All prices as of 11:30 am, 29/10/19

Large Caps Sub-Portfolio 

BHP & Rio Tinto

BHP reported mostly weaker production in 1Q20 (the September quarter), though this had been flagged and was due to planned maintenance and natural field decline in petroleum. Significantly, production and unit cost guidance for FY20 was unchanged and the company is on track to deliver slightly higher volumes than FY19. All major projects are on schedule and budget and exploration results in petroleum were encouraging. The Ruby oil and gas project in Trinidad & Tobago was approved in the quarter, the South Flank iron ore project is half-complete, the Trion 3-DEL appraisal well in Mexico found oil above previous intersections, and there were further high-grade intercepts of copper, gold, uranium and silver at Oak Dam in South Australia. By commodity, production results were:

Figure 1. BHP 1Q20 production results

Source: BHP

We will attend BHP’s petroleum briefing on 11 November, when there should be more detail on long-term prospects in this commodity. We have seen sell-side analysis that BHP could boost petroleum output by 50% by FY30, which is interesting if true and worth testing at the briefing.

Recently we downgraded adopted NROE marginally from 20.0% to 19.5%, with an accompanying reduction in adopted RI from 4.5% to 4.0%, to reflect the current slowdown in world economic growth and softness in prices for BHP’s four major commodity outputs (iron ore, copper, metallurgical coal, oil), but we still see value at ~$39 and think the current share price is factoring in too much downside. On 14 October we bought 281 shares at $36.53 to take our position up to a new model weight of 5.50%. This is still underweight against the stock’s ASX 200 weight of 6.1% but we didn’t want to be as underweight as we were. The position balances several considerations:

  • The stock’s investment quality: low gearing, respectable corporate governance, long-life and low-cost assets, access to growth options globally, low cost of equity and debt, emerging leadership on ESG matters
  • Its undervaluation and the current caution in iron ore, copper, metallurgical coal and oil markets make the stock more attractive
  • The possibility the US-China trade conflict has peaked, now there are negotiations as part of a phased process, and world growth forecasts won’t be further downgraded on trade concerns
  • Chinese infrastructure stimulus
  • Better operational execution by BHP after mishaps in the June half
  • Seasonal weakness in Chinese steel production versus supply tightness as Vale closes a major tailings dam to assess its safety.

RIO reported stronger production across most of its product suite in its third (September) quarter, particularly in Pilbara iron ore:

Figure 2. RIO 3Q20 production results

Source: RIO

The surge in iron ore production means RIO seems to have succeeded at maintaining steady shipments despite disruption from the major rail maintenance during the period. The market was concerned about RIO’s execution in iron ore after three downgrades to 2019 guidance this year, so it was reassuring to see the business running at 346mtpa.

Guidance was downgraded across the aluminium business unit with a mix of operational and external problems reducing production. Bauxite guidance is now 54mt, down from 56-59mt, alumina production was guided to 7.7mt, down from 8.1-8.4mt, and aluminium production at the lower end of guidance (3.2-3.4Mt). A consistent theme is maintenance, perhaps reflecting earlier underspend on the operating assets, and industry headwinds across the supply chain: aluminium, alumina and bauxite.

The volume downgrades in aluminium/alumina, lower grades at Oyu Tolgoi and the increased proportion of lower-quality iron ore have driven 1-3% downgrades to consensus FY19-21 EPS, with the larger downgrades to FY19. Management said “The aluminium industry continues to face challenging conditions in global markets and policy uncertainty, reflected in declining prices.” On a positive note RIO stepped up exploration and evaluation spend in the quarter (+62% q/q), reflecting increased opportunities.

Mined copper output of 157.8kt was 15% higher than the prior quarter with Kennecott the outperformer, up 40% on the previous quarter, as mining moved to a higher-grade zone. RIO maintained guidance for mined copper of 550-600kt for FY19.

Our attention now turns to RIO’s capital markets day in London on 31 October, where the company has said it will provide FY20 guidance. Production of lower-grade (58%) iron ore grew 8% in the September quarter, faster than 2.5% in 1H, a new trend likely to continue in FY20 and weigh on price realisation.

The current rally in BHP’s and RIO’s share prices reflects the better iron ore production performance discussed above, better news on US-China trade, less fear of slower world economic growth, steady Chinese steel production at over 1bn tpa to meet the demands of infrastructure stimulus, smaller cuts to steel production in China this winter, and Vale’s difficulty restoring its pre-disaster production rates. Vale reported a solid recovery in its operations in the September quarter, with iron ore output up 35%, but this is still down 17% from pcp. The miner expects to restore another 30mtpa of output in 2020 and 25mt in 2021 as it restarts operations closed after the Brumadinho disaster, but the recent closure at Vale’s Itabirucu tailings dam is a reminder the rampup to full capacity will not be without complications.

Treasury Wine Estates

On 21 October we bought 129 shares at $16.40 to take our position up to a new model weight of 2.15%. The stock was down ~12% on the announcement CEO Michael Clarke would retire in 1Q21 and while we salute the CEO’s achievements at TWE we thought the share price reaction was unjustified. TWE’s recent investor day showcased the depth and quality of the company’s senior management and we see the succession planning as orderly and unlikely to change strategic direction or disrupt operational execution, particularly as the COO and CFO have had input to the five-year strategic plan. COO Tim Ford will succeed Michael Clarke, who will remain as an adviser on key initiatives “including potential M&A” for a year after. This suggests M&A remains a key focus but is also less likely near-term.

Admittedly news of the CEO’s retirement is surprisingly early after the investor day. Michael Clarke said it had become too difficult to balance his CEO and family responsibilities. He will however remain in his position for another year and, holding 819,766 ordinary shares and 800,246 performance rights, retains plenty of skin in the game. This should give investors confidence.

TWE was pleased with 1Q performance, said it is growing in all geographies and reiterated FY20 guidance of 15-20% EBITS growth. The group wouldn’t provide FY21 guidance but said the dollar rate of growth in sales would continue to accelerate into FY21 from FY20, helped by strong vintages, but the percentage rate of growth would not. We interpret this as less upside risk to consensus estimates for FY21 percentage EBITS growth and although it contributed to last Monday’s selloff, it should help prevent the shares from becoming overvalued in FY21 then falling on earnings disappointments. Overall we think the medium to long-term growth story (China, US distribution, French product) is intact. The risks are a material slowdown in Asia, mis-execution in the Americas and declining brand equity.