weather delays, which could phase out commodity price risk.

In addition, the company has illustrated operational brilliance by efficiently using its working capital and posting exhilarating profit margins. Even though the stock exhibits book value concerns, its earnings growth rate is sublime, and its dividend profile is solid.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.