This time last year we wrote that we felt that BHP was in the midst of an upgrade cycle driven by strong commodity prices and a significantly reduced cost base. Furthermore, a sale price for their US onshore shale gas assets in excess of USD$10b was not unrealistic and would provide a catalyst to return excess capital to shareholders. We also believed that the developing trade war between China and US would not have a material impact on the global economy. Despite this buoyant outlook, BHP’s valuation was below historical averages which we felt was unjustified. Given the positive earnings momentum, compelling valuation support and capital management opportunities, BHP was well placed to deliver strong shareholder returns.
Fast forward 12 months and while the thesis has played out, the composition was slightly different than anticipated. Strong commodity prices did drive earnings upgrades, however a key driver of commodity strength was supply side constraints. Principally, iron ore supply shortages out of Brazil, the world’s second largest producer, caused iron ore prices to remain at prices well above expectations. Chinese demand remained robust, particularly for coal, and contributed to overall strength across the commodity complex. The sale of US onshore shale assets did fetch more than USD$10b, with proceeds being returned via a buyback and special dividend. However, despite strong earnings momentum and capital management, the share price has only tracked the earnings upgrade cycle and not experienced a re-rating. Whilst still not resolved, the trade war has not had a material impact on global growth but, not surprisingly, has impacted the behaviour of corporates across the world.
Where to next for BHP?
A year is a long time for commodity producers, with their earnings outlook always subject to macro events and supply side conditions. Consequently, compelling valuation support and a strong balance sheet are required to compensate for the inherent uncertainty. While the last 12 months played out slightly differently to our expectations; earnings upgrades and capital management combined with valuation support have all contributed to BHP trading back towards record levels.
We remain optimistic on the outlook for BHP, however we have less conviction than we did 12 months ago, and accordingly, the fund has reduced its position by almost 40%. Earnings expectations for the next 12months are now 30% higher than at the same time last year and are now more reflective of spot prices. Coal and iron ore, which are key earning drivers, have experienced significant tailwinds which we think are unlikely to be replicated going forward. Given these elevated prices, a supply response will ensue and likely push prices lower. So, while valuation remains supportive, we feel that earnings momentum may plateau over the next year and, unlike last year, the balance sheet will not benefit from any major divestments and the focus will be on the free cash flow trend.
A fresh idea
Since the GFC, Macquarie Group (MQG) has undertaken one of the most successful offshore expansions in Australian corporate history. Macquarie’s global empire now spans 25 countries and has grown well beyond its market facing origins into a giant of infrastructure and asset management. The firm now manages in excess of $550b with two-thirds of the operating profit in 2018 generated outside Australia. The business transformation has helped deliver outstanding financial results over the past 10 years. We expect the tailwinds from lower interest rates, deployment of surplus capital and a lower Australian dollar to continue.
Growth in annuity style business, which represented 70% of group operating performance in 2018, has been one key driver. This has contributed to lowering earnings volatility, improving ROE and increasing their dividend stream. Overall earnings and dividends have compounded at 25% and 21% respectively, over the past 5 years with ROE reaching 16.8% in 2018. This structural earnings shift has seen Macquarie’s multiple re-rate to 15x 1yr forward, which also reflects the future growth opportunities. This is a 50% premium to global investment banks and 20% above the major Australian banks.
Macquarie Asset Management, which contributes one-third group income, continues to benefit from the positive operating environment. Asset prices within their portfolio of long duration assets are supported by the low interest rate environment with significant performance fee generated from asset maturity. The group has one of the largest alternative asset management businesses globally. Given the increasing allocation of capital to alternatives, the funds are well positioned to benefit.
Buoyant asset markets allow Macquarie to deploy their balance sheet and recycle capital via asset sales. The recent sales of PEXA and Quadrant energy, which have realised substantial gains for the group, supports further reinvestment into attractive assets, such as renewable infrastructure and energy. At their most recent update, there is $A3b of unrealised gains on their balance sheet.
The upcoming Full Year 2019 result will demonstrate impressive earnings resilience for Macquarie Group. Consensus for 2020 earnings currently sits +4.5% growth, which seems conservative in the current operating environment. Earnings growth and dividends will be the primary driver of returns in the coming year, however with ROE trending higher, further valuation multiple expansion should follow.
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