BHP’s second-best pass the test

BHP Billiton's omission of the Nickel West assets from its spun-off group underscores the fact that this new venture is not a receptacle for the mining giant's trash.

With BHP Billiton unveiling its proposed spin-out of its perceived non-core assets to shareholders, the telling detail is what wouldn’t be in the new company if the demerger proceeds.

It had been widely speculated that the new entity would contain all the assets BHP didn’t want in its continuing portfolio – its unwanted and perhaps unsaleable assets. Those were thought to include its Nickel West business in Western Australia, where it has been running a trade sale process, its coal assets in New Mexico and other odd bits and pieces of the sprawling group portfolio.

The obvious omission from the demerged entity is Nickel West. While the trade sale process apparently is still alive, it is thought that Nickel West was never going to be included in the new entity.

That helps make the point that BHP went to some lengths to make tonight. The new entity isn’t designed to be a receptacle for BHP’s trash but rather as a mechanism for putting some distance between BHP’s core basin assets and a collection of not-quite-as-attractive – but still attractive – second-tier assets.

In the new company will be the Cannington silver and lead mine – the world’s largest silver producer – the group’s manganese business (also the world leader), the aluminium and alumina operations and metallurgical and energy coal operations in Australia and South Africa. The Cerro Matoso  ferro-nickel mine in Colombia will also be included.

BHP said the portfolio was cash-positive today and that in the 2014 year its underlying EBITDA (earnings before interest, tax, depreciation and amortisation) margin was 21 per cent. Over the past decade that average margin was 34 per cent and the average EBITDA was $US3.3 billion.

In other words the assets are good assets, with upside if the prices of its commodities improve or its management continues to reduce costs.

They aren’t, however, as good as the assets – iron ore, petroleum, the larger Australian metallurgical and energy coal operations, copper and potentially potash – BHP will retain. The continuing portfolio had a remarkable average underlying EBITDA margin of 42 per cent in 2013-14.

There are obvious benefits in spinning out the non-core assets. For the ongoing BHP it simplifies the portfolio and would enable its management to concentrate on the 19 assets that generated 96 per cent of its earnings before interest and tax in the latest financial year.

Chief executive Andrew Mackenzie said that focus would enable the group to extract another $US3.5 billion in productivity gains by 2016-17, on top of the better-than-expected $US6.6 billion it has achieved in the past two years.

For the new entity, distanced from assets with margins twice those of its operations, it will be possible to consider investing in assets and new projects that would never have been green-lighted by BHP because of its higher-returning alternatives.

With the new entity there are said to be a range of investment options with 20 per cent-plus internal rate of return expectations and which would, if they weren’t competing for capital in an environment where BHP is trying to ration capital, probably be approved by most other miners.

The spin-out will, if it gets a final go-ahead, be effected via a distribution of shares to all BHP Billiton shareholders, probably in the first half of 2015. That obviates the need to balance out the value received by BHP Billiton Ltd and BHP Billiton Plc shareholders.

The shareholders will be given the right to vote on the proposal, even though there is no legal requirement for a meeting. It is improbable, given that they will be given direct access to assets they already own that there would be opposition to it, particularly as BHP says it will increase, or at least maintain, its dividends per share even after the demerger.

The new company would be headquartered in Perth and listed on the ASX – where it would probably be a top 20 company – with a secondary listing in South Africa to reflect the South African flavour of its asset base.

That could deter British shareholders from holding their shares, but with the new entity likely to be given 100 per cent index-weighting in the ASX (rather than the 60 per cent that now applies to BHP) there would be an obvious source of local buying from institutions that track, or at least shadow, the ASX indices.

Long-serving BHP director David Crawford will chair the new company, BHP’s current chief financial officer Graham Kerr will be its chief executive and BHP’s head of investor relations, Brendan Harris, its CFO.

The confirmation that BHP is pushing ahead with the demerger option overshadowed the release of its annual results.

With profit up 10.1 per cent to $13.45 billion, a $US8.1 billion increase in free cash flow, capital and exploration spending falling 32 per cent to $US15.2 billion and costs and volume efficiencies of $US2.9 billion achieved in the year, it was a very solid result in a difficult environment.

BHP said lower commodity prices reduced its underlying earnings before interest and tax by $US3.4 billion but the impact of the lower prices was offset by the increased volumes and lower costs. The volume effects as BHP ramped up production, particularly of iron ore, were worth $US2.9 billion to the result.

With net debt of $US25.8 billion BHP didn’t quite get its debt down to the level at which Mackenzie has said he would consider capital management initiatives but, given that BHP plans to at least maintain its dividends per share after the demerger that proposal would effectively constitute a return of capital – and a big one, given that the assets involved would be worth more than, potentially materially more than, $US10 billion.

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