BHP Group and Rio Tinto’s focus on capital returns over reinvestment is leading to reduced capital expenditure versus historical levels, strong free cash flow yields and high shareholder distributions. We make the following observations:
There is insufficient capital being reinvested back into the businesses over the medium term to support meaningful production growth – 2019 is likely to see peak EPS before a 30% drop in earnings by 2021.
Our deep-dive analysis of the project pipeline – including 21 projects worth $43bn – shows it lacks materiality in terms of value and growth potential.
Similar yields could be achieved via utilities stocks, with less earnings risk and no reserve replacement requirement.
The organic project pipeline lacks materiality in terms of value and growth, in our view. Adding all known unapproved and conceptual-stage projects to our base case adds only 4–5% to our net present value (NPV) measure, representing less than one year of free cash flow, which points to limited valuation upside potential. We suggest excess capital should now be directed towards external growth.
We expect BHP and Rio Tinto to hit peak earnings (and yields) in 2019, with 30% EPS downside on a three-year view. Overall, we don’t believe the majors are doing enough to justify a premium valuation, based on yield alone, given the lack of forecast production growth to offset normalising commodity prices.
In our view, BHP and Rio Tinto are in great shape financially, although we struggle to identify any rerating catalysts given the backdrop of lower forecast commodity prices, a lack of material growth, valuations close to NPV, and alternative investments in defensive sectors offering similar yields without the earnings cyclicality or the need for resource replacement.
Our BHP earnings forecasts and valuation have increased slightly after undertaking a full review of the petroleum division, related mainly to natural field decline rates, asset lives and capital expenditure profiles, leading us to lift our target price for BHP $38.00 from $37.00. Our Rio Tinto target price of $94.00 remains unchanged. We maintain our Hold recommendation on both BHP and Rio Tinto, with Rio Tinto our key preference in the iron ore sector due to its slightly cheaper valuation.