BHP’s spin-off moves from ‘DudCo’ to ‘TopCo’

The preparation timespan for BHP’s South32 has played perfectly for the big miner.

Summary: Prices are rising or not falling too sharply for some commodities that BHP Billiton plans to spin off into its new vehicle, South32. Analysts are starting to show more optimism about the demerger, and takeover interest is in the air. BHP Billiton will become a bulk commodities specialist, while South32 will be a metals and mining specialist.

Key take-out: South32 CEO Graham Kerr says the new company has untapped potential and has hinted it could even outperform its parent.

Key beneficiaries: General investors. Category: Mining stocks.

From DudCo to TopCo, that’s the story of the first seven months of BHP Billiton’s spin-off, South32, which takes its next step towards independence with the release of formal demerger documents in the next few days.

By mid-year, after a meeting of BHP Billiton shareholders in May to vote on the carve-up of their company, South32 should rank as Australia’s third biggest mining company and the Australian stock exchange will have a new candidate for its 20th biggest listing.

Sitting below its parent and arch-rival Rio Tinto in terms of stock-market value, the new business is already one of the most closely watched companies in Australia, not just because of its impressive size but also because in some ways it is starting to outshine its parent.

What’s happened since August 19 last year when the spin-off was unveiled is that prices for some commodities remaining inside BHP Billiton (mainly iron ore, oil, coal and copper) have fallen while prices for some of South32’s commodities (including aluminium, manganese, silver and nickel) have risen, or not fallen as far as commodities in its parent’s portfolio.

One result of the changing commodity prices is that analysts have dropped the pseudonyms DudCo and CrapCo they were using to describe South32 as they have started to understand that the new business is more than a dumping ground for BHP Billiton’s worst assets.

Figure 1: South32 assets

Source: BHP Billiton

In time, especially if South32 becomes the takeover target that some people are tipping, it is possible that the creation of the new company will lead to a situation where the combined value of BHP Billiton and South32 will exceed that of a stand-alone BHP Billiton.

Put another way, it is possible that one one will add up to more than two. Certainly that has been the story at the majority of blue chip spin offs on the ASX in recent times. (To read more, see Spin-offs: The secrets of success, February 18.)

Predators unable to consider a bid for BHP Billiton are already circling South32. X2, the private equity fund of former Xstrata boss Mick Davis, is widely reported to be interested, as is his former associate, Ivan Glasenberg, the boss of resources giant Glencore.

The net result is that bidding tension can already be detected in South32 before it even becomes an independent business, raising the possibility that it could become one of the ASX’s shortest lived stocks.

There are months to go before South32 is listed. Formal dates for the release of the demerger documents, shareholders meeting and a listing date are yet to be finalised. That means it can’t officially become a target.

However, the potential for a takeover is a factor developing in the background of the new company which will start life with one of the world’s biggest share registers.

The equal distribution of shares in South32 to existing BHP Billiton shareholders means the new company will have almost 600,000 shareholders, mainly in Australia and the UK, thanks to the dual-listed nature of BHP Billiton.

In theory, South32, with listings in Australia, London and South Africa, will be valued at around $16 billion. This means it will slot in as the ASX’s 20th biggest stock between Amcor ($17 billion) and IAG ($14 billion).

Market value and an enormous share register are just two reasons for the high level of interest in South32, which also qualifies as the biggest spin-off by an Australian company and, while no-one has said it before, one of the most courageous.

What the directors of BHP Billiton are doing – assuming shareholders vote for the split – is admitting that the company, as it stands today, has become too big for its own good, unable to efficiently allocate capital to all of its component parts.

The dramatic solution is to hand the problem of capital allocation to shareholders by creating South32 in what can be described as an enormous return of capital in the form of complete business units that were being starved of opportunity inside the parent.

By mid-year BHP Billiton will have been re-shaped into a “bulk commodities” specialist, operating some of the world’s biggest and best mines, and South32 will be a “metals and mining” specialist with lower ranked but still world-class mines. 

Despite a sharp 5 per cent fall in the value of BHP Billiton’s ASX price mid-week as it traded ex-dividend, the miner is generally riding out the industry-wide commodity downturn thanks to its status as a low cost producer. Nevertheless, there is no chance of it pushing ahead for some time with the creation of a long-planned separate potash business because the price of that commodity is also poised to fall as a long-term contract arrangement similar to that once seen in iron ore appears close to collapse.

Spinning off South32 means that BHP Billiton is losing just 10 per cent of its assets by value, which is a minimal sacrifice while giving shareholders a choice as to how they allocate their capital.

Figure 2: South32 portfolio

Source: BHP Billiton

To understand that point it is important to consider the key differences between BHP Billiton as it will emerge after the mid-year split and South32, including:

· BHP Billiton is being redesigned to be a specialist producer of bulk minerals from ultra-long life, super low-cost, mines which will have largely predictable cash flows generating reliable dividends that will turn the company into an even more attractive yield play with some “annuity” characteristics.

· South32 will be more exposed to commodity-price cycles as it operates mines with shorter life expectancy which will make it a more volatile investment, a status which will appeal to investors with a greater appetite for risk. At times it will outperform BHP Billiton, but probably not in the long run.

· BHP Billiton will become a more focussed business thanks to its preference for bulk materials where control over transport logistics and infrastructure can be as important as ownership of an orebody.

· South32 will have to be nimble and opportunistic. It is likely to initially be focussed on cost-cutting and streamlining the businesses it inherits from BHP Billiton but, with a strong balance sheet it will quickly be able to look for acquisition opportunities to bolster its relatively short-life mines.

· BHP Billiton will be a “first world” miner with most of its assets in safe jurisdictions, including Australia, Canada, the US and Chile.

· South32 will have a big Australian rump but its name is a clue to its South African coal, manganese and metal alloy business interests which are said to be connected to Australia by the 32nd line of latitude – a rather creative piece of marketing nonsense.

The changing tune of analysts as they warm to South32 can be detected in recent comments:

  • Morgan Stanley said in late January that South32 might have become more attractive than BHP Billiton which is riding out the oil and iron ore price downturns.

  • Macquarie is forecasting that South32 will report steady earnings before tax and other charges of $US1.7 billion in the financial year to June 30, rising to $US1.9 billion next year, a strong performance at a time of weak commodity prices.

  • Deutsche Bank said South32 has two areas where it can improve its performance, cost cutting and mine-life extension, but with limited opportunities to expand its businesses which could mean a “hunt for acquisitions.”

Graham Kerr, South32’s chief executive and a former chief financial officer of BHP Billiton, said last month that the new company was starting life with a strong balance sheet which meant it could handle commodity price swings.

He also believes there is untapped potential in South32’s starter portfolio “that just haven’t been a focus point” for BHP Billiton.

Over time, Kerr hinted in an interview with London’s Financial Times newspaper two weeks ago that it might even be possible for South32 to outperform its parent.

“If I sit back and say what would you like to see at the end of the next five years, I will be brash enough to say that South32 can deliver leading sector shareholder returns,” Kerr said.

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