AllianceBernstein has downgraded BHP Group Ltd. (BHP, Financial) to market perform from a previous market outperform.
In a recently published note, the decision was explained by analyst Bob Brackett. He said Bernstein believes diminishing iron ore prices and a lack of opposing catalysts will dent BHP Group's stock performance. Moreover, the firm is of the opinion that the market believes lower commodity prices are en route, providing systemic risk to base metals miners.
It is clear Bernstein thinks BHP Group's performance is contingent on iron ore prices. However, ideally, other factors must be considered before consolidating a stance on the stock. As such, let's traverse into a deeper analysis of the stock and establish what is in store for the Australian miner.
Impact of commodity prices on BHP Group
Bernstein's commodity price argument centers itself on trend growth instead of temporary oscillation. In essence, the firm's comments suggest it believes a slowing economic cycle will result in a continued downturn of commodity prices and that the slight upticks experienced in recent months will be short-lived.
However, despite its pessimism about base metals and energy materials, Bernstein thinks copper can be partitioned from the group as it is a secular growth asset. In Brackett's own words: "Growth in copper and especially the cyclical call on aluminum offsets the risk to iron ore price."
My view on iron ore and oil prices
In my view, Brackett has a point regarding iron ore prices; however, I dispute his stance on oil prices.
Let me elaborate on my stance.
Iron ore prices might continue to soften as its reliance on industrial use poses a problem. Fundamentally speaking, the economy has reached its cyclical peak, with interest rates reaching the higher end, which has resulted in diminishing industrial production across the globe. From here on in, disinflation will likely follow, whereafter, an interest rate curtailment and fiscal stabilizers will be required to rejuvenate the economy and base metal prices alike.
However, on the other side of the playing field, coal prices are not merely determined by the economic cycle. Instead, coal prices might be supported by global energy shortages and a pending northern winter. Thus, I conclude that coal prices are currently indeterminate instead of on a definite bearish decline.
Understanding BHP Group's fundamentals
BHP Group released its annual report in August, revealing disappointing results inflicted by systemic events relating to its buyers and adverse weather in Australia.
According to its full-year report, the company earned $12.92 billion in adjusted annual profits, a substantial decrease from the $30.9 billion earned in 2022. Much of the disappointment stemmed from its coal division, which experienced a 47% decline in net profitability as lower prices proved too much to handle. Moreover, its copper segment slumped by 22% despite rising year-over-year prices, which somewhat reflects the array of production challenges faced by the company.
The diagram at the end of this section illustrates BHP Group's earnings roadmap. As evident in the figure, the company struggled with high input costs during 2023 as diesel prices and wages remained resilient. In addition, its financing costs suffered from higher interest rates, which influenced its before interest and tax profits.
Despite the possibility of lower interest rates and a softer labor market, fuel remains expensive and inventory value is in a downtrend. Therefore, there are unlikely any catalysts that would enhance the company's fortunes for the time being.
Source: BHP Group earnings roadmap
Valuation and dividends
Mining stocks often oscillate around their price-book multiples as they are asset-heavy businesses with easily measurable asset bases. However, factors such as impairments and future earnings must be intertwined into the analysis instead of looking at the price-book ratio in isolation.
As things stand, BHP Group's price-book ratio is at 1.87, suggesting the stock is in fair value territory. Although a pending interest rate pivot might adjust BHP Group's asset value upward, the company will likely remain exposed to flimsy commodity prices.
Despite its questionable valuation outlook, BHP Group provides spectacular shareholder returns through dividends and stock buybacks. The company's five-year dividend yield on cost of 21.23% is best in class, while its shareholder yield of 7.56% indicates the stock's cost basis will likely improve during an investor's holding period.
Final thoughts
BHP Group's downgrade from AllianceBernstein seems warranted as commodity prices are in uncertain territory. Moreover, salient economic indicators suggest the economy is at its cyclical peak, which might spell bad news for BHP Group's investors, especially given the stock's price-book ratio is above fair value.
Although BHP Group's stock presents solid dividends, its price risk is substantial due to its cyclical attributes. Therefore, Bernstein's downgrade is likely suitable at this stage.
