BHP: China concerns
There’s been a lot of good news around mining behemoth BHP of late, driven mainly by higher commodity prices. Unlike in previous cycles, the mining industry as a whole is behaving rationally by not overspending on new projects and returning excess cash to shareholders. In addition, BHP itself is not overpriced based on longer term commodity price forecasts. However, we remain concerned about the economic slowdown in China, which accounts for more than half the group’s revenue. After adding to BHP nearly two years ago, we’ve therefore decided to take some profits – to reduce our exposure to both cyclical stocks and the broader Chinese economy.
Mining and technology companies appear to be worlds apart – whereas the former are seen as part of the traditional, ‘boring’ economy and are slowly losing significance, the latter are viewed as exciting and innovative, and increasingly important in our modern world. While this may have a ring of truth, mining will remain essential to our world for the foreseeable future – we can’t do without resources when it comes to building the infrastructure and appliances we use every day.
BHP is the largest mining conglomerate in the world. In 2018 the group reported revenue of nearly US$44 billion and free cash flow of US$12.5 billion. Tencent, the Chinese internet company partly owned by Naspers, is likely to report about US$46 billion in revenue and US$12.7 billion in free cash flow for 2018. These are very similar numbers for radically different businesses.
BHP and Tencent do have one thing in common – they both have a competitive advantage (a ‘moat’) in the respective industries in which they operate. It can be argued that Tencent’s moat is the monopoly access to the Chinese market through its very integrated social media platform, WeChat. But what kind of moat could a mine selling a globally priced commodity possibly have?
BHP’s iron ore business in the Pilbara region of North Western Australia is one of the largest in the world, producing about 280 million metric tons (almost 20% of the global seaborne market), with iron ore resources expected to last another 100 years. The total cost to get the iron ore to China is US$30/ton. At the time of writing, the benchmark price at Chinese ports was more than US$70/ton – the cash flow margin is therefore nearly 60%!
Let’s compare this to BHP’s South African competitor, Kumba. This mining group can produce around 45 million tons from its mines at a total cost closer to US$50/ton, and its mines have an average life of only about 14 years. If prices decline again to the December 2015 lows of US$38/ton, BHP will continue to make money, whereas Kumba will not.
The moat in the mining industry is therefore ownership of the best assets (lowest cost, longest life, best quality and most stable mining jurisdictions) in commodities that’ll remain necessary to build our world. BHP’s iron ore business, which accounts for more than half of the group’s valuation, fits this description. Assets like these are seldom replicable, simply because there are only a limited number of places in the world comparable to, for example, the Pilbara region.
BHP’s other assets include low-cost copper mines in South America, most notably Escondida, the largest copper mine in the world, situated in Chile and producing around 1.2 million tons of copper out of a total market of 20 million tons. Copper, essential in most electrical applications, is the main growth area for BHP. Other assets include high-quality metallurgical coal mined in Australia (used in the steelmaking process) and low-cost conventional oil and gas produced off the coast of Australia and in the Gulf of Mexico.
Is the price justified?
Since the commodity price slump in 2014 and 2015, the global mining industry has recovered significantly – by radically reducing debt, reprioritising productivity and cost cutting, and focusing on returning cash to shareholders. BHP is likely to return at least US$17 billion to shareholders in 2019 (a 17% dividend yield), including normal dividends and a special payout following the sale of its US onshore petroleum business to BP in 2018.
It’s crucial to distinguish a good business from a good investment. As argued above, BHP has quality assets and, compared to peers, a relatively decent capital allocation track record. Is the price paid for it justified, however?
When we at Sanlam Private Wealth look at companies, we try to value them through the cycle. In the case of resource shares, we use commodity prices that we believe are normalised, as opposed to prices at either the top or bottom of the cycle.
Based on our long-term prices, we believe BHP is currently fairly valued by the market. For this reason, we think it’s no longer cheap. However, it’s also not expensive. Our price assumptions are generally more conservative compared to consensus forecasts, which in turn are still somewhat lower than spot prices – especially for iron ore and coal. The market is therefore already pricing in much higher spot prices to come down somewhere in the future.
Slowdown in China
If the underlying business looks healthy and it isn’t expensive, why are we selling BHP? The main reason is that we’re concerned about the global economic cycle, which is increasingly showing signs of losing momentum, and in particular, signs of a slowdown in the Chinese economy.
China consumes more than 60% of the world’s iron ore and metallurgical coal, about 50% of global copper and thermal coal, and 15% of the world’s oil. The country is needless to say important to BHP – in fact, 53% of the group’s revenue came from China in 2018.
Real estate accounts for about 45% of China’s domestic steel demand – and about a quarter of global steel demand – so a slowdown in this area is of particular relevance to iron ore. We expect new property projects to come under pressure in 2019 as land sales – historically a good leading indicator for new property project, and thus also steel demand – declined in 2018.
On the flip side, the Chinese government has in the past stimulated the economy by using property incentives and/or boosting infrastructure investment. The government is currently implementing infrastructure stimulus, but our concern is that this may not be enough (around 15% to 20% of Chinese steel consumption) to offset slowing property demand.
It’s important to emphasise that we certainly don’t expect a crash in property or in the Chinese economy in general – just a slowdown. We therefore continue to maintain a fairly large position in BHP – we’re not of the view that it’s time to sell and run for the hills. Given the late stages of the current economic cycle, however, we believe it’s prudent to de-risk our clients’ portfolios by reducing our exposure to cyclical shares in general and the broader Chinese economy in particular.