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BHP Group: Improving Metal Prices Pave Way For Gradual But Sustainable Price Recovery

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About: BHP Group (BBL)
by: Aitezaz Khan
Aitezaz Khan
Long/short equity, energy, commodities, base metals
Summary

Iron ore business delivered strong margins, and the outlook is supported by rising iron ore prices.

FY 2020 copper production is expected to remain in line with last year, the impact of lower Escondida grades is offset by higher concentrator throughput, together with improving copper prices.

BBL's strategic response to its operational challenges seems more appropriate compared with the response of competitor, RIO.

Here, we analyze BBL's iron ore and copper business segments in detail.

The analysis reveals that BBL's share is on a gradual road to recovery.

Thesis

BHP Group's (NYSE:BBL) share price has had a turbulent run during the past 6 months. The share price touched its 52-week lows of $23.64 following the COVID-19-triggered market crash in mid-March and has recovered since then. As BHP is a mining giant that's invested heavily in multiple significant business segments, including petroleum, copper, iron ore, coal, and nickel, a detailed analysis of BBL's each and every business segment is beyond the scope of a single article. That said, the focus of this article's discussion will be BBL's two most significant business segments namely iron ore and copper.

In this article, we will try to analyze whether (and how) BBL's stock price could build an upward trajectory from the current price levels, given its current business environment, and will also take a look at the company's competitive position compared with a peer mining giant, Rio Tinto (RIO). So, let's get into the details without further ado.

Figure-1 (Source: Mining.com)

Business Segment: Iron Ore

H1 2020: BBL's 'Iron Ore' business segment accounted for 60% of the Group's EBITDA during H1 2020, and generated the single highest EBITDA margin (of 69%) among BBL's business segments. This segment also provides the highest ROCE (read: return on capital employed) of ~50% as against 9%, 13%, and 15% for copper, metallurgical coal, and petroleum, respectively, during H1. The segment's strong performance is explained by high-end, low-cost production. To put that into context, the segment's H1 2020 production costs came out at US$13.03/t (which was at the lower end of the FY 2020 guidance range between $13 and 14/ton) compared with market prices that varied between $90 and 120/t during H1 2020.

Year-to-date ended March 2020: During the 9-months ended on March 31, 2020, BBL's attributable iron ore production from its WAIO (read: Western Australian Iron Ore) business came out at record 181.43 Mt (read: a million metric tons) that witnessed a 3% YoY increase. The significance of these numbers lies in the fact that BBL managed to increase production at the segment that generated the highest EBITDA (in terms of both EBITDA margins and the proportionate share in the Group's total EBITDA), and that positive results were achieved despite the negative weather impact of Tropical Cyclone Blake and Tropical Cyclone Damien.

BBL's ability to contain a negative catalyst and offset its impact with a stronger, positive catalyst, is commendable. This was the case when the impact of bad weather was partially offset through record production at Jimblebar (together with improved 'Fe' grades; expected to be above 60% Fe fines), and improvements across the company's supply chain network, including enhanced maintenance of car dumper. BBL states that it has maintained 'healthy stock levels' across its mining operations. Generally, I'd question such inventory levels as it would incur stock holding costs and limit a miner's potential to mine further ore. However, seeing that iron ore prices have recently passed the $100/t mark following disruptions in Brazil's iron ore supply chains, together with rising post-COVID-19 industrial demand (particularly from China; check Author's Note-1), I believe that BBL's high iron ore inventory levels would reflect favorably on its cash flows.

[Author's Note-1: BBL expects slightly increased steel production in China during FY 2020 provided the country can avoid a second wave of COVID-19. I think this would translate favorably for demand of its iron ore production.]

With ~60 Mt in Q3 iron ore production, the segment is set to finish FY 2020 at the lower end of its annual production guidance range between ~242 and 253 Mt. Have a look at Figure-2.

Figure-2 (Source: 9-months operational review)

Segment opportunities and risks

Opportunities: Since BBL's WAIO business comprises of five mines and four processing hubs, these sub-segments present unique opportunities. While rising iron ore prices (Figure-3) do provide a good opportunity for enhancing the segment's EBITDA margins going forward, the South Flank project is capable of replacing the 80 Mtpa (read: Million tons per annum) production capacity from the existing Yandi mine. This project is scheduled to go live in the next calendar year and, more importantly, is on track. BBL's strong liquidity profile (cash & equivalents well above $10 BB) de-risks the project against any possible delays.

Figure-3 (Source: Business Insider)

Furthermore, the Samarco mine's operations have been suspended since 2015 and last year, BBL received a Corrective Operating Licence (or LOC) for the restart of Samarco's Germano Complex. Currently, the project restart activities have been slowed down due to COVID-19, but it does provide an opportunity for increased production in the long run.

[Author's Note-2: The above iron ore prices relate to the 62% Fe fines. While BBL's iron ore concentration varies from the 62% benchmark, the impact of higher iron ore prices is incorporated into the discussion for reference purposes.]

Finally, another growth opportunity is spotted through BBL's target expansion of its iron ore exporting capacity at Port Hedland. The company aims to increase its long-term export capacity from 290 million tons/annum to 330 million tons/annum. The initiative is still in the very early stages (consultation phase) before it could move towards regulatory approval phase. Nevertheless, it does count as a plus for BBL's iron ore supply chain.

Risks: Although I believe that a reversal of iron ore prices from the current path is less likely, given the prevailing market conditions, however, a decline in ore prices would reflect negatively on BBL's share price since iron ore segment is a very significant contributor to the Group's EBITDA (discussed earlier). At this time, this risk is unlikely to materialize.

Another more pronounced risk in the development of the South Flank project is the protection of the sacred aboriginal sites during project development. Since BBL is proceeding the project development with caution, I think the risk is kept at bay as BBL is considering provision of financial and other benefits to the local communities (the Banjima people).

Business Segment: Copper

H1 2020: Likewise, BBL's 'Copper' business segment accounted for 20% of the Group's EBITDA during H1 2020. Together with iron ore, the two segments roughly make up 80% of the Group's EBITDA. Copper segment also posted a high EBITDA margin of ~50% but generated a substantially lower ROCE (9%, mentioned earlier). BBL's copper edge is denoted by its controlling stake in the Escondida mine (in Chile), which is arguably the world's largest copper mine. The segment's H1 2020 production costs came out at US$1.10/lb (which is lower than the FY 2020 guidance range of ~$1.20-1.35/lb).

Year-to-date March 2020: During the 9-months ended on March 31, 2020, BBL's attributable copper production from its copper assets came out at record 1,310 kt (read: a thousand tons) witnessing a 5% YoY increase. The company expects full year copper production to be in line with last year. The only operational disruption was witnessed at BBL's Antamina copper mine that saw a temporary suspension of operations due to COVID-19. However, copper segment's operating margins during YTD March 2020 were affected by lower average realized copper prices of $2.43/lb that denoted a 7% YoY decline.

In my view, BBL's ability to offset a negative catalyst with a positive one is again put to the test here. This was the case with BBL's flagship copper asset, Escondida. The mine delivered lower head grades, but the impact was largely contained through increased concentrator throughput, resulting in a 5% YoY increase in Escondida's output during the YTD 9-months ending on March 31, 2020.

Segment opportunities and risks

Opportunities: Although BBL's copper assets are capable of providing sustainable low-cost copper production, the greatest opportunity in the near-term is provided by bright copper outlook in both the near term and the long term. Copper's technical price chart (Figure-4) shows acute recovery since mid-March, and I expect copper to close at or beyond the $2.7/lb mark by the end of June 2020. This could lead BBL's weighted average realized copper prices to move past the $2.5/lb mark.

Figure-4 (Source: Finviz)

Long term, (say within the next 3-5 years horizon) copper demand is likely to see a boom following its role in making electric wiring for the EV (read: Electric Vehicles) expansion. On that note, a massive future infrastructure investment plan is already in the pipelines for major economies including the US, the European Union, and China. These plans cater to the need to reach the next level in communications technology (that is, 5G) in an attempt to reduce carbon emission levels through the evolution of the EV industry.

Risks: Then, again, a possible (though not probable) reversal in copper price trend would reflect negatively on BBL's copper segment. Prior to the spread of COVID-19, the most significant catalyst on the mind of economists was the Phase One trade deal. As the world is emerging from dealing with the first wave of the pandemic, attention is naturally diverted towards the successful execution of the trade deal. There's already too much politics into the trade deal (and I'd prefer to keep out of a political discussion). Nevertheless, the environment is tense, and I believe any significant adverse development on that front would batter the demand of copper in both countries (particularly in China).

Moreover, BBL is currently eyeing a $2.5 BB expansion project at its Spence mine to significantly enhance mine life by ~50 years, and to add ~200 kt of copper to the mine's annual production capacity. Nevertheless, COVID-19 has forced BBL to announce a recent delay in the tentative 'go-live' of the SGO (read: Spence Growth Option) which is stretched from the end of CY 2020 to the beginning of CY 2021.

Outlook for the Remainder of the Year

BBL's CEO Mike Henry stated in the presentation for YTD 9-months ended March 2020 (emphasis added by author),

While demand in China has strengthened in recent weeks, we expect other major economies, including the US, Europe and India, to contract sharply in the June 2020 quarter. The situation remains fluid, however, with our strong financial position and low-cost operations, our business is resilient, with capacity to generate solid cash flow through this period and emerge well placed as the global economy recovers.

In my view, the company's CEO is spot on. As mentioned earlier, the Chinese economy is gradually building up momentum after having a troubled Q1 2020. On the flip side, as the US is now reporting the second wave of COVID-19 cases, the economic uncertainty seems to persist over there. This may prevent what would otherwise have been a remarkable growth in BBL's product demand (at least during the remainder of the calendar year).

Nevertheless, as discussed earlier, favorable commodity prices, together with pipeline expansion projects, remain the key growth catalysts for the near-to-long term outlook, provided BBL can successfully overcome the risks.

BBL versus RIO

RIO is another mining giant that's engaged in multiple significant (and similar) business segments like BBL and has a similar business model. Therefore, I think it's only fair to compare the two companies' strategic response to the business challenges (particularly in a COVID-19-struck business environment).

Spending Strategy: When it comes to growth spending, BBL is pursuing organic growth while RIO is pursuing attractive M&A (read: Merger & Acquisition) opportunities. For BBL, the capital allocation framework introduced in 2016 had since helped the company deliver high returns together with growth. The strategy is aimed at adopting a cost-focused approach and delaying CAPEX expenditure for business expansion until the optimization of results. To put that in context, BBL expects FY 2021 actual growth spending to be lower than the original guidance of $8 BB, to accommodate the business impact of COVID-19. The company's recent agreement with Norilsk Nickel (OTCPK:NILSY) (a Russian miner) to buy the Honeymoon Nickel project strengthens BBL's nickel footprint in Australia. Nickel is used in EV battery production, and I believe this agreement will allow BBL to expand its nickel production at a time when EV boom is near (once the world emerges from the COVID-19 era). In contrast, RIO's pursuit of attractive M&A opportunities is risky since it's often difficult to value a company as an attractive acquisition target and even more so in this COVID-19 environment.

Australian reputational risk: RIO recently came in the line of fire for blasting an aboriginal sacred site expected to be more than 40,000 year old (in the Australian Pilbara region). The news caught attention of media, investors, as well as the local communities, and the authorities. Legislators are working to make framework for protecting such heritage sites and penalizing the miners involved.

BBL has adopted a proactive approach to revisit the expansion plan of its South Flank project, to prevent damage to such heritage sites. BBL's response largely protects its Australian mining reputation from damage and provides a strategic advantage over its competitor, RIO.

Technical Analysis and Investor Takeaway

BBL's 52-week price range lies between $23.64 and $51.87. At the time of writing, the stock last traded at $40.28, and that value was slightly higher than the median value (at $37.75) of its 52-week range. The current stock price is also mildly above its 50-day and 200-day EMA (read: Exponential Moving Average) of $38.21 and $39.05, respectively. For those traders who purely follow the technical analysis, I believe the train has already left the station.

Figure-5 (Source: YCharts)

Nevertheless, for long investors, I think there's safely an opportunity for 10-15% upside in share price (with a minimum price target of $45) accruing from business growth opportunities highlighted above, together with the support from improving copper and iron ore prices (that act as the backbone of BBL's two critical business segments). That said, the stock is set to continue its gradual upward trajectory over the long term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.