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Morningstar | Weak 1H for BHP but AUD 25.50 per Share FVE Maintained

BHP will need a much stronger second half to deliver on production and cost guidance and our full-year profit expectations. First-half fiscal 2019 adjusted net profit after tax of USD 4.0 billion was in line with the first half of fiscal 2018. Adjusted earnings were also flat versus a year ago at USD 0.76 per share.

BHP’s shares have risen with the Vale disaster and the iron ore price. Higher commodity prices and increased investor risk appetite in 2019 following the correction in late 2018 have also helped. There may be more upside in iron ore than we have factored in, but there is also a risk further production disruptions could frustrate BHP’s efficiency efforts. For now, we maintain our AUD 25.50 per share fair value estimate.

Higher near-term prices are likely to incentivise an eventual supply response. We can see additional iron ore supply coming from Vale as it eventually recovers, Anglo American in Brazil, and Samarco once it restarts, though the timing of these events is uncertain. More broadly, we still expect China’s steel demand to decline and for scrap to account for a greater proportion of supply. Iron ore and coking coal trade well above their respective marginal costs, a key reason we continue to see the shares as overvalued.

Our fiscal 2019 adjusted earnings forecast falls modestly to USD 2.20 per share. We’ve lowered our expectations for copper production slightly, with Escondida tracking towards the lower end of guidance. The effective tax rate of 36% in the first half was also higher than we expected, and we raise our full-year forecast. Regardless, a much stronger second half will be needed to hit our earnings forecast. There’s potential for near-term upside though from high iron ore prices if sustained. If the second half averages USD 85 per tonne, versus our USD 65 per tonne forecast, adjusted earnings would rise by 14% or USD 0.31 per share.

Unadjusted net profit rose 87% to USD 3.8 billion. BHP reported net once-off costs of USD 270 million in the half with losses from the discontinued shale operations, costs relating to Samarco, partly offset by a tax benefit. Unadjusted first half of fiscal 2018 profit was depressed by USD 2.0 billion of net once-off costs relating to U.S. tax reform and Samarco.

EBIT of USD 7.3 billion was in line with last year but EBITDA declined 10% to USD 10.1 billion. This reflected discontinued U.S. onshore petroleum and worse unit costs. The latter was a function of unplanned outages. At Olympic Dam and Spence, these saw about 70,000 tonnes of copper output lost and the Pilbara train derailment reduced iron ore volumes by four million tonnes. Lower productivity reduced EBITDA by USD 0.6 billion and onshore shale by USD 0.5 billion. The U.S. onshore assets contributed USD 0.5 billion of positive EBITDA in the first half of fiscal 2018 but were loss-making at the EBIT level due to their capital-intensive nature.

At the divisional level, underlying EBITDA increased 38% for petroleum to USD 2.3 billion, coal by 17% to USD 1.8 billion and iron ore by 1% to USD 4.3 billion compared with the first half of fiscal 2018. Copper was the laggard with EBITDA falling 40% to USD 1.9 billion. The better petroleum performance primarily reflected higher prices, but the division also delivered solidly on production and unit costs. Coal benefited from higher coking coal prices and volumes. Productivity in iron ore offset the slight reduction in the average realised price. The weaker copper EBITDA primarily reflected the lower average copper price. Costs and volumes also detracted though with the decline in grade at Escondida and several outages impacting.

BHP remains in strong financial shape. Free cash flow of USD 7.6 billion benefited from USD 6.9 billion of proceeds from the sale of U.S. onshore shale. This represents the bulk of the expected aftertax payments of about USD 10.7 billion. Cash from the sale was returned to shareholders via the off-market buyback and the USD 1.00 per share special dividend.

The USD 0.55 per share fully franked interim dividend may have disappointed some in the market hoping for an increased payout or another special dividend with the result. However, with BHP’s capital allocation strategy clear and the near-term call on cash flow for capital expenditure relatively modest, we think a large final dividend is probable. We’re forecasting total dividends of USD 2.80 per share in fiscal 2019, including the recently paid USD 1.00 per share special.

Net debt at the end of December 2018 of USD 9.9 billion is at the bottom of BHP’s stated target range of USD 10 to USD 15 billion. We can see some logic for a move to net cash, particularly when it comes to making acquisitions in a downturn. But management is adamant in adhering to the targeted net debt range. We don’t see a massive appetite for acquisitions at this point in the cycle. Asset prices are relatively high and competition to buy would likely be intense given most major miners have very strong balance sheets too. BHP’s share price has also rallied with the Vale disaster and increased iron ore price, making buybacks less attractive. Therefore, dividends appear the logical outlet for excess cash.