The allure of BHP's spun-off vehicle

One of the most striking aspects of the demerger plan BHP Billiton announced this week is how different the profiles of the NewCo spun-off vehicle and the continuing BHP will be.

As my colleague Robert Gottliebsen noted today, the continuing BHP will be a cash-generating machine. Andrew Mackenzie makes it clear in the KGB interview which will be published shortly that he will continue to drive productivity within BHP and that shareholders will be the beneficiaries of the increasing cash flows.

BHP will focus on its existing fabulous basin assets -- its core iron ore, petroleum, copper and coal assets -- eschewing greenfields developments and acquisitions, with one exception.

The Jansen potash project in Canada remains the one big greenfields option play, albeit that Mackenzie appears in no hurry to exercise the option. BHP also has a major brownfields option in the potential Olympic Dam expansion, but again that’s not likely to be exercised in the near term as Mackenzie focuses on lowering costs, increasing production and reducing the capital intensity of its existing assets.

NewCo, by contrast, is likely to be a much more dynamic vehicle with a very different risk/reward profile.

It will start life with virtually no debt, just its lease liabilities, and a suite of what analysts term 'late-cycle' commodities that are only second-tier by comparison with BHP’s basin assets. They are 'BHP quality' assets, only smaller relative to its basin assets.

The base metal, aluminium, manganese and coal assets within NewCo may not generate the margins of BHP’s basin assets, which had earnings before interest, tax, depreciation and amortisation margins of 42 per cent last financial year. However, their average margin of 21 per cent last year and 34 per cent over the past decade (and average EBITDA over the decade of more than $US3 billion) is still attractive.

Because the assets have a late-cycle tilt and because analysts think the cycle is at or near the bottom for the basket of commodities within NewCo (alumina and aluminium, for instance, is showing belated signs of life after a major rationalisation of the supply-side of the sector), it could be regarded as a kind of leverage play on the cycle.

It should, however, be more than that.

NewCo will have the balance sheet and cash flows (more than $US1bn and rising) to withstand any near term shocks. Its designated chief executive, BHP chief financial officer Graham Kerr, will also have a capacity to invest and acquire.

Within BHP, NewCo has been receiving maintenance capital. They are BHP-quality assets that are being well-managed and maintained, but were never going to be given growth capital in a capital-constrained environment where BHP has such high-returning incremental investment options within its basin assets. Left within the existing group, they would have stagnated.

For Kerr, however, the balance sheet NewCo will start out with -- a better balance sheet than any of the mid-sized miners -- will enable him to selectively invest in growth. In assets like Cannington, the world’s largest silver producer and a fabulous mine in its own right, there are said to be a range of projects that would deliver internal rates of return solidly above 20 per cent.

He would also be able to engage in some mergers and acquisitions activity if he wished.

The key differentiator between the profiles of the continuing BHP and NewCo will be the nature of their growth profiles. NewCo ought to have a more aggressive approach.

Given that the nature of the cycles underlying its portfolio are more volatile than BHP’s portfolio, it will be more volatile and arguably carry more latent risk. That ought to mean that it attracts a somewhat different type of investor than the cash-hungry shareholders on BHP’s register today, even though it is intended that it will be a dividend-paying entity.

The proposed demerger, which would take place some time towards the middle of next year, will have some impact on the diversity of BHP’s assets and cash flows.

For the past decade and a half BHP, has pursued a strategy underpinned by its unique diversity, which has enabled it to continuing investing through commodity price cycles and through the financial crisis where its peers weren’t able to.

The strategy was guided and tested by its very sophisticated cash-flow at risk model, which provided it with confidence about the level of its baseline cash flows through virtually any circumstance.

The different character of the NewCo assets raises the question of whether demerging them reduces the degree of diversity within the continuing BHP’s cash flows and therefore increase the risk profile of the business. The NewCo assets may be generating only a bit over $US1bn of cash today but they contributed EBITDA to the group, on average, of about $US3.3bn over the past decade.

Mackenzie made the point that while NewCo might be a large company by ASX standards (at about $US15bn it would be a top 20 company on the ASX) it was quite a small part of BHP's $US200bn market cap. BHP generated $US25 billion of operating cash last financial year.

He believes that BHP has sufficient diversification to maintain its strategies through the cycles through its exposure to iron ore, metallurgical coal, steelmaking, and the oil and gas businesses. It is exposed to the demand for energy and technology through copper as well as food, via potash. 

The petroleum and gas businesses, of course, provide the biggest and least-correlated diversification from BHP’s bulk commodity businesses, while potash would add another significant dimension to the resilience of the portfolio.

Thus, while the BHP portfolio might be more streamlined and focused after the demerger, it still ought to have the same stability of baseline cash flows to enable it to maintain its strategy of continuing to invest, albeit more selectively, regardless of the point within the commodities cycle. It should shift the emphasis within the portfolio to reflect changes in the longer term nature of demand.

In fact, because the post-NewCo BHP (which increased its free cash flows by more than $US8bn last year) won’t have to supply maintenance capital to the assets being set free by the demerger, it will have cleaner and may have larger cash flows at this point in the commodities cycle than if the NewCo assets were retained. It will have effectively only big, high-margin and high-returning assets within its portfolio. 

The two entities will have different investor bases, and not just because of the different asset, risk and potential growth profiles.

The initial backlash against the demerger in the UK was driven by the absence of capital management because BHP wanted to give NewCo a debt-free start while retaining its own balance sheet strength, but more particularly because NewCo won’t be listed in the UK. This will inevitably force large-scale selling by UK institutions and retail investors when the demerger is executed.

With NewCo having a 100 per cent index-weighting on the ASX compared to the dual-listed BHP’s 60 per cent, however, there will be an obvious source of buying to absorb those sales. The differences in scale and profile between NewCo and BHP ought also to attract a different kind of investor to the new entity.

The demerger will not only radically simplify the continuing BHP business but it is going to create a very interesting and potentially dynamic addition to the stock exchange lists.