BHP's Recent Downgrade by BMO: A Closer Look at Valuation Misalignment and Free Cash Flow Dynamics

In July 2025, BMO Capital Markets downgraded BHP Group (ASX: BHP) from Outperform to Market Perform, citing valuation concerns despite the stock's recent rally to its £20 price target. This decision raises a critical question: How can a company with strong operational performance and improving free cash flow (FCF) dynamics face a downgrade? The answer lies in a nuanced analysis of valuation metrics, project execution risks, and sector positioning.

Valuation Metrics: A Tale of Contradictions

BHP's valuation appears to straddle the line between opportunity and caution. As of July 2025, its trailing P/E ratio stands at 23.33, significantly above the ASX 200 average of ~15x, while its P/FCF ratio of 12.87 and EV/EBITDA of 5.83 suggest relative affordability compared to historical averages. For context, the 5-year forward P/E for BHP is 11.8x, below its 5-year average of 13.2x, and its EV/EBITDA of 5.3x is below the 6.1x average. These metrics imply that BHP is trading at a discount to its long-term norms, yet its P/E remains elevated relative to broader market benchmarks.

The disconnect between these metrics and BMO's downgrade stems from the firm's revised FCF forecasts. BMO cut its FCF projections for FY26 and FY27 by 14% and 7%, respectively, due to delays and cost overruns at BHP's Jansen potash project. The project's Stage 1 capital expenditure (capex) has ballooned to US$7–7.4 billion (up 22–29% from US$5.7 billion), pushing production timelines to mid-2027 (Stage 1) and fiscal 2031 (Stage 2). These delays have eroded BHP's FCF yield, which is now projected to fall below sector averages at 5.1% (FY26) and 4.5% (FY27), compared to peer averages of 6.3% and 7.8%.

Free Cash Flow: A Double-Edged Sword

BHP's FCF dynamics highlight a paradox: the company generates robust cash flow but faces growing scrutiny over reinvestment efficiency. Its record production levels in copper (up 8% YoY to 2.02 million tonnes) and iron ore (263 million tonnes in FY2025) underscore operational strength. However, the Jansen project's cost overruns have strained capital discipline.

The downgrade reflects BMO's skepticism about BHP's ability to convert its FCF into shareholder value. While the company maintains a disciplined payout ratio of 50% and a 4.7% dividend yield, the delayed Jansen project and iron ore price volatility (currently US$101/tonne) introduce uncertainty. Analysts at Goldman Sachs note that a sustained decline in iron ore prices below US$90/tonne would threaten BHP's margin stability and dividend sustainability.

Stock Price Performance: Volatility and Momentum

BHP's stock price has exhibited mixed signals. Over the past 12 months, it declined by 5.6%, but its beta of 0.72 suggests it is less volatile than the market. The 50-day and 200-day moving averages are nearly aligned at $50.03 and $50.61, indicating a neutral trend. Meanwhile, the RSI of 54.40 suggests the stock is neither overbought nor oversold, and its 52-week range of $39.73–$63.21 reflects significant volatility.

The recent rally to $40.31 (as of July 29, 2025) has brought the stock closer to its 52-week average of $51.50, but it remains 28.2% below its 52-week high. This volatility underscores the market's mixed sentiment: optimism over copper demand and operational efficiency improvements is tempered by concerns over potash project execution and iron ore exposure.

Investment Implications: Is BMO Right to Downgrade?

BMO's downgrade is not a dismissal of BHP's long-term potential but a recalibration of expectations. The firm's analysis highlights three key risks:
1. Project Cost Overruns: The Jansen project's US$1.7–1.7 billion cost increase is emblematic of broader challenges in resource projects, including supply chain bottlenecks and labor shortages.
2. Commodity Price Volatility: BHP's 60% exposure to iron ore makes it vulnerable to Chinese property market trends and global demand shifts.
3. Sector Competition: Peers like Rio Tinto and Fortescue, with similar valuations and higher FCF yields, offer more compelling growth prospects.

However, BHP's strategic pivot toward “future-facing commodities” like copper and nickel, combined with its 27.69% ROE and 18.84% ROIC, positions it to benefit from the energy transition. Copper demand is projected to grow at 2.5–3% annually through 2035, and BHP's record production levels align with this trend.

Final Verdict: A Buy for the Patient Investor

While BMO's downgrade is warranted in the near term, BHP remains a compelling long-term investment for patient investors. Its valuation is reasonable relative to historical averages, and its diversified portfolio provides natural hedging against commodity-specific downturns. The Jansen project's challenges are material but manageable, and the company's disciplined capital allocation framework prioritizes balance sheet strength and shareholder returns.

For those willing to tolerate short-term volatility, BHP offers a unique combination of income (4.7% yield) and growth potential in copper-driven markets. However, investors should monitor iron ore prices and project execution risks closely. In a world of unpredictable macroeconomic shifts, BHP's resilience and strategic agility make it a standout in the resources sector.