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Does BHP Group Deserve This Hammering?

Australia | Mar 18 2020

As a substantial exporter of iron ore to China's recovering steel industry, does the share price of BHP Group deserve to be slammed so hard?

-Several brokers consider now is the time to gain exposure to BHP Group
-Oil may be down but iron ore is driving upgrade momentum
-Growth projects likely to be delayed


By Eva Brocklehurst

The slump in oil prices and the subsequent de-rating of the sector has dragged BHP Group ((BHP)) into the morass. However, is the stock deserving, considering it is a substantial exporter of iron ore to China's recovering steel industry?

The slump in global oil prices will have an impact on the company's petroleum earnings as well as growth aspirations in that division. Macquarie notes BHP Group's petroleum business accounts for around 14% of group operating earnings (EBITDA), using its forecasts, albeit only 7% using spot prices.

Hence, running spot oil prices and keeping all forecasts unchanged translates to a -11-12% reduction to earnings forecasts, which compares with the decline of around -14% in the stock price.

Morgan Stanley agrees the markets have overreacted and now is the opportunity to gain exposure, as BHP has potential to generate attractive free cash flow through the cycle. Gearing is at the lower end of the target range and affords significant protection and flexibility as well.

The broker also favours BHP's commodity mix relative to Rio Tinto ((RIO)), given its diversification and higher exposure to copper compared with aluminium. The main risk is if demand disruption spills into the second half and leads to a broader downturn.

Credit Suisse has cut forecasts for 2021 to US$45-50/bbl from US$55-65/bbl and cut BHP earnings estimates by -2% and -7% over FY20 and FY21 on the back of the changes. Still, the broker acknowledges its downgrades are likely to be too punitive, as there are small cost tailwinds from lower diesel prices and the currency is also turning in the company's favour.

Iron ore is definitely running in BHP's favour, driving upgrade momentum, particularly for FY21 and beyond. As a result, while acknowledging the oil weakness erodes short-term earnings momentum, Macquarie lifts FY20 and FY21 estimates by 16% and 25% respectively.

Several brokers have acknowledged this situation by upgrading the stock to Buy over the past month. Citi, the most recent to do so, believes the low-cost assets provide an attractive entry point for long-term value.

Reasonable Yield

Citi runs a test scenario, using increasingly bearish commodity forecasts, and while gearing rises for those companies with growth projects this is not to the levels considered of concern. Under this test, BHP's net debt increases to $12.9bn in FY21 versus a base case of $10.9bn and, while the dividend is likely to be cut under the stress test, the yield is still reasonable at 3.8%.

Citi suggests investors are now being paid to wait and, while not absolutely sure the low has been reached, is confident global macro economic policies and stimulus in China should improve the 2021 outlook for commodities.

Morgans expects the BHP share price will recover once the coronavirus impacts are contained, while the major miner is likely to maintain an attractive yield profile throughout the disruption. Moreover, the iron ore exposure should be enough to offset the elevated weakness in energy and some base metals.

Steel markets have proved far more resilient to underlying demand conditions, with the broker noting that while smaller infrastructure-constrained steel mills were operating at just 20% utilisation, the larger ones have maintained production.

This appears to be confirmed by iron ore inventory at Chinese ports. China's domestic iron ore production has also been affected by suspensions which provides further support to seaborne prices.

China's government is expected to respond to the coronavirus conditions (and the rate of infections appear to have stabilised) with stimulus that could mean a sharp recovery in commodities demand in the second half of 2020, Morgans points out.

The current conditions are also unlikely to lead to any structural changes in the steel or iron ore industry, the broker adds. On a longer-term basis, with little structural implications from the coronavirus, Morgans assesses the big miners BHP Group and Rio Tinto are now in value territory.

In contrast, Credit Suisse prefers pure iron ore stocks such as Fortescue Metals ((FMG)) and sticks with a Neutral rating for BHP.

Growth Projects

Macquarie also points out that long-term growth projects for the oil & gas sector are now under pressure, and BHP's interest in both Scarborough and Trion do not generate acceptable returns at a spot oil scenario. Hence, there is a risk these are delayed if it recovery in the oil price does not occur in the near future.

While satisfied that BHP's two thermal coal assets are immaterial in terms of the earnings mix, Morgans also suspects market valuations from potential suitors are likely to be shrinking and would be impressed if the company moved to cut these carbon-intensive assets.

FNArena's database has five Buy ratings and two Hold. The consensus target is $38.08, suggesting 39% upside to the last share price. Targets range from $35 (Citi) to $41 (Credit Suisse).

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