BHP Group Limited (BHP) is a global resource company that explores, develops, and produces oil and gas. It also mines various base and precious metals and coal for metallurgical and energy purposes. The company is headquartered in Melbourne, Australia.
Despite a 17.6% drop from its early April peak, I will explain why I think this stock is a Hold.
Current Market Fears
The market has shown little enthusiasm for base metals in recent days, causing BHP stock to fall along with the share prices of other mineral resource operators.
The bearish sentiment appears to be driven by fears over base metal demand, fueled mainly by a resurgence of COVID-19 in China, rapid inflation, rising interest rates, the war in Ukraine, and signs of slowing manufacturing activity in the United States and China.
Because of these concerns, the future looks very uncertain, and indeed, analysts believe there is a possibility that the global economy could slide into a recession or worse, stagflation.
Both scenarios would have serious consequences for BHP and other mineral resource operators, so the price decline of BHP that started on April 20 could continue for some time.
Bearish Sentiment Towards Base Metals: A Misjudgement?
It cannot be ruled out, in my view, that the current bearish sentiment about base metals is due to a misjudgment of current macroeconomic and market conditions.
Aside from the recent new wave of COVID-19 in China that is reviving fears about growth, the other worries about the demand for base metals relate to conditions that have been in place for several weeks, covering both downswings and upswings for the commodities.
Higher energy costs are nothing new either, and base metals and many of their operators, including BHP, have already passed the stress test. As part of the economic recovery from the COVID-19 crisis, the rapid rise in energy costs has been going on for months, during which base metals also saw their prices moving up.
Regarding the Federal Reserve, it has been planning higher interest rates through gradual and rapid hikes for several months without these plans ever raising fears about future demand for base metals.
Therefore, high energy costs or the rise in interest rates proposed to explain low base metal prices require thorough analysis before assuming cause-and-effect relationships between variables.
Reasons to be Positive
Currently, many governments are funding reductions in certain fixed costs to reduce the weight of energy bills on household and corporate balance sheets, thereby supporting their demand for services and products, including metal-based goods.
Many investors also believe that demand for various base metal-based products is falling as they see manufacturing activity in the U.S. and China declining too sharply or dangerously.
However, if we look at the components of the Manufacturing PMI (Purchasing Managers’ Index) for the United States, we find the following: the factory’s overall growth rate has accelerated since September, thanks to a very rapid increase in production, which put pressure on production capacity and prompted companies to hire additional staff to clear the backlog, which is increasing rather than decreasing.
The Caixin China General Manufacturing PMI is currently below market forecasts, suggesting a slowdown in factory activity due to COVID-19 outbreaks taking a heavy toll on various components of China’s gross domestic product.
However, rising backlogs are leading to pent-up demand for base metals, which could unfold sooner than expected as vaccine availability and experience in containing infections should mean control measures won’t last as long as before.
The Risk of Holding BHP May Have Been Overstated
While the near-term outlook is uncertain, the above considerations can undoubtedly further mitigate the downside risk for BHP (and other operators).
Once the headwinds of the COVID-19 resurgence in China are over, multinational operator BHP could potentially rise very strongly, driven by higher metal needs around the world to meet global targets.
These targets include the introduction of green technologies, the strengthening of telecommunication network services, the electrification of industries, and the digitization of operations. The ongoing urbanization and construction of new infrastructure in Asia, along with an expected increase in usage of phones, computers, and other devices, will also help BHP generate higher sales and, ideally, profits, laying a solid foundation for better share prices.
Strong Balance Sheet
The company enjoys a robust balance sheet, as evidenced by an Altman Z-score of 4.55 and an interest coverage ratio of 29.4.
The first metric indicates that it is highly unlikely that the company could go bankrupt in the next few years. The second ratio shows that the company can easily pay interest charges on outstanding debt.
For those unfamiliar with the financial metric, the Altman Z-Score measures the likelihood that a company could go bankrupt within a few years. If the ratio is higher than 3, the chance of bankruptcy is minuscule, as the company is in the “safe zone.”
The interest coverage ratio should ideally be at least 1.5 and is calculated as EBIT divided by interest expense.
Profitability and Production Targets
BHP Group holds highly profitable operations, much higher than most peers, as indicated by its 12-month EBITDA Margin of 59.3% versus 21.3% for the sector.
This positions the stock very strongly, as a rise in the commodity price will be reflected in a rapid recovery in the share price via higher margins.
The company expects to produce between 1.59 and 1.76 million tons of copper and between 249 million and 259 million tons of iron ore in 2022.
BHP also mines metallurgical and energy coal and nickel. However, copper and iron ore are the company’s two largest contributors to consolidated earnings. Therefore, when the prices of other commodities, including oil and steel coal, trade weakly, copper and iron ore allow for a full offset.
Dividend Growth
Robust copper and iron ore businesses enabled BHP to increase the dividend by 124.4% (versus the sector median of 8.4%) in the past year and to increase it by 43.7% per annum (versus the sector median of 6.3%) in the past three years.
Wall Street’s Take
In the past three months, three Wall Street analysts have issued a 12-month price target for BHP. The company has a Moderate Buy consensus rating based on one Buy, two Holds, and zero Sell ratings.
The average BHP Group price target is $77, implying 17% upside potential.
Valuation
Shares are changing hands at $65.79 as of the writing of this article, for a market cap of $237.3 billion, a P/E ratio of 9.9, and a 52-week range of $51.88 to $82.07.
The stock has a price/book ratio of 3.4, a price/sales ratio of 2.5, a price-to-cash-flow ratio of 5.5, and a price-to-free-cash-flow ratio of 7.1. The stock offers a forward dividend yield of 10.64% as of this writing.
Conclusion
The stock is significantly down from its April highest due to the bearish sentiment on base metals. There is a likelihood this negative sentiment is an overreaction from the misjudgment of current macroeconomic and market conditions, which mitigates the risk of continuing to hold BHP today.
While there is a risk that base metals will continue to trade lower and lower and BHP (and other operators) will continue to fall, this may not be important enough to lower a Hold rating.
The stock has robust copper and iron ore businesses and is poised to benefit from an expected pick-up in demand as the world chases after its growth targets.
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