Behind the BHP numbers
When it released its results, BHP was labelled a passive beneficiary of spikes in commodity prices. But look closer and you'll see a company preparing to blow rival Rio Tinto out of the water.
There is a temptation in reviewing the BHP Billiton result issued this week to look at the underlying mix of volume and price impacts and conclude, as some have, that BHP has been a passive beneficiary of spikes in commodity prices and that the massive investments it has made in recent years are having only a minimal impact.
After all, higher net prices did contribute $US6.6 billion to BHP's $US24.2 billion of earnings before interest and tax, against the $US1.83 billion contributed by higher volumes. In the contest between BHP and Rio Tinto to demonstrate who has higher growth rates, BHP's performance on volume could be regarded as less than spectacular.
In fact, appearances can be misleading. BHP includes in its calculation of price impacts the gains above the previous year's margins on new volumes – there is an element of the benefit of new production that shows up in price rather than volume. In effect, at a time of rising commodity prices the contribution of higher prices is over-stated; similarly, if prices fell back, volumes would be exaggerated.
A better guide to the impact that the massive investment in expanding production is having is to use BHP's index of copper-equivalent production growth, which showed growth of about five per cent for the year.
That's below the 6.9 per cent growth rate BHP's Marius Kloppers has said the group will achieve through to 2015, but BHP is estimating that it will accelerate sharply to 10 per cent production growth this financial year.
Critical components of that growth over the next six to 12 months include the big new petroleum projects that are ramping up or about to come on stream and a rebound in the volume of metallurgical coal after the severe interruptions caused by the Queensland floods.
Even though oil prices have come off their peak, they are still at historically much higher levels and the petroleum business generates the best margins of any of BHP's divisions. A rebound in volumes – and the first real impact of the trebling of prices this year – should give the metallurgical coal business a massive boost.
That's why any apparent narrowing of the relativities between BHP and Rio when Rio reports next week could be temporary and, for Rio, falsely reassuring. If and when the bid gets serious – if it can get past the European competition authorities – BHP ought to be generating considerably more underlying momentum than it has in what was already a very impressive year.
If the offer gets past the authorities first half results will be critical – results which, in the absence of some new major unforeseen disruption, ought to be even more spectacular.
Disturbingly for Rio, if there were any downturn in demand for the key commodities the two rivals share, BHP's more diversified portfolio would help cushion the impact.
BHP's cashflow@risk model (which looks at the level of exposures to individual projects and commodities in its portfolio) is showing that risks are at their lowest levels since the model was first developed nearly a decade ago.
BHP's presentation of its results was framed with an eye to the bid. It made a point of highlighting that 87 per cent of its projected growth in production was from brownfield projects; 88 per cent was located in lower-risk jurisdictions; 97 per cent would be sourced within existing regions and 63 per cent would be from high-margin products. In the longer term 65 per cent of the projects in pre-feasibilty or future options stage of development were brownfields projects and 87 per cent were in existing regions.
BHP didn't need to mention Simandou, where the Guinea government has purported to rescind its concession, or Oyu Tolgoi, where Rio is struggling to come to terms with the Mongolian Government. Those were two key projects Rio has nominated – Simandou was supposed to come into production by 2013 – as supporting its claim that it had better growth prospects that BHP.
The other aspect of the BHP result that showed it is preparing to board Rio was its balance sheet. With cash pouring through the group, and no ability to conduct a buy-back while the bid is afoot, gearing is down to less than 18 per cent. It chose to retain that cash rather than pay out an even bigger dividend.
It needs to do that partly because it has said it will conduct a $US30 billion buyback if the all-scrip bid for Rio succeeds but allowed for only $US15 billion of funding for that buyback in the bid financing. Rio has raised about $US3 billion of the $US10 billion it has targeted from asset sales this year to reduce the debt it took on to acquire Alcan last year, which helps reduce the amount of liquidity BHP will need to generate.
While there have been some murmurs that BHP should have paid a higher dividend, the stronger balance sheet delivers more flexibility if the bid for Rio goes live. The foreshadowed buyback could readily be turned into the core of a cash or partial cash alternative.
Rio will look at the BHP result, its performance on costs, its rapidly increasing financial flexibility and, more particularly, the missing ingredients that won't be missing when the two groups report their first half results early next year.
Its problem is that it isn't enough for Rio to simply match BHP, assuming it could do that with a narrower portfolio and without an exposure to petroleum.
With BHP offering Rio shareholders a substantial premium and a continuing exposure to the combined group, it has to significantly outperform BHP to make a strong case against the bid.
That won't be easy, given that BHP generated a 38 per cent return on capital and a 48 per cent EBIT margin last year despite a number of significant issues beyond its control, like the Queensland floods or South African power crisis.
Rio is going to need some luck, and probably some superior management, to do so.
After all, higher net prices did contribute $US6.6 billion to BHP's $US24.2 billion of earnings before interest and tax, against the $US1.83 billion contributed by higher volumes. In the contest between BHP and Rio Tinto to demonstrate who has higher growth rates, BHP's performance on volume could be regarded as less than spectacular.
In fact, appearances can be misleading. BHP includes in its calculation of price impacts the gains above the previous year's margins on new volumes – there is an element of the benefit of new production that shows up in price rather than volume. In effect, at a time of rising commodity prices the contribution of higher prices is over-stated; similarly, if prices fell back, volumes would be exaggerated.
A better guide to the impact that the massive investment in expanding production is having is to use BHP's index of copper-equivalent production growth, which showed growth of about five per cent for the year.
That's below the 6.9 per cent growth rate BHP's Marius Kloppers has said the group will achieve through to 2015, but BHP is estimating that it will accelerate sharply to 10 per cent production growth this financial year.
Critical components of that growth over the next six to 12 months include the big new petroleum projects that are ramping up or about to come on stream and a rebound in the volume of metallurgical coal after the severe interruptions caused by the Queensland floods.
Even though oil prices have come off their peak, they are still at historically much higher levels and the petroleum business generates the best margins of any of BHP's divisions. A rebound in volumes – and the first real impact of the trebling of prices this year – should give the metallurgical coal business a massive boost.
That's why any apparent narrowing of the relativities between BHP and Rio when Rio reports next week could be temporary and, for Rio, falsely reassuring. If and when the bid gets serious – if it can get past the European competition authorities – BHP ought to be generating considerably more underlying momentum than it has in what was already a very impressive year.
If the offer gets past the authorities first half results will be critical – results which, in the absence of some new major unforeseen disruption, ought to be even more spectacular.
Disturbingly for Rio, if there were any downturn in demand for the key commodities the two rivals share, BHP's more diversified portfolio would help cushion the impact.
BHP's cashflow@risk model (which looks at the level of exposures to individual projects and commodities in its portfolio) is showing that risks are at their lowest levels since the model was first developed nearly a decade ago.
BHP's presentation of its results was framed with an eye to the bid. It made a point of highlighting that 87 per cent of its projected growth in production was from brownfield projects; 88 per cent was located in lower-risk jurisdictions; 97 per cent would be sourced within existing regions and 63 per cent would be from high-margin products. In the longer term 65 per cent of the projects in pre-feasibilty or future options stage of development were brownfields projects and 87 per cent were in existing regions.
BHP didn't need to mention Simandou, where the Guinea government has purported to rescind its concession, or Oyu Tolgoi, where Rio is struggling to come to terms with the Mongolian Government. Those were two key projects Rio has nominated – Simandou was supposed to come into production by 2013 – as supporting its claim that it had better growth prospects that BHP.
The other aspect of the BHP result that showed it is preparing to board Rio was its balance sheet. With cash pouring through the group, and no ability to conduct a buy-back while the bid is afoot, gearing is down to less than 18 per cent. It chose to retain that cash rather than pay out an even bigger dividend.
It needs to do that partly because it has said it will conduct a $US30 billion buyback if the all-scrip bid for Rio succeeds but allowed for only $US15 billion of funding for that buyback in the bid financing. Rio has raised about $US3 billion of the $US10 billion it has targeted from asset sales this year to reduce the debt it took on to acquire Alcan last year, which helps reduce the amount of liquidity BHP will need to generate.
While there have been some murmurs that BHP should have paid a higher dividend, the stronger balance sheet delivers more flexibility if the bid for Rio goes live. The foreshadowed buyback could readily be turned into the core of a cash or partial cash alternative.
Rio will look at the BHP result, its performance on costs, its rapidly increasing financial flexibility and, more particularly, the missing ingredients that won't be missing when the two groups report their first half results early next year.
Its problem is that it isn't enough for Rio to simply match BHP, assuming it could do that with a narrower portfolio and without an exposure to petroleum.
With BHP offering Rio shareholders a substantial premium and a continuing exposure to the combined group, it has to significantly outperform BHP to make a strong case against the bid.
That won't be easy, given that BHP generated a 38 per cent return on capital and a 48 per cent EBIT margin last year despite a number of significant issues beyond its control, like the Queensland floods or South African power crisis.
Rio is going to need some luck, and probably some superior management, to do so.
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