Mackenzie's pedal to the metal

Andrew Mackenzie took up the chief executive role at BHP Billiton promising to do more with less. Eighteen months into the role, he’s delivering exactly that – and the results are ahead of expectations.

As with Sam Walsh at Rio Tinto, Mackenzie’s focus has been on lifting volumes from his key assets while reducing costs and the capital intensity of his portfolio, or in his terms, after the massive investments made during the Marius Kloppers era. This has lifted the productivity of the existing asset base.

Mackenzie has achieved the volume gains, with a 10 per cent increase in volume across the portfolio contributing an extra $US1.2 billion in earnings before interest and tax. About $US705 million of the impact of volume increases was attributed to growth projects, but a very significant $US542 million came from working the existing assets harder and generating those sought-after productivity improvements.

He has also pulled $US1 billion out of “controllable” cash costs. BHP says the combination of the productivity gains and cost efficiencies over the past 18 months now amounts to an annualised $US4.9 billion. By financial year-end, they are expected to reach about $US5.5 billion.

The productivity improvements and cost reductions of $US2.2 billion in the December half far out-weighed the impact of lower commodity prices, which stripped $US774 million from EBIT.

The third plank of the agenda was to reduce the amount of new capital invested. A quick look at BHP’s famous ‘bubble’ chart (its project development pipeline) shows there has been a seachange in approach, with the once-dense mass of bubble appearing far less cluttered.

Capital and exploration expenditures were cut by 28 per cent in the half, from $US11 billion to $US7.94 billion. BHP says full-year capital and exploration expenditure is expected to be 25 per cent lower at about $US16.1 million, compared with $US21.7 billion in 2012-13. It will fall further next financial year.

Given the increase in volumes, lower costs and lower investment, it isn’t surprising that BHP generated a massive surge in cash flows (which surged 65 per cent from $US7.2 billion to $US11.86 billion); or that it was able to lift EBIT 15 per cent to $US12.4 billion; and its underlying profit 31 per cent to $US7.8 billion.

The disparity between the rates of growth in cash flow and earnings relates to the $US4 billion of non-cash depreciation and amortisation charges ($US3.4 billion previously). This is a legacy of the expansion spree and the nature of the group’s immature US onshore oil and gas business.

As the more recent projects and the US shale gas business matures and the new capital expenditures shrink, the gap between those growth rates also ought to shrink. If commodity price and exchange rate settings were reasonably stable, the growth in underlying earnings would accelerate.

Shareholders will get a modest US 2 cents a share increase in dividend, in keeping with BHP’s commitment to a ‘progressive’ and sustainable dividend policy. However, like Rio, BHP is focused on strengthening its balance sheet. It expects its net debt of $US27.1 billion to be reduced to about $US25 billion by year-end.

BHP said it was “well-placed to extend our strong record of capital management”. It’s a hint that, if its cash flows continue to swell, it might do something more for shareholders in the near future.

BHP, Rio and their peers are scrambling to unwind the cost inflation that occurred during the resources boom in an environment of lower commodity prices and the prospect of a combination of weaker demand growth and a big increase in supply.

BHP was notably pessimistic about the short-term outlook for iron ore. It said Chinese steel production growth rates were expected to decelerate to levels “considerably below” GDP growth as the economy matures after a period of steel-intensive infrastructure-led growth.

It shares the conviction of many in the market that the big increase in high-quality low-cost supply coming from the Pilbara and Brazil is going to create an over-supplied market. A big fall in iron ore prices would hit Rio, which is almost completely reliant on its iron ore business, harder than the more diversified BHP.

The fixation with costs and capital intensity has lifted BHP’s underlying EBIT margin to 38 per cent and its return on capital to 22 per cent. BHP says the internal competition for capital that is now being rationed will see the average internal rate of return for projects within its diminished project pipeline raised to more than 20 per cent.

Mackenzie has been trying to concentrate the portfolio on its core iron ore, copper, petroleum and coal assets. Asset sales generated $US2.2 billion of cash during the half. He said that continued simplification of the portfolio (more asset sales) would further strengthen the balance sheet.

As with last week’s Rio result, the extent of the productivity gains Mackenzie has been able to extract from the portfolio surprised the market.

There are a myriad of very small decisions that go into improving the productivity of an existing asset. The miners are clearly desperate to take full advantage of the inverting of their relationship with contractors and suppliers – who used to exploit the upper hand in any negotiation – to drive down costs and capital intensity and strip out the boom-time inflation embedded into their operations while they can.

The results of BHP and Rio – and the distress experienced by contractors and engineering groups – says they are succeeding beyond expectations.