South32 could be interesting

Far from being the dregs of its famous parent, proposed BHP spinoff South32 looks rather promising.

BHP Billiton (ASX:BHP) released more details of its proposed spin off, dubbed South32, and from early indications it looks like an interesting idea.

Last year BHP made 96% of its profits from just four commodity groups and 19 mines. Hiving off its smaller, less profitable assets into a new business means that management can concentrate on its largest most profitable mines.

The new BHP will produce iron ore, petroleum, copper and metallurgical coal. Its remaining mines will be colossal assets where BHP has control of huge resource rich basins, like Pilbara in WA or the Bowen Basin in QLD. Each asset boasts decades of reserves and stable, generous returns.

The break up of BHP is a significant event in the mining industry. It signals the end of the diversified mining model and, perhaps the beginning of a new profit driven strategy. This is a welcome change from the past 15 years when success was measured by size and output rather than profit and returns to shareholders.

South32, which will include manganese, silver, base metals, aluminum, alumina and coal, will be a significant business, about $12bn worth, and it is more than just waste from its parent.

It will contain some genuinely high quality mines. Worsley alumina is one of the lowest cost alumina producers in the world; the Cannington mine is the worlds largest producer of silver and a significant lead and zince mine; the Australian manganese business is the largest, lowest cost producer of manganese anywhere. These are fine assets that generate high returns.

There are also, however, some lousy assets. The South African coal and magnesium alloy business are low quality and could be divestment options.Imbued with just $700m in debt, South32 will carry little debt but is more likely to be an acquisition target than an acquirer itself.

South32’s mines have been neglected for years. Its reserves base has shrunk from a lack of drilling and BHP has skimped on capital expenditure as it focused cash and attention on is trophy assets.

By lavishing attention on neglected mines, the new miner should improve profitability and rates of return but it will also have to plough more cash into exploration and capital expenditure than BHP has done in the recent past. It will need to deploy its balance sheet on its own mines.

Management has promised to do all this as well as pay generous dividends. It’s unlikely to be able to do both. Despite these concerns the proposed split is an excellent idea and we’ll be looking at it closely once prices are announced. 

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