External Factors Could Keep BHP Pinned In Place

Key Takeaways

• A large exposure to the iron-ore market with a muted medium-term outlook leaves BHP vulnerable.
• The company's second-largest segment (copper) can provide growth but is at risk of prolonged higher capex.
• Lower forward-looking valuation is neutralized by diminished dividend yield.
• Management can boost margins through prudent cost control, but external factors can cause a prolonged lack of growth.

COMPANY CATALYSTS

Close Ties with the Maturing Chinese Market Pose Risks

• BHP has long relied on China as a major consumer of its products, particularly iron ore and copper. However, as China's economy matures, its demand for these resources has stabilized, posing a risk for future growth prospects. China's property market struggles are one of the main factors behind the stagnation of demand for steel and iron ore.
• BHP's reliance on iron ore, which makes up most of its earnings, ties the company's revenues closely to China’s real estate sector. Any further decline could reduce demand for steel and iron ore, hitting BHP’s revenues.

• BHP acknowledges that the country’s uneven recovery and fragile property sector add volatility to its commodity outlook, particularly in iron ore and coal, which are key drivers of its profitability. Although China has implemented pro-growth policies, the effectiveness of these measures remains uncertain.

Failed Anglo American Acquisition Means Higher Copper Capex

• After the unsuccessful attempt to acquire Anglo American, BHP is pivoting towards organic growth in copper. This shift implies a higher capital expenditure (capex) to boost copper production in regions like Chile and South Australia, as BHP aims to secure long-term copper output.
• The copper capex cycle, which includes projects like Escondida in Chile, may divert resources otherwise available for shareholder distributions. With BHP now planning to spend an average of $11 billion per year for growth projects, shareholders might see reduced payouts in the short term.
• Copper production at major mines like Escondida is projected to decline after 2027 without new investments, further necessitating the current capex push to maintain output levels. Unionized workers at Escondida are also prone to strikes, the last of which occurred in August when the union demanded a $7,000 compensation hike per worker for 2,400 of its members.

Samarco Dam Collapse Total Cost Remains Unknown

• Despite the company reaching the final resolution with the Brazilian government, the UK's unresolved class action lawsuit case presents ongoing fiscal risks to the company, especially as legal proceedings continue.
• With over 620,000 claimants seeking up to £36 billion ($47 billion) in damages, the final settlement could drastically exceed previous payments of nearly $8 billion.

Suppressed Valuation Demands Attention

• BHP’s stock trades at a forward price-to-earnings (P/E) ratio of 12.5x, lower than its five-year historical average of 13.1x. This undervaluation suggests that the stock offers a buying opportunity for investors who believe in the company's long-term prospects.
• In FY2024, BHP’s EBITDA was in line with the previous year, and the company's valuation at 4.9x forward EBITDA shows resilience despite commodity price pressures. While the near-term outlook for commodities like iron ore and metallurgical coal is challenging, any stabilization or recovery in these prices could drive BHP’s stock higher.

INDUSTRY CATALYSTS

New Supply Could Prolong Iron Ore Weakness

• Rio Tinto’s Simandou project in Guinea is expected to start production in 2025. This project will provide the global market with high-grade iron ore and increase supply pressure, likely weighing on prices.
• Despite the war, Ukraine's iron ore exports rose 115% year-over-year in the first seven months of 2024, exceeding expectations. While there could be a decline of 15% in the second half, Ukraine remains a key player in the global supply landscape.
• China’s property sector continues to decline, reducing steel demand and, consequently, iron ore. New construction starts have fallen since 2020, contributing to a bearish outlook for iron ore prices. Chinese steel mills face mounting losses, leading to production cuts and reduced consumption of higher-grade ores.
• While China’s demand weakens, growing demand in India and Southeast Asia could mitigate some of the downward price pressure. However, this is unlikely to offset the oversupply expected in the coming years fully.
• Donald Trump’s second presidential term possesses an additional risk as his foreign policy is geared towards tariffs and negative for China, further threatening their output.

China’s property market boom and bust, Source: FT

The Copper Supply Crunch is a Major Positive Catalyst

• The global push for renewable energy, including electric vehicles, solar panels, and wind turbines, is driving a significant increase in copper demand. Copper consumption from these sectors is expected to rise fivefold by 2030.
• Developing new copper mines can take over a decade, creating a lag between growing demand and available supply. The slow pace of new mining projects is a key factor in the looming supply shortage, with JP Morgan forecasting a four million metric tons shortage.
• Decades of underinvestment in copper exploration have led to fewer new discoveries, with most current copper production coming from expansions of older mines rather than new projects.
• Countries with major copper reserves, like Chile, impose higher royalties and tighter regulations, making it harder for new projects to come online and exacerbating the supply crunch.

RISKS (to my thesis)

Iron Ore Price Recovery

• The widespread expectation of declining iron ore prices has led to a heavily crowded short trade. Many traders are betting on further price drops, which raises the risk of a short squeeze.
• If market conditions shift, this could trigger a rapid reversal, with traders forced to cover their short positions, potentially sparking a sharp short-term price rally.

The Success of Chinese Monetary Policy

• The Chinese government has introduced a series of stimulus efforts, including cutting interest rates, reducing mortgage rates, and lowering bank reserve requirements to inject more liquidity into the economy.
• If China's government stabilizes the property market through targeted measures like debt restructuring and support for housing projects, steel demand—and, by extension, iron ore—could recover.

New Supply in Unstable Guinea

• Additional iron ore supply from Guinea, a country with significant political instability (ranking just 16.98% in the World Bank's Political Stability and Absence of Violence index), introduces further risks to the global supply chain.
• Guinea has reserves of over 2.5 billion tons of high-grade iron ore. However, any disruptions in this region due to political unrest or logistical challenges could tighten supply, potentially supporting prices even in the face of weakening demand elsewhere.

 Renewed Bid For Anglo American

• After long negotiations, Anglo American rejected BHP’s $49 billion bid in May. The mandatory 6-month pause expires in December, after which BHP could bid for the company again.
• However, with Samarco dam costs still looming and the company committing $3 billion for the Filo Corp joint venture with Lundin Mining, an immediate rebidding process would be unlikely, although the management seems internally divided about the matter.

Global Recession Hurting the Commodity Cycle

• A global recession could drastically cut demand for commodities like iron ore, mirroring the 2008 financial crisis when iron ore prices dropped by over 40%. China’s steel production slowed, causing a 15% drop in global demand back then.
• According to the World Bank, price cycles are highly synchronized across commodities. Furthermore, since 1996, global macroeconomic shocks have been the main driver behind the price volatility, accounting for 50% of the commodity price variance.  Although a recession looks unlikely right now, the high interconnectedness of commodity markets deems it a notable risk.

ASSUMPTIONS

• Per the Bank of Canada's definition, the commodity super cycle is an extended period during which commodity prices are well above or below their long-run trend. These cycles occur because of the long lag between commodity price signals and changes in supply. As BCA Research Chief Strategist Marko Papic noted, I believe that the world entered one of those supercycles in 2023, and its effects should strongly boost commodity producers.
• BHP's revenue already showed signs of a slowdown in 2023, contracting 17%. I believe its growth will be muted owing to its large reliance on iron ore prices, which have a bleak medium-term projection. I agree with projections by S&P Global, BMI, and Goldman Sachs about the prolonged slump in iron ore prices, which could remain under $100 per ton for the foreseeable future.

BHP Revenue FY 2005-2024, Source: Statista

• This scenario is mostly influenced by subdued Chinese demand but also by notable quality assets coming online, like the Simandou mine in Guinea—the largest of its kind, producing 60 million tons per year (2.5% of global production). I expect a ramp-up in producing high-quality iron from Simandou, which will also pressure metallurgical coal. High-quality iron ore creates opportunities to use hydrogen in steelmaking, significantly reducing carbon footprint.
• I expect copper's demand to help alleviate iron's muted outlook, as newly acquired assets in South America help grow the production. BHP also owns Olympic Dam, arguably the best young copper mine globally.
• I assume that no large global recession will occur soon, but I acknowledge that it represents an additional risk for the demand side.
• I expect BHP's net margins to start recovering. Although higher capex (up to $10b per year), tied to the unsuccessful acquisition of Anglo American, weighs on the company, I expect the management to intervene regarding the margins as cost control is largely under their control compared to various external factors.
• If prolonged iron ore prices and higher capex materialize, I expect the company to cut its dividends further (the last cut was 14% in August 2024), negatively impacting dividend investor sentiment. I expect this sentiment to decrease the P/E ratio toward a long-term average of 15x.
• I expect the number of shares outstanding to remain stable at 2.53 billion, as it has been for the last several years. 

VALUATION

•  I expect revenues to stall at $56 billion annually, with subdued growth of 2%, supported mainly by growing copper prices.
• With terminal FY 2030 revenue of $61.82 billion and an average margin of 20%, it creates net earnings of $12.37 billion. At 2.53 billion shares outstanding, this translates into $4.88 per share.
• Using the median P/E ratio over the last 10 years (15x), this translates into the terminal price per share of $73.30
• Discounted using the 7.24% rate (which is SWS’s current discount rate), the present value is $52.