I have found that simple financials and ratios to be most useful as the first snapshot when looking at a company. This is like the first date. You are just going to see a glimpse of this person with all the excitement and risks. Is she pretty, is he handsome? What are his or her likes and dislikes? Any major dealbreaker like smoking (if you are non-smoker), drugs, violence etc. That’s simple financials. Today, we have this interesting set of numbers:
Simple financials (Jun 2023 estimate, USD)
Sales: 55.7bn
EBITDA: 30.0bn
Net income: 14.9bn
FCF: 12.4bn
Debt: 5.1bn, Mkt Cap 144.9bn
Ratios
ROE 33.4%, ROIC 30.3%
EV/EBITDA 5.2x (Jun 24)
PER 10.4x (Jun 24)
Past margins: OPM 25-45%
FCF yield 8.6% (consistently at mid to high single digit, with last two years double digits)
This set of numbers could be the strongest we have seen so far, beating Roche’s! Alas, it is in an industry even more cyclical than Roche’s! In the lean years, it goes into losses and ROE turns negative. It is also highly capex intensive (10-35% of sales) and the firm suffered a couple of years of negative FCF over the last 30 years but only once in the past 20 years. Over the last 10 years, it has compounded nicely with share price doubling for GBP12 to GBP24 today.
Company has these great pics in its results presentation to kick off earnings discussion
Investors, skeptical of the boom bust cycles in the recent past, has ascribed inexpensive valuation across the whole sector with PER at very low double digits and EV/EBITDA at 4-6x. Meanwhile FCF of the whole industry has been exceptionally strong over the last few years.
This company is none other than BHP (used to be called BHP Billiton and before that Broken Hill Proprietary), an Australian commodity giant turned multi-national resource powerhouse. While it is dual listed in UK and Australia today, BHP provides reported no.s in USD and has been one of the strongest compounders driven by the firm’s unique competitive advantage and world class operational execution and capital management.
The investment thesis is as follows:
BHP owns some of the best commodity assets on Earth which allows for low cost production and has been able to generate ridiculously high Return on Capital Employed (slide below) and EBITDA margins of 30-60% over the last 15 years. Its management has also been able to drive further value with operational execution and capital management that has resulted in quadrupling of its book value per share from USD2 in 2003 to USD8.8 today (GBP1.2 in 2003 to GBP7.3 today).
Strong return on capital across key businesses and at the same time building new pillars for the future
The predecessors of today’s BHP have had long illustrious histories dating back to the 1800s which is worth more scrutiny for people who like to go back in time and study things. For today, let’s focus on the birth of BHP Billiton in 2001. Since then, it went through many mergers and demergers which simplified its business portfolio to focus on a few major commodities: copper, iron ore, coal, nickel and potash today.
Notably, it divested its steel business in the very early years and more recently it completely got out of energy, selling its US shale oil and gas business in 2017 and then engineering the full exit by merging the energy business with Woodside, Australia’s largest independent gas producer.
Today, BHP’s segments are clearly defined and the following chart from its 1H results briefing in Feb 2023 provides a good snapshot of the company:
Management
BHP is currently helmed by Mike Henry. He was appointed CEO in 2020 and has over 30 years of experience in resource and mining. He is supported by CFO David Lamont who was also CFO previously at CSL, Oz Mineral and other large cap Australian names. As the leading company in Australia, BHP attracts the best talent from the country to join like how Roche did as the leading Swiss pharmaceutical company.
With the best talent, strong culture of meritocracy and less politicking and bullshit, BHP continues to exhibit the positive traits of well-run companies with the right incentives and values even as it evolved into the multi-national resource powerhouse it has become today. This is exemplified by the impeccable capital allocation decisions described above.
1. Positives
Australia is blessed by the iron and mineral gods. Starting as an Australian company, the geographical advantage formed billions of years ago naturally found themselves in BHP’s portfolio, becoming part of the company’s moat. Some assets are simply legacies of the company’s history and other important assets were added by design, thanks to generations of strong, savvy management.
There are some places on Earth that provide easy access to minerals and fossil fuels. For example, Middle East is blessed with oil and gas. Africa has diamonds and gold. US has shale gas, which was made possible to extract by technological advancement. Australia has a bit of everything, iron ore, coal, minerals in abundance and they are easy to extract, benefiting BHP in the early years.
BHP’s two key assets in Australia for iron ore and coal built the foundation which it has leveraged on with efficient extraction and transportation. Then by management design, successful M&As has allowed the company to build a formidable suite of assets that enjoy high return on capital. The following lists the key assets today:
- Western Australia Iron Ore (WAIO)
- BHP Mitsubishi Alliance (BMA) producing metallurgical coal
- New South Wales Energy Coal (NSWEC)
- Escondida, Chile (Copper)
- Nickel West, Australia
- Jansen, Canada (Potash)
In short, the first positive which is also a strong business moat is that BHP enjoys a huge competitive advantage as the lowest cost producer in its key assets as a result of Australia’s geography, which allowed BHP to own low cost mines with long lives such as WAIO and BMA. Building on this, it has gone out and acquire similar good mines and maintained and strengthened its competitive advantage across key minerals.
This solid portfolio of assets has generated supernormal free cashflow over the last 10-20 years. Cumulatively, BHP made USD168.6bn of FCF from 2003 to 2023, which is more than its market cap today. Looking back for just 10 years, it has also returned more than half of this humongous FCF amount as dividends. For an investor who bought the stock in Australia in 2013 when the share price was c.A$15 (post stock splits), the dividends distributed has more than exceeded this amount.
So here’s the second positive - BHP is simply a cash generative machine much like Pepsico was, but trading at a much cheaper valuation with slightly more volatility.
The third and last positive is BHP’s potential in Potash and Nickel. While both businesses generate negligible EBITDA today, BHP’s assets in both businesses will allow it to become a dominant player in the future as long as it continues to execute. Potash is a key mineral in fertilizers and nickel is widely used in batteries which is needed to power the millions of electric vehicles in our sustainable future.
By positioning itself with key assets that can extract these elements at low costs, BHP stands to become a dominant player in both fields when the mines come online. Both potash and nickel have also seen shortages as a result of the Russian-Ukraine war, which further improves BHP’s position. Markets like to hope and dream and given the right circumstances, share price can skyrocket into trillions of market cap if the picture of a dominant clean potash and nickel producer solving global environmental and geo-political issues can emerge. This is the upside for BHP.
2. Risks
Investing in BHP comes with three major risks: regulations, accidents and disasters and deep cyclicality. We shall discuss them below.
Regulations
In 2018, BHP settled a longstanding dispute with the Australian Taxation Office (ATO) by paying A$529m (c.USD350m) in additional taxes for the income years 2003 to 2018. The crux of the issue was related transfer pricing in its Singapore marketing arm which ATO claimed that BHP made use of to evade tax. As such, in this author’s opinion, regulations ranked as the highest risk factor. The following are the regulatory disputes from chatGPT (edited and verified to be true):
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Western Australia Iron Ore Royalty Dispute: BHP was involved in a legal dispute with the Western Australian government regarding iron ore royalty payments. This was similar to the above ATO dispute and was settled for A$250m.
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BHP admitted that it underpaid over 170,0000 days of work across the company’s current and former employees after miscalculating public holiday leave for more than a decade. The cost of remediating the issue will be c.US$280m.
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Anti-bribery Fines: In 2015, SEC fined BHP for US$25m for violating US anti-bribery law by failing to properly monitor a program under which it paid for dozens of foreign government officials to attend the 2008 Summer Olympics in Beijing.
Samarco Dam Disaster: BHP’s joint venture with Vale S.A., suffered a catastrophic dam failure at the mine resulted in a massive release of toxic mining waste, causing significant environmental damage and loss of lives. BHP faced legal actions and regulatory investigations from Brazilian authorities, leading to significant penalties and ongoing legal proceedings. More on this later.
As we can see, regulatory risk is BHP’s biggest risk. BHP’s regulatory issues are complex, recurring and has significant negative impact on earnings at times. Investors have to be mindful. Once in a while, a tsunami level issue hits and the company could be crippled for years. The mitigating factor is that BHP has managed to navigate these so far and still generate strong FCF and shareholder returns.
Accidents and Disasters
Samarco dam disaster in 2015
The second risk which is related to the above is the accident and disaster risk. In 2015, one of BHP’s asset in Brazil, the Samarco Mining Complex caused one of largest environmental damage and human tragedy when its dam broke, causing toxic mudflow to hit villages and houses, resulting in 19 deaths. BHP and its partner Vale were fined USD4.8bn. But this does not cover civil damages and the cost of recovery.
Lawsuits are ongoing and some news articles have floated that further cost escalation to USD55-65bn for the duo is possible. Such disaster can post significant risk to commodity companies. Recall that BP’s Deepwater Horizon disaster, which was made into a Hollywood movie, still haunts the company today.
The mitigating factor is that BHP understands that safety is paramount. On the first slide of its every presentation, BHP talks about safety. BHP latest results highlighted death of one of their colleague due to accident and the CEO makes a personal message to emphasize the importance of safety. It is unclear at this juncture how big Samarco might become, but its strong share price is saying perhaps this is not going to be as crippling as it was for BP.
Deep Cyclicality
Commodity stocks are destined to be cyclical and BHP is no different. Over the last 20 years, share price have seen >50% drawdowns multiple times as we can see from the chart below. Despite its low valuations, investors will still sell commodity stocks to receive cash during market crashes in order to preserve capital. However, we also know that strong players like BHP bounce right back up and the best times to buy is when the share price has corrected significantly. Over the long run, it has also compounded value nicely and we stand to collect massive dividends along the way.
BHP has suffered a couple of huge drawdowns over the last 20 odd years: 2009, 2017, 2020 and 2022.
3. Valuations
BHP trades only at a slight valuation premium in terms of PE amongst it peers. But this can be easily justified as it is the best and the largest player. On FCF, it trades at a very palatable 9.7% FCF yield, which is ironically at a discount to industry average. Looking at its history, this seemed to be sustainable level of FCF which means that, in theory, someone should take the whole company private and reap this 9.7% dividend indefinitely.
Using our usual valuation methodologies to triangulate the fair value for BHP, we have projected FCF and Net Income at USD14bn and EBITDA at USD29bn. Applying the respective multiples give us 22-42% upside (based on the table below) which again provides enough margin of safety. I would argue that these no.s also err on the conservative side.
Lastly to ascertain the risk reward profile, we first look at the share price movement of the last 10 years. While a 50% drawdown has happened before, this brings its FCF yield to c.20%. Although it is possible, I would put it as unlikely, and if it happens, management or some deep pocket buyer would simply take the company private. As such, a bear scenario with 30% drawdown seemed more reasonable. The upside scenario, as alluded in the valuation above is 42%. So with that in mind, the risk reward for BHP seemed balance at -30% to +42% but with the potential go up much higher given its history of strong FCF generation, dividends and simply compounding returns.
