World class assets at a world class price

The Australian iron ore industry is world-class. BHP’s iron ore operation in Western Australia is one of the world’s great businesses. Return on capital employed of over 45%... even ~20% during low prices. Accounting for over 50% of earnings it’s a business that anyone would love to own. What’s the bad news? There’s a couple of things:

COVID-19 Impact

BHP’s business has been relatively resilient through the crisis to-date. China has the biggest impact on Iron Ore demand and hence price. Emerging from their lockdown China is getting back to work and monetary conditions are easy with further commodity-intensive fiscal stimulus likely. 

The iron ore price has been remarkably resilient and at these levels, along with a currency tailwind, the major producers are printing cash. Importantly, with a very strong balance sheet (Net debt/EBITDA ~0.5x), BHP is well placed for whatever comes next.

The big COVID-19 risk for the company is that one of their mining sites has a virus breakout. We understand the company is working hard (distancing, testing and quarantining) to mitigate this risk.

Iron ore inventories in China

BHP is a diversified mining company, however, its most profitable commodity remains iron ore. China is by far the most important customer for iron ore and tracking their iron ore inventories remains a key metric to watch – as we are currently seeing in the oil market, any large build-up in inventories can be a big headwind for prices.

The good news for BHP is that iron ore inventories in China remain at normal levels with a reduction in China’s steel production due to COVID-19 being offset by only modest supply growth from the major producing countries, particularly Brazil.

BHP’s strong financial position, quality business and management team are supported by an attractive valuation. Since the beginning of 2020 BHP has underperformed its key peer RIO (yellow line) as well as its key commodity iron ore (green line).

  

Source: J.P. Morgan estimates, Bloomberg

Below is a valuation chart which uses a metric, Net Present Value (“NPV”), that captures earnings through a full commodity price cycle. The chart shows that BHP over the long term has traded around 1x NPV and is currently trading at a ~20% discount, further providing attractive valuation support.

Source: J.P. Morgan estimates

A rare opportunity to buy high-quality businesses at very attractive prices

At the heart of BHP lies a world-class asset. Strong financial discipline in the good times has put the company in a very healthy financial position to navigate whatever lays ahead. In our experience, market dislocations like the one we are experiencing throw out some rare opportunities to buy high-quality businesses at very attractive prices. 

For us, BHP is one of several of these opportunities on offer at present.  

Invest where fair value exceeds market price

Airlie Funds Management employs a prudent, common-sense investment approach that identifies Australian companies based on their financial strength, attractive durable business characteristics and the quality of their management teams. To learn more, click ‘contact’ below.

The above wire was co-authored by Matt Williams, Portfolio Manager of the Airlie Australian Share Fund and Terry Couper, Head of Research at Airlie Funds Management