South32 starts today

Shortly after Eureka Report goes to publication this evening BHP shareholders are set to formally approve South32, a substantial spin-off from the ‘Big Australian', the new company is expected to instantly become an ASX Top 50 stock. So what's the deal?

If all goes to plan BHP Billiton shareholders will get one share in South32 for every share they currently own in the parent company, and be able to trade in the new company from Monday, May 18, on the Australian, London or Johannesburg stock exchanges.

Most BHP Billiton shareholders will be familiar with the story behind South32 and how its name comes from the line of latitude connecting the company's head office in Perth with some of its assets in South Africa.

What's happening now is the start of the formal de-merger process at simultaneous BHP Billiton shareholder meetings in Perth and London.

Almost certainly a formality given the high degree of support from investment banks, fund managers and proxy-vote advisers, the split requires a simple 50 per cent majority vote from the combined tally of shareholders on the Australian and London share registers of BHP Billiton.

Tonight's meetings in Perth and London will be video-linked and conducted simultaneously. The result should be known quickly, but it's also possible that BHP Billiton management will take time with the count to ensure its accuracy.

Once the all-clear is sounded after approval of a remarkably simple 38-word resolution – which is in stark contrast to the 196-page circular and 1355 page information memo explaining the rationale behind the split the way will be cleared for South32 to trade independently – and that's when the real fun should start.

Opening day share price tips for South32 range from $2 to $3.50, a gap so wide that it illustrates the uncertainty over how to value a new business which is actually not a new business because so much is already known about the assets being transferred across from BHP Billiton.

Among the inherited operations there are aluminium and alumina processing plants in Australia, South Africa and Brazil, coal mines in Australia and South Africa, manganese mines in Australia and South Africa, a nickel mine in Colombia, and a silver, lead and zinc mine in Queensland.

All of the assets being transferred are regarded by BHP Billiton as not fitting its future as a simpler business operating fewer but nevertheless giant mines in four sectors: iron ore, oil, copper and coal, with a fifth division, potash, possibly being added later.

Once South32 is liberated it will become one of the most closely watched companies on any stock exchange in the world, not only because it could outperform its parent at certain times of the commodity-price cycle (such as now) but also because of the advantages that most new companies lack, including:

• Spin-off companies, especially those loaded with quality assets, generally do better than the wider market. A recent study of 20 demergers by the investment bank, Morgan Stanley, found that the new businesses outperformed the ASX200 index by 6 per cent in their first year and by 17 per cent after two years.

• In South32's case the assets have all been built to “gold-plated” status by BHP Billiton, a company with a long record of not cutting corners with capital projects. Some of South32's assets fall into the second tier on a global comparison base but the Groote Eylandt manganese mine, the Cannington silver/lead/zinc mine and the Worsley alumina project rated as tier one.

• Assets being transferred at what looks to be close to the bottom of the commodity cycle, and while no-one is tipping a rapid recovery there is also widespread agreement that prices for South32 commodities such as aluminium, coal and manganese will not drift much lower.

• A high level of interest from fund managers, especially some who will be required to top up after South32's listing to balance the funds they manage. Morgan Stanley estimates that funds will be required to buy around 112 million South32 shares given the company's expected position as a top 50 stock on the ASX. The same bank is forecasting that South32 will start life with a market capitalisation of $8.5 billion which implies an opening price of $2.65.

• Starting life with just $US674 million in debt, roughly half what had been expected when the demerger was announced last August.

• Being launched with a skilled management team in place, but with South32's chief executive, Graham Kerr, saying that he will run the assets in a very different way to how they were run when part of BHP Billiton.

• Speculation that South32 will be targeted for a takeover bid early in its life with X2, the comeback vehicle of former Xstrata chief executive, Mick Davis, the prime suspect given that he tried to buy most of the assets in South32 from BHP Billiton before the demerger decision was made, and

• The potential for early additions to earnings from cost cutting that will go well beyond what BHP Billiton has already undertaken.

The biggest negative factor, apart from possible commodity-price swings, is the company's heavy exposure to South Africa where resource nationalism remains a worry for all international investors as the country rebalances its economy through black empowerment laws.

Kerr, in talks with analysts and fund managers during a well-attended four-day tour of South32's Australian assets last week, played down potential problems in South Africa and talked up future earnings and a dividend policy which should see 40 per cent of earnings returned annually to shareholders.

He also talked down the prospect of South32 indulging in corporate activity (takeovers or mergers) in its early life adding that he expects South32 to have a much “nimbler” management structure able to make quicker decisions about assets and costs than when they were under the control of BHP Billiton.

Among the early decisions likely to drive earnings will be the closure of several regional offices and the centralisation of supply operations.

No early decisions are expected at an operational level but assets slated for improvement include a possible extension to the life of the Cannington mine which has just eight years left without a decision to dig deeper, or to develop a small open pit adjacent to the underground development.

Groote Eylandt, one of the world's biggest manganese mines, could also be in for change, including a re-start on exploration to further bolster the resource base and a possible offer to buy out the mine's minority (40 per cent) shareholder, London-based Anglo American.

No changes are expected at South32's biggest and most valuable business, the 86 per cent-owned Worsley alumina refinery south of Perth which sends much of its production to South32's aluminium refineries at Hillside in South Africa and Mozal in Mozambique.

After today's meetings, and after South32 is listed, the new company will rank as one of Australia's top miners, well behind BHP Billiton and Rio Tinto but probably higher than other leaders such as Newcrest and Fortescue.

But, it will also be different to those companies in that its asset composition provides exposure to an interesting combination of bulk materials (coal and alumina), base metals (nickel, zinc, lead and aluminium), and a precious metal (silver).

That is not a combination which will suit all investors, though the balance means South32 should be able to perform well through the commodity cycle with the real test being whether the management team can do a better job with the assets than when they were in BHP Billiton.