BHP earnings highlight all the reasons I don’t invest in miners
There are no good and bad investments. There are good and bad investments for each of us.
Mentioned: BHP Group Ltd (BHP)
A good place to start is with BHP's BHP results. I will turn this part over to Morningstar Analyst Jon Mills who published the following note after BHP reported earnngs on the 27th of August.
“No-moat BHP’s fiscal 2024 adjusted earnings before interest, taxes, depreciation and amortisation (“EBITDA”) of USD 29 billion was about 4% lower than we expected. However, it increased 4% on last year, driven by higher prices and foreign exchange, partially offset by increased unit cash costs.
Adjusted net profit after taxes (“NPAT”) of USD 13.7 billion, or USD 2.69 (AUD 3.96) per share, was modestly higher than a year ago. BHP will pay a fully franked final dividend of USD 0.74 (about AUD 1.09) per share in October, taking total fiscal 2024 dividends to USD 1.46 (AUD 2.15) per share fully franked, down 14%. The 54% payout ratio was in line with its target minimum of 50% but reduced on last year’s 64% payout ratio. Management guided to a higher effective tax rate but lower unit costs at Escondida and Copper South Australia than we expected.
We maintain our fair value estimate of $40.50 per share, with shares trading modestly above fair value. We continue to forecast BHP's share of Western Australia Iron Ore, or WAIO, sales to be about 255 million metric tons in fiscal 2025, similar to fiscal 2024. Our forecast for WAIO unit costs of USD 19.20 per metric ton is also unchanged. This is toward the upper end of guidance and about 6% higher than fiscal 2024 due to inflation. We forecast WAIO sales rising to about 270 million metric tons—BHP's share—by the end of our five-year forecast period.
We expect BHP's share of copper sales to be around 1.4 million metric tons in fiscal 2025, a 5% increase driven by its 58%-owned Escondida mine in Chile. Escondida accounts for roughly half of forecast attributable copper sales. However, we now forecast unit cash costs of about USD 1.55 per pound for Escondida in fiscal 2025, near the top end of guidance but 6% lower than we projected previously.
WAIO is the main driver of BHP’s near-term earnings, with iron ore accounting for 55% of forecast fiscal 2025 EBITDA of about USD 30 billion, modestly higher than fiscal 2024. Copper accounts for much of the remainder.”
BHP rose slightly after earnings. Those gains were given up the next day. Year to date BHP is down a bit more than 19%.
How mining fits into my investment strategy
I have been vocal about what I look for in a company that I choose to invest in. And BHP checks few of my boxes. Before focusing on the results it is worth taking a step back and looking at mining as an industry.
The mining industry searches for, develops, extracts, and processes commodities. Many investors gloss over the word commodity when considering miners. A commodity is fungible. Prices are set at the intersection of supply and demand. There is no way to differentiate a commodity. There is no way to escape the vagaries of supply and demand. In summary, miners are price takers. A commodity has a price and a commodity producer can choose to sell at that price or stop producing. Simple as that.
This dynamic is why moats are so rare in the mining industry. It is also the first reason I don’t invest in miners. I want companies with moats or sustainable competitive advantages. I’m a long-term investor and over time the benefits of a moat accrue to shareholders. And moats provide downside protection which limits the volatility of cash flows generated by the company and in most cases the share price.
This fits my personality but more importantly fits my goal of generating steady and growing income. Steady cash flows provide protection from dividend cuts. A moat means higher returns on capital invested in the business. Over the long-term that leads to growing cash flows. That supports higher dividends.
The next place to focus when considering a miner is the process of developing, extracting and processing commodities. This is an extremely expensive endeavour. We’ve exhausted many of the easily accessible supplies of commodities which makes it harder and more expensive to expand and replace production. And there is a constant need to find and develop new supply since existing reserves are constantly depleted. This requires periodic large capital expenditures.
All things being equal, the best companies to own are scalable and generate increasing cash flows as revenue grows. Miners don’t fit the bill. Periodically cash flows increase after new production comes online. In some cases this is offset as new supply results in lower prices. If prices rise and capital expenditures drop temporarily it is inevitable that these period of high cash flows will end as capital expenditures surge for new mines to replace and expand supply.
This cyclicality presents opportunities for investors that want to nimbly adjust their portfolio based on the prevailing commodity cycle. But this is a hard game to play. You have to be right about what is going to happen and you have to be right first. Once the market has moved it is too late.
I don’t want to play this game. I want to find great companies that perform well in any environment. I want to find companies with sustainable competitive advantage that compound those advantages over time. I want to hold the shares I buy for the long-term. I’m patient and I know that building wealth takes time.
As previously mentioned, my goal is to generate income from my portfolio. Consistent and growing income. And the inherent cyclicality and need for large capital expenditures in mining creates a boom-and-bust cycle for dividends. For speculative miners and poorly run large miners this cycle can result in bankruptcy. Since I spend some of my dividends this variability impacts my spending. That is not a recipe for what I want out of life.
BHP results
Our analyst Jon Mills provided a rational long-term assessment of how BHP’s earnings impact his view. Most of the media focused on simplistic headlines from the results. There are some specific parts of BHP’s earnings announcement that got attention. The dividend cut of 14% was highlighted. But it was portrayed largely as BHP hoped and described as a prudent investment in future growth. BHP CEO Mike Henry said the dividend cut “demonstrates a good healthy balance between reinvestment in the business and cash returns to shareholders.”
Some of this reinvestment will be into cooper which is a focus of BHP as demonstrated by the failed bid for Anglo American. Perhaps this is a great strategy. Perhaps not. Either way it will be very expensive which explains the dividend cut.
The other headline is BHP’s push to expand market share in iron ore. Once again this sounds very sensible. Growing market share is what every company strives to do. But – and pardon the pun – if we dig into this a bit for the mining industry it is less clear.
Since miners sell commodities and there is no way to compete on price or quality there are only two ways to gain market share. The first is if demand increases and one miner has more capacity. The second is if other miners cut production.
In the case of iron ore demand is expected to drop as Chinese steelmaking is expected to decline given the issues in the real estate industry and the shocking unprofitability where only 1% of firms make money according to Mysteel, a Chinese reporting agency.
This is one of the reasons that iron ore prices have dropped around 28% this year. When BHP vows to increase market share they are really saying that if prices of iron ore drop enough other companies with higher costs will stop production. Under this scenario BHP as a low-cost producer will gain market share. They will also likely make less money. If prices rise again the high-cost miners will resume production. In a nutshell this is the challenge faced by commodity producers.
The reason that I would never purchase BHP is not because it isn’t a great company. If I had to purchase a mining, company chances are that BHP would be high on my list. It is a financially sound company and is the lowest cost producer of iron ore. That doesn’t mean the industry aligns with my investment strategy.
I hope BHP does well. BHP and the mining industry are important to Australia. And this is not an argument to avoid investing in BHP or the mining industry. It is a plea to think about what you want to accomplish and establish criteria for selecting investment that fit your strategy. BHP just doesn't happen to meet mine. You can read an example of the approach I’ve taken in this article. In the meantime, here are some things to think about:
- What are the overarching factors that influence the value of any product, service, asset or business? How much control does the company have over these factors? If they don’t have control – who does?
- What are the underlying forces that impact the competitive positioning of each company in the industry?
- How do these various factors and forces impact your investment strategy? If you are investing for income how are the cash flows that will fund the dividend impacted? If you are investing for capital gains is there a right and wrong time to buy shares when valuation levels will fluctuate?
