GOLDMAN: It's time to sell BHP

Heavy equipment at Escondida mine, of BHP Billiton, in Chile. Photo: Franceso Gegasperi / AFP / Getty Images.

Goldman Sachs thinks it’s time to sell the Big Australian.

Analysts at the global investment bank have cut their rating on BHP shares, arguing the downturn in commodity prices, especially iron ore, will hurt the company’s free cash flow and crimp its ability to reduce debt.

Goldman downgraded its rating on BHP to “sell”, and slashed its 12-month price target on BHP’s London-listed shares to £11, from £14 previously. BHP shares last traded on the London Stock Exchange at £12.06 and closed at $23.94 on the ASX on Monday.

In a note to clients, the metals and mining equity analysts team led by Eugene King said they saw multiple looming catalysts for the stock:

… (1) consensus downgrades: with commodity prices having started to turn, we expect consensus earnings to start to decline for first time in almost 12 months; (2) commodity prices: iron ore and coal, which account for c.50% of the company’s EBITDA, are impacted by Chinese steel market – this has started to weaken a little. As such, there could be a significant earning downgrade cycle in those two business units.

The bank also downgraded Anglo American to sell because of its coal exposure.

Predictably, the deterioration in the outlook reflects changed circumstances in China. Mining stocks have been rallying over the past six or eight months, thanks in large part to better-than-expected economic performance in the world’s second-largest economy.

Deutsche Bank noted in September that China’s five year slowdown seemed “done”, and indeed its GDP growth rate has hovered between 6.5% and 7% lately when many economists expected it to fall to 6% or below.

Much of this has been driven by further stimulus measures from Beijing, including infrastructure spending which has helped commodity demand. Goldman sees this stimulus as having done its job and says Beijing monetary policy makers are shifting to a tightening bias.

Goldman also notes that iron ore inventories are at record highs at Chinese ports. A drawdown on these would be negative for spot prices and the team predicts that this volatile input will drive share prices in iron-ore exposed miners.

The stocking levels are highlighted in this chart:

Source: Goldman Sachs

The analysts note that around 41% of BHP’s EBITDA in FY18 comes from iron ore. They write:

when we adopted a more positive stance on the miners, was that significant deleveraging as a result of higher commodity prices would support higher valuations, even at lower commodity prices, as value was transferred from debt to equity holders. A key underlying assumption was that that commodity prices would taper slowly, supporting cashflows. However, the recent significant leg down in most commodity prices suggests that a large part of this anticipated cash flow is unlikely to materialise. While we continue to believe that the valuations of most of the miners are likely to be above current levels in the medium term, over the short term we believe the trajectory of commodity prices which will drive share prices and valuations, not fundamentals.

Iron ore spot prices have suffered a dramatic collapse, falling from above $U90 earlier this year to around $US67 now.

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