A London listing will ease the birth of BHP's spin-off

When BHP Billiton announced the spin-off of its second-tier assets last month, the immediate reaction in London was very negative, with a large-scale sell-off of its shares. That makes BHP’s about-face on the question of a London listing of shares in the demerged entity more interesting than it might otherwise have been.

The original intention was that shares in SpinCo (as it is temporarily named within BHP) would be listed in Australia, with a secondary listing in South Africa but no listing in London.

The absence of a UK listing was due to the soundings BHP took with UK institutions, where the initial reaction was that there would be no interest in owning shares in an entity that wouldn’t be big enough to be included in the FTSE 100. Some institutions, of course, have mandates or index-related strategies that don’t allow them to invest outside the primary indices.

The UK investors may also have been hoping that, given the southern hemisphere weighting of assets within the new entity, instead of receiving shares in SpinCo they would be compensated either with cash or bonus shares in the continuing BHP. Given the requirement that shareholders in the dual-listed entity be treated equally, that was never going to happen.

Once the initial backlash to the lack of a capital management element for UK shareholders within the demerger proposal subsidised, and the investors began to focus on the detail of SpinCo, it would appear the attitude of the UK institutions changed and they began urging BHP to change its listing plans. It was their about-face, rather than BHP’s, which has led to BHP planning a standard (or secondary) listing of SpinCo shares in London.

While index-related institutions would still probably not be able to or want to hold shares in SpinCo, more active investors will be able to own and trade them.

That’s positive, not just for the UK investors, but for all shareholders in the new entity.

About 40 per cent of BHP’s shareholders are in the UK and so the change of heart will help limit the 'flow back' or selling of SpinCo shares by those shareholders, which might otherwise have weighed heavily on its initial pricing.

SpinCo will be a top 20 company in Australia, so the flipside of losing index-driven investors in the UK will be the forced buying by index-related institutions in Australia.

Behind the quick shift in attitude by UK institutions would be a better understanding of what SpinCo will look like. Any suspicion that it would be a dumping ground for assets BHP couldn’t sell or make viable has been dispelled by the composition of the portfolio SpinCo will own.

While the assets within SpinCo are non-core to BHP’s more focused strategy of concentrating on its core iron ore, petroleum, copper and coal assets (with an option to expand into potash) and would therefore be starved of capital within BHP itself, they are all high-quality assets within their sectors.

They are also generally exposed to 'late-cycle' commodities, with considerable leverage to any improvement. As a portfolio, the SpinCo assets have generated average earnings before interest and tax of about $US2.25 billion since 2001, according to Commonwealth Bank analysis, with peak EBIT of $US5.4bn in 2008.

Last financial year EBIT was only $US764 million, providing an indication of their potential within a better price environment.

Most analyses of SpinCo, which will have minimal if any borrowings, have produced valuations of around $US15bn, which translates to around $A3.15 a share. Some valuations have been materially higher.

It will be a very meaningful mid-sized miner, owning the world’s largest and lowest-cost silver mine, arguably the best manganese assets, very significant alumina and aluminium operations, a large and high-quality nickel mine in Colombia and a high-quality metallurgical coal business in the Illawarra region of NSW.

Even at least financial year’s depressed levels, the assets had earnings before interest, tax, depreciation and amortisation margins that averaged 21 per cent. Their average margin over the past decade has been 34 per cent, under-scoring the entity’s leverage to any improvement in prices.

With a very conservative balance sheet, SpinCo will have the capital to ride out a continued and prolonged period of low commodity prices and still invest in its assets if it wants -- there is a major development option at the Cannington silver-lead mine in Queensland, for instance. It will also have the capacity to pay dividends.

BHP hopes to complete the demerger in the first half of next year. When SpinCo shares are separately listed, there will inevitably be volatility in its price as its register is reshaped. The re-thinking of the London listing, however, will help minimise the churn and ease the birth of a significant new miner while considerably simplifying its former parent in the process.